CHAPTER 25

Government and Product Markets:
Antitrust and Regulation

Chapter 22 introduced the theory of perfect competition and the workings of the perfectly competitive market. Chapters 23 and 24 dealt with markets that are not perfectly competitive—specifically, with the cases of monopoly, oligopoly, and monopolistic competition. One of the great debates in economic theory and policy concerns whether or not the government should intervene in these noncompetitive market structures and, if so, what form that intervention should take. Chapter 25 addresses this debate, looking at the rationale for government intervention and the various ways that government intervenes in the market, as well as the recent trend toward reducing government intervention in certain markets. Specifically, Chapter 25 discusses the evolution of antitrust law, which aims at dealing with the anti-competitive tendencies of monopolies and other highly concentrated industries. The chapter also discusses regulation of monopolies, regulation of nonmonopolistic markets, and the rationale and recent record of deregulation.

n CHAPTER OBJECTIVES

Upon completing this chapter, you should be able to:

1.Explain the details of various important antitrust laws.

2.Explain why the definition of the market is important to antitrust policy.

3.Explain how antitrust officials gauge competition in a market.

4.Explain the difference between a vertical and horizontal merger.

5.Discuss a few important antitrust cases and actions.

6.Discuss natural monopoly and ways to regulate it.

7.Discuss the various theories of regulation.

8.Identify some of the unintended effects of regulation.

9.Identify some of the unintended effects of  deregulation.

n KEY TERMS
 

n CHAPTER OUTLINE

I.ANTITRUST—A monopoly produces less output, charges a higher price, and causes a welfare loss to society, relative to the perfectly competitive solution for an industry with the same revenue and cost considerations.

As a result, many economists feel that government should take some action to restrict the  behavior and structure of monopolies (and cartels, since they function as monopolies) and the formation of new monopolies and cartels.

In this section we look at ANTITRUST LAW—legislation passed for the purpose of controlling monopoly power and promoting competition. Anti-trust laws focus on changing the behavior and/or the structure of ant-competitive firms. They prohibit mergers and acquiistions that reduce competitionj (structures) and forbid market practices (behavior) that are anticompetitive.

1.The Sherman Act (1890)—The term “antitrust” originated in the era of the Sherman Act. At the time that the act was passed, firms often combined to form trusts.

TRUSTS—combinations of firms that come together to act as a monopolist.

The purpose of the Sherman Act was to “bust” these trusts and was laid out in two provisions:
    (1) “Every contract, combination . . , or conspiracy, in restraint of trade or commerce ... is hereby declared illegal,”
    and (2) “Every person who shall monopolize..., or conspire with other persons  to monopolize any part of trade or commerce . . . shall be guilty...”

2.The Clayton Act (1914)—The Clayton Act made the following business practices illegal when their effects “may substantially lessen competition or tend to create a monopoly”:

a.Price Discrimination—charging different customers different prices for the same product, where the price difference is not related to cost differences.

b.Exclusive Dealings—selling to a retailer on the condition that the retailer not carry any rival products.

c.Tyin Contracts—agreements whereby the sale of one product is conditioned upon the purchase of some other product(s).

d.The Acquisition of Competing Companies’ Stock, if the Acquisition Reduces Competition.

e.Interlocking Directorates—an agreement whereby the directors of one company sit on the board of directors of a competing firm. The Clayton Act prohibited interlocking directorates under all circumstances, regardless of their effect on competition.

1.Does the Definition of the Market Matter?—
a. Should a market be defined broadly or narrowly?
b. Should only actual competitors be considered, or should potential competitors also be included?

The way a market is defined and the number of competitors (real and potential) will significantly affect whether or not a particular firm or merger is found to be a monopoly or an attempt at monopolization.

 
2.Concentration Ratios—Recall from Chapter 23 that a concentration ratio measures the percentage of total sales, revenues, profits, etc., accounted for by thelargest firms in the market. For many years, the four-firm concentration ratio was the “measuring stick” by which the competitiveness of an industry was measured.

The problem with concentration ratios is that they ignore two key considerations:

(1)the presence of foreign competition and

(2)the degree to which market power is dispersed beyond the four (or eight) biggest firms—that is, the total number of firms in the market and their ability to compete with the biggest firms.

3.Innovation and Concentration Ratios—More than half of the productivity gains of the past 50 years have come from innovation and technical change. There is evidence that the larger firms in the modern economy innovate more because the risks to them are lower. Today, the Justice department considers the impact on innovation when it analyzes proposed mergers.

1.HORIZONTAL MERGER—a merger between firms that are selling similar products in the same market.

eg Hewlett Packard - Compaq

 
2.VERTICAL MERGER—a merger between companies in the same industry, but at different stages of the production process.

Newscorp- Hughes

 
3.CONGLOMERATE MERGERS—a merger between companies in different industries.

General Electric Corp and all of their various mergers

The question is: How can we achieve that level of output?

There are two basic options: (1) The Old Monopolist currently producing Q₁ could increase its output  or (2) another firm, the New Competitor, could enter the industry and drive the price down. But actually the new competitor needs a higher price to break even than the monopolist does because of the shape of long run economies of scale (reflected in the Long Run Average Total Cost Curve).

The problem is that if the Old Monopolist is a natural monopoly, it is not in its best interest to increase output, nor will any firm be able to enter the industry and make up the difference between the monopoly’s output and the efficient level of output.

Furthermore, the natural monopolist will charge a higher-than-competitive price  but a price lower than what a small competitor can charge just to break even.

So, it is very difficult or impoosible for new firms to break into industries dominated by a natural monopoly.

As a result, many economists will argue that natural monopolies should be regulated. But how?

B.Regulating the Natural Monopoly
 

1.Price Regulation—One possibility is to regulate price. Specifically, we want to make the price the monopolist charges approximate the competitive price as closely as possible. In order to do this we may use marginal-cost pricing, which requires the monopoly to charge a price equal to its marginal cost.

2.Profit Regulation—A second possibility is to limit the monopolist to zero economic profit, either by taxing all economic profits away or by using average-cost pricing, which requires the monopolist to charge a price equal to average total cost. The rationale is that the monopolist will just break even. (Remember the concept of a normal profit as part of implicit costs as opposed to an economic profit),

The problem here is that the monopolist has no incentive to minimize costs, since it will be allowed to pass all costs on to customers and gains no additional benefit by being cost-efficient.

3.Output Regulation—The third possibility is for government to mandate a quantity of output it wants the natural monopoly to produce. In this way, the government can assure a particular level of output, and the monopolist can gain additional economic profits by lowering its costs.

1.Distorted Incentives—

Any regulation—price, profit, or output—that guarantees zero economic profit for the natural monopoly will reduce the monopolist’s incentives to reduce costs.

Furthermore, the owners of regulated monopolies will have an incentive to use time and otherwise-productive resources in the pursuit of influencing their regulators, which, as we saw with rent seeking, is highly inefficient.

2.Information Problems—Each of the types of regulation we discussed requires information. Three problems arise here:

(1) cost information is not easy to come by, even for the firm itself;

(2)what cost information is available can be “rigged” by the firm; and

What if they don’t?

2.The CAPTURE THEORY OF REGULATION—No matter what the motive for the initial regulation, eventually the agency responsible for the regulation will be “captured” (controlled) by the industry that is being regulated.

As a result, the regulatory measures enacted will be affected by this relationship. There are several reasons to support the capture theory.

First, regulatory agencies are often staffed by former employees of the regulated firm(s).

Second, regulated industries will generally be disproportionately represented at regulatory hearings, since consumers/taxpayers often do not make the effort to attend.

Third, regulated firms will expend substantial resources lobbying their regulators.

    The little stream in Idaho.

I.Deregulation—Using the capture and public choice theories of regulation, economists began arguing that regulation actually promoted and protected market power instead of reducing it. The solution? Deregulate.

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