Download What is Economics? 1 Chapter 14 regulation and antitrust law 1

C h a p t e r
14
REGULATION AND
ANTITRUST LAW
Chapter Key Ideas
Social Interest or Special Interests?
A. Natural monopoly is regulated by the U.S. Government.
1.
A city water supply, telephone service and cable TV service are often supplied by
regulated natural monopolies.
2.
Does regulation work in the interest of all—the social interest—or in the interest of the
regulated—special interests?
B. Antitrust law restricts the actions of monopolies and blocks some large firms from merging
into one firm.
1.
PepsiCo and 7-Up wanted to merge, as did Coca-Cola and Dr. Pepper. The government
blocked these mergers.
2.
Do these laws serve the social interest or merely satisfy certain special interests?
Outline
I.
The Economic Theory of Government
A. The economic theory of government explains the economic roles of governments, the
economic choices that they make, and the consequences of those choices.
1.
Governments exist for two reasons:
a)
First, they establish and maintain property rights, the foundation of which all
market activity takes place.
b) Second, they provide mechanisms for allocating scarce resources when the market
economy results in inefficiency—a situation called market failure.
2.
In the case of market failure, choices made by consumers or producers are made in selfinterest, but these choices fail to align with the social interest.
a)
Market failure presents the government with an opportunity to correct the inefficient
allocation of resources.
b) Economic analysis can reveal whether these social choices are efficient or
inefficient.
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B. There are many examples of market failure that create the potential for government regulation
to increase efficiency:
1.
Decisions made by firms operating in a monopoly or oligopoly prevent resources from
being allocated efficiently.
2.
The market for public goods creates a free-rider problem because once the good is
provided, everyone can enjoy consuming it without having to pay for it.
a)
Producers are unable to make consumers pay for their level of consumption and so
they under-produce the good.
b) The market process does not motivate these producers to provide sufficient
quantities of the good for an efficient allocation.
3.
A lack of defined property rights makes people’s consumption of common resources
inefficient.
a)
Common resources are resources that are not owned by anyone and yet are used by
everyone.
b) The market fails to make consumers reflect the opportunity cost of consumption in
their choices.
c)
4.
People consume too much of the common resource and the market allocation is not
efficient.
A lack of protection of property rights creates external costs and external benefits.
a)
Externalities are created when production or consumption costs are borne by people
not involved with the production or consumption of the good.
b) The market fails to motivate producers and consumers of goods that generate
externalities to take into account the opportunity cost of their choices on society.
c)
The producers create too much of the good and the allocation of resources in this
market is inefficient.
C. Besides regulating economic behavior of producers and consumers, the government can also
reallocate resources to address concerns about equity.
1.
The government can tax some people and distribute the revenues to others.
2.
This form of income redistribution can only legitimately be performed by the
government, which must make choices.
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D. A government operating within a democratic society can be described and analyzed as a
complex organization making resource allocation decisions in a political marketplace.
1.
Economists have developed a public choice theory of the political market place.
2.
Figure 14.1 shows how the political
marketplace can be described with
four decision making groups
interacting with each other to
produce outcomes.
a)
Voters are the consumers in the
political marketplace who
express their preferences
through voting, campaign
contributions and lobbying
activities, supporting those
policies that they perceive will
make them better off and
opposing those policies that
they perceive will make them
worse off.
b) Firms are also consumers in the
political marketplace that
express the preferences of their
owners through campaign
contributions and lobbying
activities, supporting those policies that they perceive will make them better off and
opposing those policies that they perceive will make them worse off.
c)
Politicians are the entrepreneurs of the political marketplace, seeking votes for reelection by creating policies that garner a majority of voters and campaign
contributions.
d) Bureaucrats are the hired officials that produce goods for the political marketplace,
seeking job security and advancement by maximizing the scope and budget of their
own programs.
3.
Political equilibrium in the market place is the outcome that results from the choices
of the voters, politicians and bureaucrats when all their choices are compatible and no
one group can improve its position by making a different choice.
II. Monopoly and Oligopoly Regulation
A. Government intervenes in monopoly and oligopoly markets in two ways:
1.
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.
2.
Antitrust law is law that regulates or prohibits certain kinds of market behavior, such
as monopoly and monopolistic practices.
B. The economic theory of regulation is a part of the broader theory of public choice. There are
two components to regulation:
1.
Citizens and firms demand regulation that makes them better off.
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a)
Voters and firms express their demand through the political activity of voting,
lobbying, or making campaign contributions.
b) The larger the consumer or producer surplus per voter or firm, or the greater the
number of voters and firms, then the greater will be the demand for regulation by
voters and firms.
2.
Politicians supply regulations that increase campaign contributions and votes.
a)
Regulations that are noticed by and benefit more voters and firms are favored and
supplied by politicians.
b) Regulations which are not noticed by or do not benefit many voters or firms are not
favored or supplied by politicians.
c)
The larger the consumer or producer surplus per voter or firm, or the greater the
number of voters or firms, the greater the supply of regulations produced by
politicians.
C. In a political equilibrium, the regulation produced might be in the social interest or in the
self-interest of the regulation producers.
1.
The social interest theory of regulation maintains that politicians supply the
regulation that achieves an efficient allocation of resources.
a)
Government relentlessly seeks out and identifies deadweight loss.
b) Politicians introduce regulation to eliminate it.
2.
The capture theory of regulation maintains that regulation is in the self-interest of the
producers.
a)
Political organization is a costly activity.
b) Only those groups that stand to gain highly concentrated benefits will organize
politically and try to influence proposed regulations.
c)
The politicians propose regulation with benefits to organized groups and costs that
are dispersed thinly across all citizens.
d) This makes it very unlikely that the voters outside the politically organized group
will be motivated to organize and oppose the regulation.
III. Regulation and Deregulation
A. The Scope of Regulation
1.
Some of the main U.S. government agencies involved in regulation includes:
a)
Interstate Commerce Commission.
b) Federal Trade Commission.
c)
Federal Power Commission
d) Federal Communications Commission
e)
Securities and Exchange Commission
f)
Federal Maritime Commission
g) Federal Deposit Insurance Corporation
h) Civil Aeronautical Board
i)
Copyright Royalty Tribunal
j)
Federal Energy Regulatory Commission.
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2.
Activities regulated have included interstate railroads, trucking, buses, water, oil, and gas
pipelines, airlines, electricity, natural gas, broadcasting, telecommunications, banking
and finance.
3.
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.
B. The Regulatory Process
Regulatory agencies differ in many detailed ways, but all have the following features in
common:
1.
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.
2.
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.
3.
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.
C. Natural Monopoly
A natural monopoly occurs when one firm can supply the entire market at a lower price than
two or more firms can. The government often regulates natural monopolies.
1.
Figure 14.2 shows the demand curve,
MC curve, and ATC curve of a natural
monopoly.
a)
A natural monopoly’s ATC curve
falls throughout the relevant range
of production.
b) The falling ATC curve means that
the firm’s MC curve is below its
ATC curve when the MC curve
crosses the firm’s demand curve.
2.
Figure 14.2 illustrates how regulating in
the social interest can be achieved
using the marginal cost pricing
rule, which forces the monopoly firm
to set its price equal to its marginal
cost, P = MC. There are some
complicating factors to this pricing
rule:
a)
Using this regulatory policy will maximize the sum of consumer and producer
surplus, but the firm incurs an economic loss.
b) The firm might be able to cover its economic loss by employing price discrimination
(see Chapter 12). Another example is for the firm to use a two-part price, such as the
hook-up fee cable TV companies charge their subscribers.
c)
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.
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3.
Figure 14.3 illustrates how the
deadweight loss from the marginal cost
pricing rule might be minimized by
allowing the firm to use the average
cost pricing rule, which sets price
equal to average total cost, P = ATC.
B. Implementing pricing rules is difficult
because the regulator doesn’t know the
firm’s cost curves. Regulators often use two
practical pricing rules:
1.
Rate of return regulation requires a
firm to justify its price by showing that
the price enables it to earn a specified
target percent return on its capital.
a)
The target rate of return is
determined with reference to what
is normal in competitive
industries. This type of regulation
is equivalent to average cost
pricing.
b) However, firm 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 incur other costs for
beneficial amenities that do not
promote efficiency but deflate
reported profits.
c)
2.
Figure 14.4 shows the maximum
economic profit that a firm can
earn when its managers inflate
capital costs under rate of return
regulation.
A price-cap regulation is a price
ceiling—a rule that specifies the
highest price the firm is permitted to
set.
a)
Price cap regulation gives
managers an incentive to minimize
costs because there is no limit on
the rate of return they are
permitted to earn. Figure 14.5
shows the effects of price cap
regulation.
b) The market price equals the cap
price and output is the quantity
demanded at the price cap,
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allowing the firm to earn a normal profit.
c)
This outcome contrasts with that in a competitive market, where a price ceiling
decreases the quantity. A monopoly regulated using a price cap will increase its
output because the price cap replicates the conditions of a competitive market.
d) Price cap regulation is often combined with earnings sharing regulation, so if
the firm’s profits rise above a target level, they must be shared with the firm’s
customers.
C. Whether social interest or capture theory best describes how most natural monopoly markets
are regulated is unclear.
1.
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.
a)
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.
b) While there has been some
variation in rates of return
over time, there is no overall
trend to show a difference in
rates of return exist between
regulated and unregulated
industries.
2.
Another test is to study changes in
the levels of producer and
consumer surplus following
deregulation.
a)
Table 14.2 shows the gains
(losses) in producer and
consumer surplus when the
railroad, telecommunications
and cable TV industries were
deregulated.
b) These results show that
railroad regulation hurt both
producers and consumers, and
that regulation in the other two
industries mainly hurt the consumer.
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D. 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.
1.
A cartel that acts like a monopoly earns
maximum economic profit.
2.
However, there is a strong incentive for
each member of a cartel to cheat on the
cartel arrangement. Figure 14.6 shows
two possible outcomes of cartel
regulation.
a)
If the regulation is in the social
interest, price and quantity will equal
their competitive levels and the
outcome will be efficient.
b) If the cartel captures the regulator, the cartel uses regulation to prevent cheating to
ensure that price and output equal monopoly levels and the outcome is inefficient.
E. Does Cartel Regulation Reflect the Social Interest Theory or Capture Theory?
1.
If the regulation is in the social interest, the rate of return for the industry would not
decline after the industry is deregulated. If the regulated firms capture the regulators,
then the rate of return for the industry would decline after the industry is deregulated.
a)
Table 14.3 shows the
regulated and unregulated
rates of return on investment
for the airlines and trucking
industry as compared to the
economy as a whole.
b) The returns after deregulation
of these industries decreased
considerably and returned to
the economy average.
2.
If the regulation is in the social
interest, consumer surplus for the industry would not increase after the industry is
deregulated. If the regulated firms capture the regulators, then consumer surplus for the
industry would increase after the industry is deregulated.
a)
Table 14.4 shows the change
in consumer and producer
surplus after the airlines and
trucking industries were
deregulated.
b) While consumer surplus
increased in both the trucking
and airlines industries,
producer surplus decreased in
the trucking industry.
REGULATION AND ANTITURST LAW
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F.
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The empirical evidence on which theory of regulation prevails is mixed, but some
industries show evidence that the capture theory of regulation prevails.
Deregulation of many industries occurred in the late 1970s and arose from three main
influences:
1.
Economists have more vocally predicted gains from deregulation.
2.
The significant hike in energy prices of the early 1970s increased the cost of regulation
borne by consumers.
3.
Technological progress has ended many natural monopolies through increased
competition, especially in the telecommunications industry.
IV. Antitrust Law
A. Antitrust law provides an alternative way in which the government may influence resource
allocation in the marketplace.
B. The significant antitrust laws include:
1.
The Sherman Act was the first federal antitrust law and was passed in 1890.
a)
It outlawed any “combination, trust, or conspiracy in restraint of trade.”
b) It also prohibited the “attempt to monopolize.”
2.
A wave of merger activities occurred at the start of the 20th century, motivating
Congress to create a stronger antitrust law in 1914 called the Clayton Act.
a)
It made illegal specific business practices such as price discrimination, being a
director of competing firms, exclusive dealing, tying contracts, and acquisition of a
competitor’s shares if the practices “substantially lessen competition or create
monopoly.”
b) The Clayton Act has had two major amendments:
3.
i.
the Robinson-Patman Act, passed in 1936
ii.
the Cellar-Kefauver Act passed in 1950
The Federal Trade Commission was also formed in 1914 to look for cases of “unfair
methods of competition and unfair or deceptive business practices.”
C. While price fixing between firms is always illegal under antitrust laws, there are other
practices that generate three antitrust policy debates:
1.
Resale price maintenance occurs when a manufacturer agrees with a retail
distributor on the price at which the product will be resold. Is this an efficient
agreement?
a)
It is inefficient if it allows retailers of the goods to operate a cartel and charge the
monopoly price.
b) It is relatively more efficient if it allows the manufacturer to induce dealers to
provide the efficient standard of service in selling the product.
2.
A tying arrangement is an agreement to sell one product only if the buyer agrees to
buy another, different product. Is this an efficient arrangement?
a)
It is inefficient if it allows manufacturers to sell one type of goods that would not
otherwise be profitable.
b) It is relatively more efficient if it allows manufacturers to price discriminate.
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3.
Predatory pricing is setting a low price to drive competitors out of business with the
intention of setting a monopoly price when the competition is gone. Is this an efficient
practice?
a)
It is inefficient in theory if the manufacturer can successfully charge a monopoly
price once the competition is eliminated.
b) However, it is likely to be efficient in practice because unless there is some barrier
to entry, the remaining firm would be unable to charge a monopoly price after the
competition is eliminated.
D. A Recent Showcase: The United States Versus Microsoft
1.
The most recent famous antitrust case was against Microsoft. In 1998, a trial began
considering the following charges:
a)
Microsoft possesses monopoly power in the market for PC operating systems and
attained that position by exercising monopoly practices.
b) Microsoft used predatory pricing in the market for web browsers by offering its web
browser for free.
c)
Microsoft used tying arrangements to achieve monopoly in the web browser market.
d) 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.)
2.
But Microsoft counters that it has not violated antitrust law.
a)
Although Microsoft enjoys monopoly today, it did not use monopolistic practices to
attain that position. It merely survived a highly competitive market for operating
software.
b) Microsoft is still vulnerable to competition from any newly developed operating
systems (there are no real barriers to entry).
c)
3.
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 (innovation), rather than using a tying arrangement to monopolize the
browser software market.
The final court decision found Microsoft not in violation of the anti-trust laws, but it was
ordered to disclose details of its operating systems software to other software developers
so they could more effectively compete against Microsoft.
D. Merger Rules
The Federal Trade Commission uses guidelines to determine which mergers to examine and
possibly block.
1.
The Herfindahl-Hirschman Index (HHI) is one of those guidelines (first introduced in
Chapter 9).
a)
If the original HHI is less than 1,000, a merger is not challenged.
b) If the original HHI is between 1,000 and 1,800, any merger that raises the HHI by
100 or more is challenged.
c)
If the original HHI is greater than 1,800, any merger that raises the HHI by more
than 50 is challenged.
E. Social or Special Interest?
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1.
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.
2.
On balance, the overall thrust seems to have been toward efficiency.
Reading Between the Lines
A news article discusses one aspect of re-importation of drugs: Is it legal for drug companies to restrict
their exports to Canada in order to limit the amount of drugs re-imported back to the United States?
The analysis looks at the market for drugs in Canada and the United States.
New in the Seventh Edition
The sequence of chapters in the seventh edition has changed such that Chapter 14 replaces Chapter 17
in the sixth edition. The Reading Between the Lines examines the market power of pharmaceutical
firms in the United States.
Te a c h i n g S u g g e s t i o n s
1.
2.
Market Intervention: The amazing Federal Register. Get your students to go to Federal
Register Web site at http://www.nara.gov/fedreg/ and click on “Today’s Table of Contents.” They
(and you) will be amazed at the volume and detail of regulatory activity, almost all of which has
an economic dimension and impact.
There is no “free lunch” in regulating firms and industries that embody market power.
Make the issue of industry regulation intriguing for the students by emphasizing the following
countervailing opportunity costs that arise in regulating the firms in those industries that are
creating a market failure:
Emphasize the tension between the potential for efficiency in production inherent with a
natural monopoly and the inefficiency potential from the firm exercising its inherent market
power. Be sure the students understand that economies of scale (or scope) enable the unregulated
natural monopoly to provide products and services at the lowest possible cost. Yet the lack of
competition also enables the firm to increase producer surplus at the expense of consumer surplus
and creates a significant deadweight loss to society. Regulating this firm is the only way to ensure
that the firm exploits economies of scale or scope without exploiting consumer surplus.
Emphasize the tension between a manufacturer who wishes to insure that the consumer is
properly informed of all the characteristics and potential benefits of the product and the
retailer who wishes to minimize the cost of selling the product. Be sure the students understand
that competition can take place within more dimensions than just between firms operating on the
same level of production. Most manufacturers must sell to retailers who can enhance or minimize
the information that consumers find useful when buying a newly available or complex product.
Disallowing tying arrangements can raise consumer surplus by keeping prices lower but it can
lower consumer surplus by keeping consumers ignorant of product characteristics for which they
would voluntarily pay a higher price.
Emphasize the tension between real and imagined concerns over predatory pricing practices.
Be sure that the students understand the limitations of the claim that big businesses routinely price
smaller firms out of the market and then monopolize the market after they have left. To get the
smaller firms to exit, the price that the bigger store charges must be lower than what the smaller
store can maintain with a normal profit.
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
2.
If the larger store is still able to earn a normal profit, it is charging a price higher than ATC.
Barring any barriers to entry, prevent the larger store from offering a lower price decreases
consumer surplus, because the more efficient big store cannot then raise price once the
small stores have left the market.
 If the larger store is unable to earn a normal profit, then it is charging a price lower than
ATC. In theory, it might be able to do so due to its “deep pockets,” which allow it to borrow
money more cheaply to fund such a losing venture. However, its size advantage in the
financial markets is the very same characteristic that hurts its ability to predatory price the
smaller firms out of business. It must lose money on a far greater quantity of goods than the
smaller stores, meaning it will bleed losses at a far higher rate than the smaller stores. If the
larger store were successful in driving out its competitors, and if barriers to entry existed
allowing the large store to raise prices to monopoly levels, it would take a substantial
amount of time to make up for the huge losses incurred. This means that over a long time
period, the firm would earn only normal profit, making predatory pricing a much less
attractive practice that it appears to be in theory.
Emphasize the tension between combining formerly separate goods into a product as a
monopolizing action (tying agreements) and combining goods as a form of technological
advancement to enhance consumer surplus (product innovation). Microsoft’s defense to
antitrust charges alludes to the inevitable combining of web browsers into computer
operating system software to assure consumer satisfaction.
 If Microsoft is truly enhancing its product by incorporating its web browser with its
ubiquitous operating software, breaking up the company would decrease consumer
surplus by slowing product innovation.
 However, if Microsoft is using its market power in one market to leverage market power
in another, more competitive market, allowing Microsoft to continue tying its web
browser to its operating systems software could decrease consumer surplus in the web
browser software market.
Economic Theory of Regulation: Emphasize the tension between social interest theory and
capture theory of regulation.
Point 1: Point out how the political equilibrium is swayed by the consumers or producers
with the most motivation to organize and spend resources influencing the politicians and
bureaucrats supplying the regulation. Because the producers are fewer in number and have a
high concentration of potential benefits, they are easy to organize into a special interest
lobby. The consumers, on the other hand, are much greater in number and can expect only
thinly spread benefits. They are less likely to be well organized and more likely to suffer from
rational ignorance.
Point 2: For regulation to achieve efficiency, both price and rate of return regulation require
accurate knowledge of using industry-specific technology and firm-specific production costs.
The only way the government can adequately assess these issues is to hire former senior
managers from the regulated industries who still have a strong network of connections to
current managers of firms in that industry. This is the classic case of hiring one fox to provide
accurate production data on the other foxes that may or may not be raiding the chicken coop.
How will the social interest theory answer the question, “Who is watching the watchman?”
3.
Regulation and Deregulation: The California power debacle. The special Web feature on this
topic is a ready to go case study with which you can have fun and review the entire section on
pricing rules and their effects.
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The Big Picture
Where we have been
Chapter 14 builds on the student’s understanding of efficiency introduced in Chapter 2 and
elaborated in Chapter 5. It also builds on natural monopoly introduced in Chapter 12 and
oligopoly and cartels introduced in Chapter 13. This chapter uses the tension between social
interest and capture theories to explore the implications of antitrust law, which are elements of the
social choice theory introduced in Chapter 16.
Where we are going
Chapter 14 is the first of three chapters dealing with government intervention in the economy as a
result of market failure. Chapter 15 examines externalities and chapter 16 examines social choice
economic analysis.
O ve r h e a d Tr a n s pa r e n c i e s
Transparency
Text figure
Transparency title
92
Figure 14.1
The Political Marketplace
93
Figure 14.2
Natural Monopoly: Marginal Cost Pricing
94
Figure 14.3
Natural Monopoly: Average Cost Pricing
95
Figure 14.4
Natural Monopoly: Inflating Cost
96
Figure 14.5
Price Cap Regulation of Natural Monopoly
97
Figure 14.6
Collusive Oligopoly
98
Table 14.5
The Sherman Act of 1890
Electronic Supplements
MyEconLab
MyEconLab provides pre- and post-tests for each chapter so that students can assess their
own progress. Results on these tests feed an individualized study plan that helps students
focus their attention in the areas where they most need help.
Instructors can create and assign tests, quizzes, or graded homework assignments that
incorporate graphing questions. Questions are automatically graded and results are tracked
using an online grade book.
PowerPoint Lecture Notes
PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full
summary of the chapter.
PowerPoint Electronic Lecture Notes for students are available in MyEconLab.
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CHAPTER 14
Instructor CD-ROM with Computerized Test Banks
This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual
files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator
Software.
Additional Discussion Questions
1.
Are you an informed consumer-voter? Get the students to appreciate the significant challenge of
becoming an informed voter and successfully influencing the government’s regulatory process to
become more oriented toward the social interest. Point out the level of effort and amount of
resources needed by using the following example:
Example: Would you become well informed on a regulatory issue if it saved you (maybe) about
$1 per textbook? Tell the students that a proposed regulation in the textbook industry could
impact their lives through an increase in the price of textbooks.
Assume the following points:
 College textbook firms are seeking to ban the resale of textbooks by secondary textbook
firms in order to increase the profitability of selling new textbooks.

Some book market experts estimate that textbook prices will not be affected because nearly
all professors adopt the latest edition of the text for their classes anyway (making the last
edition near worthless) and the market trend has been to significantly decrease the time
elapsing between text editions.

But some experts disagree, stating that the trend of shrinking time periods between editions
will reverse itself once the secondary book market is made illegal. These experts estimate that
the average textbook will increase in price by $1.00.
Ask the following questions:
 How would you determine which group of experts to trust? Point out that a rational student
wouldn’t want to expend his or her valuable time and money becoming an informed
consumer voter if there really was nothing to be concerned about in the first place.
 If you found that there was a legitimate concern, how would you find out what to do next?
Point out that it is difficult to even know where to start becoming informed. Search the
internet, newspapers and magazines, watching TV news programs, etc.?
 How would you become organized as an effective group of textbook consumers? How
would you organize your efforts effectively? Perhaps the biggest challenge is to get a
disparate group of students together to act with one voice.
 Who is your federal government representative and how would you reach him or her?
Which government body should you approach with your concerns? It will become obvious
to the class that the average student doesn’t even know the names of their own federal
Congressional representatives, let alone how to go about finding their addresses and actually
contacting them.
 Will your voice be heard? Is it worth the effort and cost for one dollar per textbook? The
students should ultimately see the futility in this effort when they realize that it is easier to
just pay a small increase in textbook fees. Point out that this regulatory issue is only one of
thousands addressed by the federal government each year, meaning that in reality, they are
likely bearing much more in total regulatory costs than just one more dollar per textbook.
2. How would you define market behavior that is an attempt to monopolize the market? Get the
students to appreciate the difficulty in differentiating competitive activities from monopolization
REGULATION AND ANTITURST LAW
357
activities.
 Ask the students to define the market for computer software games. Point out that Microsoft
includes the card game Solitaire on their Windows computer operating system. Ask if
Microsoft is attempting to monopolize the software game industry by exerting their market
power in the computer operating system software market? Ask them to explain why the
inclusion of Microsoft Explorer with Windows should be thought of as monopolizing the web
browser market.
3.
4.

Ask the students to define the market for car audio components. Imagine if General Motors,
Ford, and Chrysler-Mercedes were to all install “free,” high-end car stereo equipment in their
automobiles. Would we want to claim that the “Big Three” are using the barrier to entry in
domestic car manufacturing that arises from their huge economies of scale as a means of
exerting market power in the car audio market?

Ask the students to explain why selling output “below cost” could be thought of as hurting
consumer interests, even in the long run. Point out that the only way a larger firm can drive
out smaller firms from the industry through below-cost-pricing practices is if the large firm is
willing to suffer far more economic losses than the smaller firms (because the larger firm
must sell a much higher level of output per period). The only reason that the small firms
would not be able to withstand extended periods of losses longer than the large firm (which is
bleeding cash more heavily than the smaller firms) is if the financial capital market was
sufficiently biased in favor of larger firms (who are assumed to have deep pockets) to
overcome the larger volume of economic losses the larger firm is suffering.
How does one define the market in order to assess market concentration before and after a
proposed merger? This issue was first addressed in Chapter 12 but is worth reiterating here. Does
the market for personal transportation include just automobiles? Or should it include pick-up
trucks and SUVs? How about motorcycles? What about imports? Point out that the defining line
between within-market products and outside-the-market products is a vast gray area. The broader
the definition, the lower the concentration ratio, and the greater the sense of competition to tame
inefficient monopoly practices.
Is similarity in prices across firms evidence of price fixing or of extremely competitive market
pressures? Ask the students to consider the case of four gasoline stations, one on each corner,
with each charging an identical price per gallon. Ask them how they would distinguish between
the claim that they are acting collusively to raise prices from the claim that they are merely
responding to high competitive pressures that force them all to charge a price equal to average
total cost. Consider the following points:
 If direct comparisons to other gasoline station prices in the city reveal a price premium, this
premium may not be legitimate evidence in support of regulating the gasoline station cartel,
as the price of property on that busy street corner may be higher than property used by other
gas stations, increasing their production costs and the price necessary to maintain normal
profits.

Observing consistent, simultaneous changes in price among all four gas stations is also
insufficient evidence of collusive actions requiring regulation. It may simply reflect high
competitive pressure on each firm to: i) quickly drop prices in the face of decreasing costs
and pass the cost savings to the consumer to avoid losing market share, and ii) reflect the
absence of economic profits, which implies firms cannot steal away market share by delaying
a necessary price increase in the face of rising costs.

Comparing the rates of return on capital for the four firms with that of other gas stations may
be legitimate, although there may be differences in rates of return across gas stations that are
attributable to characteristics unrelated to the business of selling gasoline.
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Answ ers to the Review Quizzes
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1.
1. Governments exist for two reasons: a) they establish and maintain property rights, the
foundation of which all market activity takes place, and b) they provide mechanisms for
allocating scarce resources when the market economy results in inefficiency—a situation called
market failure.
2.
Market failure occurs when the market economy allocates scarce resources inefficiently.
Examples on school campuses include insufficient parking spaces (a common resource
problem), poor quality food services in the dorms (natural monopoly provider), and noise
pollution in the dorms (poorly defined property rights).
3.
The political marketplace where resources are allocated through a democratic system where
voters and firms (who demand policies that provide benefits) interact with politicians (who
supply policies) and bureaucrats (who try to increase the size and scope of their programs).
Demanders pay their suppliers with votes (just voters), campaign donations and lobbying
activity (both voters and firms).
1.
Consumers and producers express their demand for regulation in the political market. Each of
these groups desires the kind of regulation of an industry that furthers their own special
interests. These two groups organize into special interest groups and spend resources getting
out the vote, lobbying, and campaigning for regulations that best further their own interests.
2.
Politicians that supply regulation are trying to appeal to the largest number of voters so as to
achieve or maintain their elected office. Bureaucrats that supply regulation are trying to
maximize their budgets. These objectives may be in conflict with each other, because the
regulation that may maximize a the budget of a bureaucratic department may not be supported
by the special interest group willing to bring the most votes or make the most campaign finance
contributions.
3.
Political equilibrium is when a regulation arises for which no interest group finds it worthwhile
to use additional resources to press for changes and no group of politicians finds it worthwhile
to offer different regulations. According to the social interest theory of regulation, political
equilibrium achieves efficiency—regulations are supplied to satisfy the demand of consumers
and producers to maximize total surplus. The capture theory of regulation predicts that most
regulation is aimed at protecting producers’ interests to the neglect of consumers’ interests.
Industries with large producer surplus per firm and well-organized firms lobby politicians with
campaign finance support. The regulations they seek increase producer surplus and economic
profit at the expense of consumer surplus. Because consumers are numerous and widespread,
they find it too costly to effectively organize a group to defend their interests by lobbying the
politicians on their own behalf.
1.
The Interstate Commerce Commission (ICC) was authorized in 1887 to control prices, routes
and the quality of service of interstate railroads. Additional federal regulatory agencies were
established during the Great Depression in the 1930s, and again in the 1970s. Regulation
reached its peak in the 1970s when about one quarter of the economy was subject to some type
of regulation.
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2.
A natural monopoly that is not regulated produces the quantity that maximizes profit, where
marginal cost equals marginal revenue. It creates a deadweight because price (marginal benefit)
exceeds marginal cost.
3.
The marginal cost pricing rule eliminates inefficiency and forces the monopoly to price at
marginal cost. This rule is difficult to implement because the monopoly incurs a loss. The firm
must receive some subsidy equal to its fixed costs in order to stay in business in the long run.
4.
Rate of return regulation requires the natural monopoly firm to justify its price by showing that
the price enables it to earn only a specified target percent rate of return on its capital. This rate
usually set as the rate of return the firm could expect on its capital under the pressures of a
competitive market. However, managers of the firm have an incentive to use too much capital
needed to boost total returns and to inflate depreciation charges and hide economic profits.
5.
A price-cap regulation imposes a price ceiling on the firm. This regulation gives the managers
an incentive to keep costs under control, because they cannot inflate the price to increase
returns on capital investment. The price cap can be set to generate a normal rate of return on
capital. But the regulators do not know the actual cost curves of the firm and may set the price
high enough to allow the firm to earn an economic profit.
6.
Social interest theory implies that cartel regulation can be used to ensure a competitive
outcome that would increase output and decrease price as compared to the cartel’s profitmaximizing prices and production levels. However, there is evidence that deregulating cartels
has increased consumer surplus. This evidence supports the capture theory of regulation of
cartels.
1.
The four acts of Congress that make up our antitrust law and the years of their enactment are:
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a.
b.
c.
d.
The Sherman Act of 1890
The Clayton Act of 1914
The Robinson-Patman Act of 1936
The Cellar-Kefauver Act of 1950
2.
Price fixing always is a violation of antitrust law, whether or not the act was found to be
harmful to consumers. If the Justice Department can prove the existence of price fixing, a
defendant can offer no acceptable excuse.
3.
Attempts to monopolize an industry are more difficult to define and are a matter of
interpretation by the courts. The “rule of reason” seemed to say that size alone doesn’t
constitute an attempt to monopolize as in the 1920 U.S. Steel case. But the “rule of reason” was
overturned when size did matter as in the 1945 Alcoa case. Even in more recent cases, it is
difficult to predict what the court will define as an attempt to monopolize. Decisions continue
to be divided in this area of the law.
4.
Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at
which the product will be resold. Resale price maintenance agreements are illegal but reseal
price maintenance guidance is not illegal. Resale price maintenance can create inefficiency if it
allows the manufacturer to set the monopoly price for its product. However it can create
efficiency when it enables manufacturers to induce resellers to give the efficient level of sales
service for the product.
Tying arrangements occur when the seller agrees to sell one product to a buyer only if the
buyer also buys another product. Tying can sometimes allow the producer to price discriminate
and increase its profit. Tying arrangements can be illegal under the Clayton Act.
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Predatory pricing is setting a low price to drive competitors out of business in order to then set
a high, monopoly price. If predatory pricing occurs, it can lead to monopoly but economists are
skeptical that it occurs often because the firm trades off a sure loss for an uncertain future
profit.
5.
A merger is likely to be approved by the Justice Department as long as the merger does not
raise the HHI index above 1,000 points. If it raises the HHI to a level between 1,000 and 1,800,
the merger would generate a “moderately concentrated industry” by FTC definitions, and the
merger would be approved only if it raises the HHI index by a small number of points (50 to
100 points).
REGULATION AND ANTITURST LAW
361
Answ ers to the Problems
1.
a.
b.
c.
2.
a.
b.
c.
3.
a.
b.
c.
d.
e.
4.
a.
b.
The price is 30 cents a bottle.
Elixir Springs is a natural monopoly. It produces the quantity that makes marginal revenue
equal to marginal cost, and it charges the highest price it can for the quantity produced. The
marginal revenue curve is twice as steep as the demand curve, so it runs from 50 on the y-axis
to 1.25 on the x-axis. Marginal revenue equals marginal cost at 1 million bottles a year. The
highest price at which Elixir can sell 1 million bottles a year is 30 cents a bottle, read from
the demand curve.
Elixir Springs sells 1 million bottles a year.
Elixir maximizes producer surplus.
If Elixir maximizes total surplus, it would produce the quantity that makes price equal to
marginal cost. That is, it would produce 2 million bottles a year and sell them for 10 cents a
bottles. Elixir is a natural monopoly, and it maximizes its producer surplus.
The price is 60 cents a bottle.
Cascade Springs is a natural monopoly. It produces the quantity that makes marginal revenue
equal to marginal cost, and it charges the highest price it can for the quantity produced. The
marginal revenue curve is twice as steep as the demand curve, so it runs from 100 on the yaxis to 500 on the x-axis. Marginal revenue equals marginal cost at 400,000 bottles a year.
The highest price at which Cascade can sell 400,000 bottles a year is 60 cents a bottle, read
from the demand curve.
Cascade Springs sells 400,000 bottles a year.
Cascade maximizes producer surplus.
If Cascade maximizes total surplus, it would produce the quantity that makes price equal to
marginal cost. That is, it would produce 800,000 bottles a year and sell them for 20 cents a
bottles. Cascade is a natural monopoly, and it maximizes its producer surplus.
The price is 10 cents a bottle.
Marginal cost pricing regulation sets the price equal to marginal cost, 10 cents a bottle.
Elixir sells 2 million bottles.
With the price set at 10 cents, Elixir maximizes profit by producing 2 million bottles—at the
intersection of the demand curve (which shows price) and the marginal cost curve.
Elixir incurs an economic loss of $150,000 a year.
Economic profit equals total revenue minus total cost. Total revenue is $200,000 (2 million
bottles at 10 cents a bottle). Total cost is $350,000 (total variable cost of $200,000 plus total
fixed cost of $150,000). So Elixir incurs an economic loss of $150,000 (a revenue of
$200,000 minus $350,000).
Consumer surplus is $400,000 a year.
Consumer surplus is the area under the demand curve above the price. Consumer surplus
equals 40 cents a bottle (50 cents minus 10 cents) multiplied by 2 million bottles divided by
2, which is $400,000.
The regulation is in the social interest because total surplus is maximized. The outcome is
efficient.
The outcome is efficient because marginal benefit (or price) equals marginal cost. When the
outcome is efficient, total surplus is maximized.
The price is 20 cents a bottle.
Marginal cost pricing regulation sets the price equal to marginal cost, 20 cents a bottle.
Cascade sells 800,000 bottles.
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c.
d.
e.
5.
a.
b.
c.
d.
e.
6.
a.
b.
c.
d.
With the price set at 20 cents, Cascade maximizes profit by producing 800,000 bottles—at
the intersection of the demand curve (which shows price) and the marginal cost curve.
Cascade incurs an economic loss of $120,000 a year.
Economic profit equals total revenue minus total cost. Total revenue is $160,000 (800,000
bottles at 20 cents a bottle). Total cost is $280,000 (total variable cost of $160,000 plus total
fixed cost of $120,000). So Cascade incurs an economic loss of $120,000 (a revenue of
$160,000 minus $280,000).
Consumer surplus is $320,000 a year.
Consumer surplus is the area under the demand curve above the price. Consumer surplus
equals 80 cents a bottle (100 cents minus 20 cents) multiplied by 800,000 bottles divided by
2, which is $320,000.
The regulation is in the social interest because total surplus is maximized. The outcome is
efficient.
The outcome is efficient because marginal benefit (or price) equals marginal cost. When the
outcome is efficient, total surplus is maximized.
The price is 20 cents a bottle.
Average cost pricing regulation sets the price equal to average total cost. Average total cost
equals average fixed cost plus average variable cost. Because marginal cost is constant at 10
cents, average variable cost equals marginal cost. Average fixed cost is total fixed cost
($150,000) divided by the quantity produced. For example, when Elixir produces 1.5 million
bottles, average fixed cost is 10 cents, so average total cost is 20 cents. The price at which
Elixir can sell 1.5 million bottles a year is 20 cents a bottle.
Elixir sells 1.5 million bottles.
Elixir makes zero economic profit.
Economic profit equals total revenue minus total cost. Total revenue is $300,000 (1.5 million
bottles at 20 cents a bottle). Total cost is $300,000 (1.5 million bottles at an average total
cost of 20 cents). So Elixir makes zero economic profit.
Consumer surplus is $225,000 a year.
Consumer surplus is the area under the demand curve above the price. Consumer surplus
equals 30 cents a bottle (50 cents minus 20 cents) multiplied by 1.5 million bottles divided by
2, which is $225,000.
The regulation creates a deadweight loss, so the outcome is inefficient. The regulation is not
in the social interest.
The price is 40 cents a bottle.
Average cost pricing regulation sets the price equal to average total cost. Average total cost
equals average fixed cost plus average variable cost. Because marginal cost is constant at 20
cents, average variable cost equals marginal cost. Average fixed cost is total fixed cost
($120,000) divided by the quantity produced. For example, when Cascade produces 600,000
bottles, average fixed cost is 20 cents, so average total cost is 40 cents. The price at which
Cascade can sell 600,000 bottles a year is 40 cents a bottle.
Cascade sells 600,000 bottles.
Cascade makes zero economic profit.
Economic profit equals total revenue minus total cost. Total revenue is $240,000 (600,000
bottles at 40 cents a bottle). Total cost is $240,000 (600,000 bottles at an average total cost of
40 cents). So Cascade makes zero economic profit.
Consumer surplus is $180,000 a year.
REGULATION AND ANTITURST LAW
e.
7.
a.
b.
c.
d.
8.
a.
b.
c.
d.
9.
363
Consumer surplus is the area under the demand curve above the price. Consumer surplus
equals 60 cents a bottle (100 cents minus 40 cents) multiplied by 600,000 bottles divided by
2, which is $180,000.
The regulation creates a deadweight loss, so the outcome is inefficient. The regulation is not
in the social interest.
The price is $500 a trip, and the quantity is 2 trips a day.
Regulation in the social interest is marginal cost pricing. Each airline charges $500 a trip and
produces the quantity at which price equals marginal cost. Each airline makes 1 trip a day.
The price is $750 a trip, and the number of trips is 1 trip a day (one by each airline on
alternate days).
If the airlines capture the regulator, the price will be the same as the price that an unregulated
monopoly would charge. An unregulated monopoly produces the quantity and charges the
price that maximizes profit—that is, the quantity that makes marginal revenue equal to
marginal cost. This quantity is 1 trip a day, and the highest price that the airlines can charge
for that trip (read from the demand curve) is $750.
Deadweight loss is $125 a day.
Deadweight loss arises because the number of trips is cut from 2 to 1 a day and the price is
increased from $500 to $750. Deadweight loss equals (2 minus 1) trip multiplied by ($750
minus $500) divided by 2. Deadweight loss is $125 a day.
If there are only a few large producers and many consumers, public choice theory predicts
that regulation will protect the producer’s interest and politicians will be rewarded with
campaign contributions. But if there is a significant number of small producers with large
costs or if the cost of organizing consumers is low, regulation will be in the social interest.
The price is 5 cents a call, and the number is 500 calls a day.
Regulation in the social interest is marginal cost pricing. Each telephone company charges 5
cents a call and produces the quantity at which price equals marginal cost. Each phone
company produces 250 calls a day.
The price is 17.5 cents a call, and the number of calls is 250 a day. Each phone company
produces 125 calls a day.
If the telephone companies capture the regulator, the price will be the same as the price that
an unregulated monopoly would charge. An unregulated monopoly produces the quantity that
maximizes profit—that is, the quantity that makes marginal revenue equal to marginal cost—
and charges the highest price (read from the demand curve). The quantity that maximizes
profit is 250 calls a day, and the highest price that the telephone companies can charge for
250 calls (read from the demand curve) is 17.5 cents a call.
Deadweight loss is $15.625 a day.
Deadweight loss arises because the number of calls is cut from 500 to 250 a day and the price
is increased from 5 cents to 17.5 cents. Deadweight loss equals (500 minus 250) calls
multiplied by (17.5 cents minus 5 cents) divided by 2. Deadweight loss is $15.625 a day.
Whether the regulation will be in the social interest or the producer interest will depend on
which regulation will generate the more votes or campaign contributions for the politicians. If
the producer demand for regulation offers the politicians the greater return, the regulation
will be in the producer interest. But if consumers’ votes will give the politicians the greater
return, the regulation will be in the social interest.
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. Antitrust law regulates or prohibits price fixing and the attempt to monopolize.
Regulation applies mainly to natural monopoly and antitrust law to oligopoly. Regulation of
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electric utilities is an example of regulation. The ruling against Microsoft is an example of the
application of the antitrust law.
10. The first part of the Sherman Act, which outlaws all forms of price-fixing, has been applied
consistently and firmly. The second part of the Sherman Act, which outlaws attempts to
monopolize, has been applied with varying degrees of firmness. Price fixing is clear, easy to
define, and once discovered, clearly violates the Act. Attempts to monopolize are vague and
varied, hard to define, and ambiguous even when detected. This difference in the clarity of the
violation probably accounts for the difference in the way the law has treated the two parts of the
Act.
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