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REGULATION AND
ANTITRUST LAW
14
CHAPTER
Objectives
After studying this chapter, you will able to
 Explain how government arises from market failure and
redistribution
 Define regulation and antitrust law
 Distinguish between the social interest and capture
theories of regulation
 Explain how regulation affects prices, outputs, profits,
and the distribution of the gains from trade between
consumers and producers
 Describe the antitrust laws and review three of today’s
antitrust policy debates
Social Interest or Special Interests?
Natural monopoly is regulated
But does regulation work in the interest of all—the social
interest—or in the interest of the regulated—special
interests?
Antitrust law restricts the actions of monopolies and blocks
mergers.
Do these laws serve the social interest or special
interests?
The Economic Theory of Government
The economic theory of government explains the purpose
of governments, the economic choices that governments
make, and the consequences of those choices.
Governments exist for two main economic reasons:
To establish property rights and set the rules for the
redistribution of income and wealth.
To provide a non-market mechanism for allocating scarce
resources when the market economy results in
inefficiency—a situation called a market failure.
The Economic Theory of Government
Public choices deal with five economic problems.
 Monopoly and oligopoly regulation
 The provision of public goods
 The use of common resources
 Externalities
 Income redistribution
The Economic Theory of Government
Monopoly and Oligopoly Regulation
Monopoly and oligopoly, and the rent seeking to which
they give rise, prevent the allocation of resources from
being efficient and redistribute the consumer surplus to
producers.
The Economic Theory of Government
Provision of Public Goods
Public goods are goods that are consumed by everyone
and from which no one can be excluded
Examples are national defense, law and order, and
sewage and waste disposal services.
The market economy under produces these goods
because it is impossible to exclude non-payers from
enjoying them—called the free-rider problem.
The Economic Theory of Government
The Use of Common Resources
Some resources are owned by no one and used by
everyone.
Examples are fish in the ocean and the lakes and rivers.
The market economy over uses these resources because
no one has an incentive to conserve them—called the
problem of the commons.
The Economic Theory of Government
Externalities
External costs and benefits are consequences of an
economic transaction between two parties that are borne
or enjoyed by a third party.
A chemical factory that dumps waste into a river that kills
the fish downstream imposes an external cost.
A bank that builds a beautiful office building creates an
external benefit.
External costs and benefits prevent the market allocation
of resources from being efficient.
The Economic Theory of Government
Income Redistribution
The market economy delivers an unequal distribution of
income and wealth.
Progressive income taxes pay for public goods and
redistribute income.
The Economic Theory of Government
Public Choice and the Political Marketplace
Public choice theory applies the economic way of thinking
to the choices that people and governments make in a
political marketplace.
The actors in the political marketplace are:
 Voters
 Firms
 Politicians
 Bureaucrats
The Economic Theory of Government
Figure 14.1 illustrates the
political market place.
Voters and firms are the
“consumers” in the political
marketplace.
Politicians are the
“entrepreneurs” of the
political marketplace.
Bureaucrats are the
producers, or firms, of the
political marketplace.
The Economic Theory of Government
Voters and firms express
their preferences for
publicly provided goods
and services by allocating
their votes, making
campaign contributions,
and lobbying government
decision makers.
They also pay the taxes
that provide the funds that
pay for public goods and
services.
The Economic Theory of Government
The objective of politicians is
to get elected to office and
remain in office.
Votes to a politician are like
profits to a firm, so they
propose policies that they
expect to attract enough
votes to get elected.
Bureaucrats produce the
public goods and services.
The Economic Theory of Government
Political Equilibrium
A political equilibrium is the outcome of the choices of
voters, politicians, and bureaucrats.
It is a situation in which the choices of the three groups are
compatible and no group can improve its own situation by
making a different choice.
Monopoly and Oligopoly Regulation
Government intervenes in monopoly and oligopoly
markets to influence prices, quantities produced, and the
distribution of the gains from economic activity.
It intervenes in two main ways:
 Regulation
 Antitrust laws
Monopoly and Oligopoly Regulation
Regulation consists of rules administered by government
agency to influence economic activity by determining
prices, product standards and types, and the conditions
under which new firms may enter an industry.
Monopoly and Oligopoly Regulation
Antitrust law is law that regulates or prohibits certain
kinds of market behavior, such as monopoly and
monopolistic practices.
Monopoly and Oligopoly Regulation
The Economic Theory of Regulation
The economic theory of regulation of monopoly and
oligopoly is an application of the general theory of public
choice that we’ve just reviewed.
Regulation is influenced by the demands of voters and
firms, the supply by politicians and bureaucrats, and the
equilibrium that balances the two sides of the political
market place.
Monopoly and Oligopoly Regulation
Four main factors influence the demand for regulation:
 Consumer surplus per buyer
 Number of buyers
 Producer surplus per firm
 Number of firms
The greater the potential benefit from regulation, the
greater is the demand for it.
But numbers alone don’t translate to demand. Small wellorganized groups can be more effective than large
unorganized groups.
Monopoly and Oligopoly Regulation
Politicians and bureaucrats supply regulation.
Politicians choose policies that appeal to a majority of
voters.
Bureaucrats support policies that maximize their budgets.
Monopoly and Oligopoly Regulation
Given these objectives, the supply of regulation depends
on three main factors:
Consumer surplus per buyer
Producer surplus per firm
Number of people affected
Monopoly and Oligopoly Regulation
In a political equilibrium, no interest group finds it
worthwhile to use additional resources to press for
changes.
And no group of politician or bureaucrat wants to offer
different regulations.
The political equilibrium might be in the public interest or
private interest.
Monopoly and Oligopoly Regulation
The social interest theory is that regulations are supplied
to satisfy the demand of consumers and producers to
maximize the sum of consumer and producer surplus—to
attain efficiency.
The capture theory is that the regulations are supplied to
satisfy the demand of producers to maximize producer
surplus—to maximize economic profit. In this case,
regulation seeks to maximize profits.
Monopoly and Oligopoly Regulation
Because the public interest and the special interest of the
producer are in conflict, the political process cannot satisfy
both groups in any particular industry.
The highest bidder gets the regulation it wants.
Regulation and Deregulation
The Scope of Regulation
Some of the main agencies are:
 Interstate Commerce Commission.
 Federal Trade Commission.
 Federal Power Commission
 Federal Communications Commission
 Securities and Exchange Commission
 Federal Maritime Commission
 Federal Deposit Insurance Corporation
 Civil Aeronautical Board
 Copyright Royalty Tribunal
 Federal Energy Regulatory Commission.
Regulation and Deregulation
Activities regulated have included interstate railroads,
trucking, buses, water, oil, and gas pipelines, airlines,
electricity, natural gas, broadcasting, telecommunications,
banking and finance.
Regulation reached its peak in the 1970s when about one
quarter of the economy was subject to some type of
regulation.
Since then, deregulation of many industries (including
broadcasting, telecommunications, banking and finance,
and all forms of transportation) has occurred.
Regulation and Deregulation
The Regulatory Process
Regulatory agencies differ in many detailed ways, but all
have features in common:
Each agency is run by bureaucrats who are experts in the
industry it regulates (often recruited from the industry) and
who appointed by the president or by Congress and
funded by Congress.
Each agency adopts a set of rules and practices designed
to control the prices and other aspects of economic
behavior in the industry it regulates.
Regulation and Deregulation
Firms are generally free to their technology and quantities
of inputs.
But they are not free to set their own prices and
sometimes, they are regulated in the quantities they can
sell, and the markets they can serve.
Regulation and Deregulation
Natural Monopoly
Natural monopoly occurs
when one firm can supply
the entire market at a lower
price than two or more firms
can.
Figure 14.2 shows the
demand curve, marginal
cost, MC, curve and
average total cost, ATC,
curve of a natural monopoly.
Regulation and Deregulation
A natural monopoly’s ATC
curve falls throughout the
relevant range of
production so that the
firm’s MC curve is below
its ATC curve when the
MC curve crosses the
demand curve.
Regulation and Deregulation
Regulating in the public
interest—efficient
regulation—is achieved
using the marginal cost
pricing rule, which sets
price equal to marginal
cost: P = MC.
The sum of consumer
surplus and producer
surplus—total surplus in
the figure—is maximized.
Regulation and Deregulation
With marginal cost pricing,
the firm incurs an
economic loss.
Regulation and Deregulation
The firm might be able to cover its economic loss by price
discrimination. An example is the hook-up fee cable TV
companies charge their subscribers.
The government might pay the firm a subsidy.
But the taxes that generate the revenue for the subsidy
create a deadweight loss in other markets.
Regulation and Deregulation
Deadweight loss might be
minimized by allowing the
firm to use the average
cost pricing rule, which
sets price equal to
average total cost.
Figure 14.3 illustrates the
average cost pricing rule.
Regulation and Deregulation
Implementing the marginal cost and average cost pricing
rules is difficult because the regulator doesn’t know the
firm’s cost curves. Two practical rules that regulators use
are:
 Rate of return regulation
 Price cap regulation.
Regulation and Deregulation
Under rate of return regulation, a regulated firm must
justify its price by showing that the price enables it to earn
a specified target percent rate of return on its capital.
The target rate of return is set at that of a competitive
market and with accurate cost observation is this type of
regulation is equivalent to average cost pricing.
Managers have an incentive to use more capital than the
efficient quantity so that total returns increase. They also
have an incentive to inflate depreciation charges and other
costs and deflate reported profits.
Regulation and Deregulation
Figure 14.4 shows the
maximum economic profit
that a firm can earn when
its managers inflate
capital costs under rate of
return regulation.
Regulation and Deregulation
A price-cap regulation is a price ceiling—a rule that
specifies the highest price the firm is permitted to set.
Price cap regulation gives managers an incentive to
minimize cost because there is no limit on the rate of
return they are permitted to earn.
The regulator might set the price cap too high, so pricecap regulation is often combined with earnings sharing
regulation, under which profits that exceed a target level
must be shared with the firm’s customers.
Regulation and Deregulation
Figure 14.5 shows the effects
of price cap regulation.
Unregulated, the monopoly
maximizes profit by producing
the quantity at which MR =
MC.
A price cap is imposed that
enables the firm to earn zero
economic profit.
Regulation and Deregulation
The price cap lowers the price
and increases output.
This outcome contrasts with
that in a competitive market.
In monopoly, the profitmaximizing quantity is less
than the efficient quantity and
the price cap provides an
incentive to increase output to
avoid economic loss.
Regulation and Deregulation
Social Interest or Capture in Natural Monopoly
Regulation?
Whether the social interest theory or the capture theory
best describes how most natural monopoly markets are
regulated is unclear.
A test to determine whether the regulated firm has
“captured” the regulator and influenced regulation to favor
the firm is to compare the rates of return to capital for
regulated industries against that of the rest of the
economy.
Regulation and Deregulation
Higher rates of return are evidence in support of capture
theory of regulation.
Table 14.1 shows the rates of return for regulated
monopolies in the electricity, gas and railroad industries
and compares these rates to the average rate of return for
the overall economy. While there has been some variation
over time, there is no overall trend to show a difference in
rates of return exist between regulated and unregulated
industries.
Regulation and Deregulation
Another test is to study changes in the levels of producer
and consumer surplus following deregulation.
Table 14.2 shows the gains (losses) in producer and
consumer surplus when the railroad, telecommunications
and cable TV industries were deregulated.
These results show that railroad regulation hurt both
producers and consumers, and that regulation in the other
two industries mainly hurt the consumer.
Regulation and Deregulation
Cartel Regulation
A cartel is a collusive agreement among a number of firms
that is designed to restrict output and achieve a higher
profit for cartel members.
Cartels are illegal in the United States and in most other
countries.
A cartel that acts like a monopoly earns maximum
economic profit, but there is a strong incentive for each
member of a cartel to cheat on the cartel arrangement.
Regulation and Deregulation
Figure 14.6 shows two
possible outcomes of
cartel regulation.
If the regulation is in the
public interest, price and
quantity will equal their
competitive levels and the
outcome will be efficient.
Regulation and Deregulation
If the cartel captures the
regulator, it uses regulation
to prevent cheating and
price and output equal
their monopoly levels and
the outcome is inefficient.
Regulation and Deregulation
Public Interest or Capture in Cartel Regulation?
Table 14.3 shows the rates of return on investment for the
airlines and trucking industry as compared to the economy
as a whole.
The returns after deregulation of these industries
decreased considerably and returned to the economy
average.
This evidence supports the capture theory of regulation.
Regulation and Deregulation
Table 14.4 shows the change in consumer and producer
surplus after the airlines and trucking industries were
deregulated.
While consumer surplus increased in both the trucking and
airlines industries, producer surplus decreased in the
trucking industry.
This evidence supports the capture theory of regulation.
Regulation and Deregulation
Making Predictions
Deregulation of many industries occurred in the late 1970s
and arose from three main influences:
Economists have more vocally predicted gains from
deregulation.
The significant hike in energy prices of the early 1970s
increased the cost of regulation borne by consumers.
Technological progress has ended many natural
monopolies through increased competition, especially in
the telecommunications industry.
Antitrust Law
Antitrust law provides and alternative way in which the
government may influence the marketplace.
The Antitrust Laws
The first antitrust law, the Sherman Act, was passed in
1890. It outlawed any “combination, trust, or conspiracy
that restricts interstate trade,” and prohibited the “attempt
to monopolize.”
A wave of merger activities at the beginning of the
twentieth century produced a stronger antitrust law, the
Clayton Act and created the Federal Trade Commission.
Antitrust Law
The Clayton Act was passed in 1914 and made illegal
specific business practices such as price discrimination,
interlocking directorships, and acquisition of a competitor’s
shares if the practices “substantially lessen competition or
create monopoly.”
Table 14.6 summarizes the Clayton Act and its
amendments, the Robinson-Patman Act passed in 1936
and the Cellar-Kefauver Act passed in 1950.
The Federal Trade Commission, formed in 1914, looks for
cases of “unfair methods of competition and unfair or
deceptive business practices.”
Antitrust Law
Three Antitrust Policy Debates
Price fixing is always a violation of the antitrust law.
If the Justice Department can prove the existence of price
fixing, there is no defense.
But some practices are more controversial and generate
debate. Three of them are:
 Resale price maintenance
 Tying arrangements
 Predatory pricing
Antitrust Law
Resale price maintenance
Most manufacturers sell their product to the final consumer
through a wholesale and retail distribution chain.
Resale price maintenance occurs when a manufacturer
agrees with a distributor on the price at which the product
will be resold.
Resale price maintenance is inefficient if it promotes
monopoly pricing.
But resale price maintenance can be efficient if it provides
retailers with an incentive to provide an efficient level of
retail service in selling a product.
Antitrust Law
Tying arrangements
A tying arrangement is an agreement to sell one product
only if the buyer agrees to buy another different product as
well.
Some people argue that by tying, a firm can make a larger
profit.
Where buyers have a differing willingness to pay for the
separate items, a firm can price discriminate and take a
larger amount of the consumer surplus by tying.
Antitrust Law
Predatory pricing
Predatory pricing is setting a low price to drive
competitors out of business with the intention of then
setting the monopoly price.
Economists are skeptical that predatory pricing actually
occurs.
A high, certain, and immediate loss is a poor exchange for
a temporary, uncertain, and future gain.
No case of predatory pricing has been definitively found.
Antitrust Law
A Recent Showcase: The United States Versus
Microsoft
The most recent antitrust case is against Microsoft.
In 1998, a trial began considering the following charges:
Microsoft possesses monopoly power in the market for PC
operating systems and attained that position by exercising
monopoly practices.
Antitrust Law
Microsoft used below-cost pricing (called predatory
pricing) in the market for web browsers by offering its web
browser for free.
Microsoft used tying arrangements to achieve monopoly in
the web browser market.
Tying arrangements are when a seller requires products to
be sold together rather than sold individually, extending its
market power from one market into another market.
Antitrust Law
Microsoft used other anti-competitive practices to
strengthen its monopoly in these two markets.
Some charge that Microsoft enjoys economies of scale
and network economies that create an effective barrier to
entry by competing firms.
But Microsoft counters that although the firm enjoys
monopoly today, it is vulnerable competition from new
operating systems.
Antitrust Law
Additionally, Microsoft claims that incorporating its web
browser software with its operating system software is an
attempt to increase customer value of the operating
system software, rather than using a tying arrangement to
monopolize the browser software market.
Antitrust Law
Merger Rules
The Federal Trade Commission uses guidelines to
determine which mergers to examine and possibly block.
The Herfindahl-Hirschman index (HHI) is one of those
guidelines (explained in Chapter 9).
Antitrust Law
Figure 17.6(a) illustrates
these HHI guidelines.
If the original HHI is less
than 1,000, a merger is not
challenged.
If the original HHI is
greater than 1,000 a
merger might be
challenged.
Antitrust Law
If the original HHI is
between 1,000 and 1,800,
any merger that raises the
HHI by 100 or more is
challenged.
If the original HHI is
greater than 1,800, any
merger that raises the HHI
by more than 50 is
challenged.
Antitrust Law
Figure 17.6(b) shows how
these guidelines were
applied to the carbonated
soft drink industry in 1986
to deny mergers between
Pepsi/7-Up and Coke/Dr.
Pepper.
Antitrust Law
Figure 17.6(b) shows how these guidelines were applied
to the carbonated soft drink industry in 1986 to deny
mergers between Pepsi/7-Up and Coke/Dr. Pepper.
Antitrust Law
Social or Special Interest?
The intent of antitrust law has been to protect consumers
and pursue efficiency, but at times the court interpretation
of these laws has favored the interests of producers.
On balance, the overall thrust seems to have been toward
efficiency.
THE END