Chapter 15

Economic Regulation
and Antitrust Policy
 Types of Government Regulation
• Market power
– Raise the price
• without losing all sales to rivals
– Firms
• downward-sloping demand curve

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 Types of Government Regulation
• Government regulations
– Social regulations
• Improve health and safety
– Economic regulations
• Control: price, output, entry of new firms, quality of
service
– Desirable monopolies
• Control natural monopolies
– Antitrust policy
• Outlaws monopolies and cartels

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 Regulating a Natural Monopoly
• Natural monopoly
– Downward-sloping LRAC curve
• Unregulated profit maximization
– MR=MC
– Economic profit
– Consumer surplus
– P>MC, higher social welfare if output
expanded
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 Regulating a Natural Monopoly
• Government
– Increase social welfare
– Lower P, expand Q
• Public utilities
– Government-owned monopoly
– Government regulated monopoly

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 Regulating a Natural Monopoly
• Setting P=MC
– Where D intersects MC
– Higher consumer surplus
– Monopolist: economic loss
– In long-run: monopolist exits the market
– Needs subsidizing

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 Regulating a Natural Monopoly
• Subsidizing the natural monopolist
– Government covers the loss
– Firm: earn normal profit
– Drawback: government must raise taxes,
forgo public spending
• Setting P=average cost
– ‘Fair return’: normal profit
• Stay in business without a subsidy
– Higher social welfare (than unregulated)
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 Regulating a Natural Monopoly
• Setting P=MC or P=average cost
– Reduce P
– Increase output
– Erase economic profit
– Increase consumer surplus
– Increase social welfare

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 Regulating a Natural Monopoly
• The regulatory dilemma
– If p=MC
• Socially optimal allocation of resources
– Marginal benefit=MC
• Monopolists: loss
• Requires government subsidy
– If p=average cost
• Monopolist: normal profit
• No socially optimal allocation

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 Exhibit 1
Regulating a natural monopoly
a Natural monopoly maximizes profit: MR=MC,
per trip

q=50, p=$4. Inefficient: p>MC.

Dollars

Demand
Efficient output rate: set p=$0.50, then
q=105 efficient outcome. But the firm:
$4.00 c b economic loss; requires subsidy.

Profit Alternative: set p=$1.50;

then q=90, the firm breaks
2.50
even (p=average cost);
1.50 h g earns normal profit.
1.25 LRAC
f Loss e
0.50 Long-run MC
MR
0 50 90 105 Trips per month (millions)

Social welfare could still be increased by expanding output as long as the

price >MC; but that would result in an economic loss, requiring a subsidy.
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 Alternative Theories: Econ.
Regulation
• Economic regulation
– Public interest, promotes social welfare
– Special interest of producers
• ‘Capture theory of regulation’
• Producer groups
– Expect to gain
– Persuade public officials to impose restrictions
• Consumers have no special interest
• Reduce competition
• Increase prices
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 Airline regulation and deregulation
• 1938 Civil Aeronautics Board
– Regulated interstate airlines
– 40 years: No new interstate airline
– Fixed prices among the 10 major airlines
– Blocked new entry
– Labor unions
• Higher wages
• Pilots worked 2 weeks/month
– High price 12
 Airline regulation and deregulation
• 1978 Deregulation
– Price competition
– New entry
– Price: one quarter below regulated price
– More efficient airlines
– FAA regulates quality and safety
• Accident rates declines by 10-45%
• More people fly (passenger miles tripled)

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 Airline regulation and deregulation
• Fierce competition
• Mergers
• Disappeared
• Bankrupt
• Lower wages
• Lower fares
• More flights
• Saving lives

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 Antitrust Law and Enforcement
• Antitrust policy
– Reduce anticompetitive behavior
– Promote competition
• Origins of antitrust policy
– Developments
• Technology: economies of scale
• Railroad: reduced transport costs
• Bigger firms, wider markets

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 Origins of Antitrust Policy
• 1873-1883 sharp economic decline
– Competing firms formed a trust
• Sugar, tobacco, oil industries
• Widespread criticism
• Sherman antitrust act of 1890
– Trusts, restraint of trade, monopolization
• Clayton act of 1914
– Price discrimination, tying contracts,
exclusive dealing

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 Origins of Antitrust Policy
• Federal trade commission act of 1914
– Federal trade commission
– Enforce antitrust laws
• Cellar-Kefauver anti-merger act
– Horizontal mergers
– Vertical mergers

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 Antitrust Enforcement
• Antitrust division of the US Justice
Department
• FTC
• Consent decree
• Court trial
• Judge decides

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Per Se Illegality and Rule of Reason
• Per se illegal
– Illegal regardless of the economic
rationale or consequences
– Firm’s behavior
• Rule of reason
– Reasons and its effect on competition
– Firm’s behavior
– Market structure
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 Mergers and Public Policy
• Antitrust division and FTC
– Approve/deny mergers and acquisitions
– Herfindahl-Hirschman Index HHI
• Sales concentration
• Horizontal mergers
– Firms in the same market
• Nonhorizontal mergers
– Challenged mergers if
• Post-merger HHI>1800
• Merger increases HHI by >100 points
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Exhibit 2
Herfindahl-Hirschman Index (HHI) based on market share in three industries

Industry I Industry II Industry III

Market Market Market Market Market Market
Share Share Share Share Share Share
Firm (%) Squared (%) Squared (%) Squared
A 23 529 15 225 57 3,249
B 18 324 15 225 1 1
C 13 169 15 225 1 1
D 6 36 15 225 1 1
Remaining
40 firms 1 each 40 1 each 40 1 each 40

HHI 1,098 940 3,292

Each of the three industries has 44 firms. The HHI is found by squaring each
firm’s market share then summing the squares. Only the market share of the
top four firms differ across industries; the remaining 40 firms have 1% market
share each. 21
The HHI for Industry III is nearly triple that for each of the other two industries.
Exhibit 3
U.S. merger waves in the past century

Wave Years Dominant type Examples Stimulus

of merger
First 1887-1904 Horizontal U.S. Steel, Span national
Standard Oil markets

Second 1916-1929 Vertical Copper refiner Stock market

with fabricator boom

Third 1948-1969 Conglomerate Litton Industries Diversification

Fourth 1982- Horizontal Banking, tele- Span national

present and vertical communications, and global
health services, markets, stock
insurance market boom

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 Merger Waves
• First wave
– Technological progress in transportation,
communication, and manufacturing
• Second wave
– Stock market boom of 1920s
• Third wave
– After WWII
• Fourth wave
– One-third: hostile takeovers 23
 Competitive Trends in the US
Economy
1. Pure monopoly
– One firm controls the market
– Block entry
1. Dominant firm
– One firm: more than half market share
– No close rival

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 Competitive Trends in the US
Economy
3. Tight oligopoly
– Top 4 firms: more than 60% of market
output
– Evidence of cooperation
3. Effective competition
– Low concentration
– Low barriers to entry
– Little or no collusion
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Exhibit 4
Competitive trends in the US economy: 1939 to 2000

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 Competitive Trends in the US
Economy
• Growth in competition (1958-2000)
– Competition from imports
• One-sixth
– Deregulation
• One-fifth
– Antitrust policy
• Two-fifths

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 Microsoft on trial
• Charges
– Protect Windows monopoly (90%)
– Extend monopoly into Internet Explorer
– Internet Explorer’s integration into
Windows 98
• Microsoft: to make life easier for customers
• Government: boost IE’s market share
– Predatory practices
– Anticompetitive behavior
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 Recent Competitive Trends
• Increased competition in US
• Growing world trade
• Three major automakers
– 80% of US market in 1970; only 54% by 2006
• Deregulation
• International phone service
– $0.88 a minute in 1997; under $0.10 by 2007
• Technological change
• Three major TV networks
– 90% in 1980; under 40% by 2007 29
 Problems with Antitrust Policy
• Competition may not require that many
firms
• Abuse of antitrust
• Growth of international markets

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