18 Limiting Market Power Regulation and Antitrust The

18 Limiting Market Power: Regulation and Antitrust. . . The one law you can’t repeal is supply and demand. WILLIAM SAFIRE, NEW YORK TIMES, JULY 13, 1998

Contents ● The Public Interest Issue: Monopoly Power Versus Mere Size ● Part 1: Regulation ♦ What is Regulation and Who Regulates What? ♦ Some Objectives of Regulation ♦ Two Key Issues That Face Regulators ♦ The Pros and Cons of “Bigness” ♦ Deregulation Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Contents (continued) ● Part 2: Anti-Trust Laws and Policies ♦ The Public Image of Business When Anti-Trust Laws Were Born ♦ Measuring Market Power: Concentration ♦ A Crucial Problem for Anti-Trust ♦ Mergers and Competition ♦ Use of Antitrust Laws to Prevent Competition Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Part I: Regulation

The Public Interest Issue: Monopoly Vs Mere Size ● Firms that possess monopoly power may threaten the public interest. ● The abuse of monopoly power is undesirable because: ♦ High prices reduce the wealth of consumers. ♦ High prices lead to resource misallocation. ♦ Efficiency and innovation may be stifled. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Public Interest Issue: Monopoly Vs Mere Size ● But firms that are big do not necessarily have power Howmarket and Why Did Regulation Arise? ♦ oligopoly market ♦ easy entry Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

What Is Regulation and Who Regulates What? ● Regulation: government agencies that enforce rules about business conduct enacted by Congress ● Types of government regulation of industry ♦ Limiting market power ♦ Promoting consumer and worker protection and safety Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

What Is Regulation and Who Regulates What? ● Federal Communications Commission: broadcasting and telecommunications ● Federal Energy Regulatory Commission: interstate transmission of electric power and sale of natural gas ● Securities and Trade Commission: sales of securities ● Federal Reserve System: banking Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Some Objectives of Regulation ● Control of market power resulting from economies of scale and scope ● The pricing of “bottleneck” facilities and the parity-pricing principle ● Universal service and rate averaging Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Price and Cost per Unit FIGURE 18 -1 Economies of Scale $7 B A 5 P AC 3 MC 0 50 100 Quantity Produced per Year Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Two Key Issues That Face Regulators ● Prices intended to promote the public interest may cause financial problems for firms. ● How to prevent firms with monopoly power from earning excessive profits without eliminating all incentives for efficiency and innovation Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Two Key Issues That Face Regulators ● Marginal versus Average Cost Pricing ● In many regulated industries, firms would go bankrupt if P = MC because: ♦ Many exhibit significant economies of scale. ♦ In industry with economies of scale, long-run average cost curve is downward sloping. ♦ If average cost is declining, marginal cost must be below average cost. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Two Key Issues That Face Regulators ● Marginal versus Average Cost Pricing ♦ Setting price equal to average cost is also problematic, especially for a multi-product firm. ♦ The Ramsay pricing rule is a regulatory solution. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Two Key Issues That Face Regulators ● Preventing Monopoly Profit but Keeping Incentives for Efficiency and Innovation ♦ When regulators control profits, they face the danger of removing the useful incentive effects of profits. ♦ The existence of regulatory lag may offer some incentive for efficiency. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Two Key Issues That Face Regulators ● Price Caps as Incentives for Efficiency ♦ An adjusting price cap is a way of controlling profits yet retaining some of the incentive effects of profits. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Pros and Cons of “Bigness” ● Bigness in industry may benefit the general public: ♦ Economies of large size: where small-scale operation is inefficient ♦ Required scale for innovation Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Deregulation ● Effects of Deregulation ♦ Effects on prices: generally lower prices ♦ Effects on local services: some communities have been hurt, some have gained ♦ Effects on entry: many new competitors Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Deregulation ● Effects of Deregulation ♦ Effects on unions: unions have been hurt ♦ Effects on concentration and mergers: many mergers following deregulation ♦ Effects on product quality: “no frills” services have become common Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Deregulation ● Effects of Deregulation ♦ Effects on safety: no change ♦ Effects on profits and wages: profits and wages have been depressed ♦ Conclusion: Deregulation has helped some and hurt others, but, in general, it has promoted the welfare of consumers. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

18 -2 A “Hub and Spoke” Airline Routing Pattern FIGURE E F A H B D C Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

18 -3 U. S. Airline Accident Rates, 1960 -2000 FIGURE 2. 0 Rate per 100, 000 Depar tures 1. 8 1. 6 1. 4 All Accidents 1. 2 1. 0 0. 8 Deregulation (1978) 0. 6 0. 4 Fatal Accidents 0. 2 0 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Part 2: Antitrust Laws and Policies

The Antitrust Laws ● The Sherman Act (1890) ● The Clayton Act (1914) ● The Federal Trade Commission Act (1914) ● The Robinson-Patman Act (1936) ● Celler-Kefauver Antimerger Act (1950) Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

TABLE 18 -1 Basic Antitrust Laws Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Antitrust Laws ● The Sherman Act ♦ “Per Se” Issues: courts have consistently held that price fixing among competitors is illegal Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Antitrust Laws ● The Sherman Act ♦ Rule of Reason: Courts have developed different and varying standards for deciding when large companies have illegally: ■ Monopolized trade ■Engaged in tacit collusion ■Used predatory pricing ♦ According to the “rule of reason, ” size alone is not an offense. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Antitrust Laws ● The Clayton Act ♦ Prohibited price discrimination in restraint of trade ♦ Prohibited tying contracts ♦ Prohibited stock purchases that reduced independence ♦ Prohibited interlocking directorates Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Antitrust Laws ● The Federal Trade Commission Act ♦ The FTC was created to investigate “unfair” and “predatory” competitive practices. ♦ In 1938, the FTC was also charged with preventing false and deceptive advertising. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Antitrust Laws ● The Robinson-Patman Act ♦ Sought to protect small wholesale and retail firms from the “unfair competition” of chain stores and mass distributors Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Measuring Market Power: Concentration ● Concentration: Definition and Measurement —The Herfindahl-Hirschman Index ♦ Four-firm concentration ratio ■% of industry’s output produced by four largest firms ■ a common, but flawed, measure of concentration. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Measuring Market Power: Concentration ● Concentration: Definition and Measurement —The Herfindahl-Hirschman Index ♦ The Herfindahl-Hirschman Index is a more accurate measure of industry concentration and is used by the Department of Justice in analyzing potential mergers. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

18 -2 Concentration Ratios and H-H Indexes TABLE Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Measuring Market Power: Concentration ● Concentration: Definition and Measurement ♦ Three conclusions are widely accepted: ■If an industry has a very low concentration ratio, then its firms are very unlikely to have any market power either before or after the rise in concentration. ■If circumstances in the industry are favorable for successful price collusion, a rise in concentration will facilitate market power. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Measuring Market Power: Concentration ● Concentration: Definition and Measure ♦ Three conclusions are widely accepted (cont’d): ■Where the market is highly contestable, market power will not be enhanced because an excessive price will attract new entrants who will soon force the price down. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Measuring Market Power: Concentration ● Evidence on Concentration in Reality ♦ The concentration of industry has not increased in the United States in the twentieth century. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

18 -3 The Trend in Concentration in Manufacturing TABLE Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

A Crucial Problem for Antitrust ● It is often a challenge for the antitrust authorities to distinguish between vigorous competition and acts that undermine competition and support monopoly power. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Anti-Competitive Practices and Antitrust ● Predatory pricing = pricing that threatens to keep a competitor out of the market ♦ One principle widely followed by the courts holds that prices are predatory only if they are below either marginal or average variable costs. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Anti-Competitive Practices and Antitrust ● Even in cases where prices are below MC or AVC, predatory only under two conditions: ♦ If evidence that the low price would have been profitable only if it succeeded in destroying a rival or in keeping it out of the market. ♦ If a real probability that the allegedly predatory firm could raise prices to monopoly levels after the rival was driven out. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Anti-Competitive Practices and Antitrust ● There have been many predatory pricing cases, but few convictions. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Microsoft: Bottlenecks, Bundling, & Network Extern. ● Bottlenecks ♦ MS Windows, an operating system that runs about 90 percent of all personal computers, is a prime example of a bottleneck. ■Microsoft itself supplies not only Windows, but also many applications. ♦ The worry is that Microsoft will use Windows in a way that favors its own programs and handicaps competing programs. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Microsoft: Bottlenecks, Bundling, & Network Extern. ● Bundling ♦ Computer manufacturers receive a discount if they buy a bundle of Microsoft programs, not just Windows alone. ■This means that rival producers of applications have a price disadvantage in selling their products to PC owners. ♦ The question: is Microsoft’s low bundle price legitimate or constitutes a case of predatory pricing to destroy competitors. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Mergers and Competition ● Horizontal Mergers ♦ The merging firms compete directly by supplying products that are identical or very similar ♦ Reviewed by both the Department of Justice and the Federal Trade Commission to prevent mergers that would reduce competition Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Mergers and Competition ● Recent Surges in Merger Activity ♦ Since the early 1980 s, more permissive merger guidelines have lead to a significant increase in merger activity that continues today. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Mergers and Competition ● Are Mergers Anti-Competitive? ♦ Mergers sometimes reduce competition, particularly in markets that are not contestable. ♦ However, where there is reason to believe that mergers will not reduce competition, mergers may lead to greater efficiency. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Mergers and Competition ● Do Mergers Improve Performance? ♦ The evidence here is mixed. ♦ Several mergers have been disappointing and brought limited cost savings. ♦ Still, a number of recent studies of merger activity during the 1980 s has reported significant productivity. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Use of Antitrust Laws to Prevent Competition ● A serious concern is the potential misuse of the antitrust laws to prevent competition. ● Firms that try to protect themselves in this way always claim that their rivals have not achieved success through superior ability but, rather, by means that they call “monopolization. ” Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Use of Antitrust Laws to Prevent Competition ● Various steps have been suggested to deal with the misuse of U. S. antitrust laws: ♦ Implementation of a “loser pays the legal costs” rule ♦ Prescreening of suits by a government agency Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Use of Antitrust Laws to Prevent Competition ● Anything that restricts anti-competitive, private antitrust suits will almost certainly also inhibit legitimate attempts by individual firms to defend themselves from genuine acts of monopolization by rival enterprises. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

Concluding Observations ● Most economists believe that by the 1970 s government intervention had clearly gone too far in some respects and that deregulation was, thus, in the public interest. ● However, the general issue is still open to considerable debate. Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.