Chapter 12: Regulating Firms with Market Power

Antitrust Law, Regulations to Increase Economic Efficiency, Natural Monopolies

Antitrust Law

What are Antitrust Laws?

Legislation that restricts deliberate formation of monopolies & prevents firms from engaging in anticompetitive practices. It’s intended to prevent practices that reduce competition & lead to economical inefficiency where prices are higher than they need to be, output is less than it otherwise would be, and technological progress is slowed.

Where do Antitrust Laws Come From?

Standard Oil Company, owned by John D. Rockefeller, bought refineries & oil companies throughout the Americans. It even convinced railroads to give them special discounts. This led to Standard Oil eventually controlling almost 90% of the petroleum industry. They then formed a trust, basically a cartel. Laws were introduced to prevent this activities, thus known as ‘antitrust’.

What are Trusts?

Groups of firms who have legally agreed to work together, often in ways that will reduce competition.

What are Cartels?

Groups of firms who have agreed formally or informally to work together in ways that will in essence, create the advantages of being a monopoly.

The Sherman Antitrust Act of 1980

Section 1: Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal.

Section 2: Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or person, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.

What is the Sherman Antitrust Act of 1980?

The principal antitrust law that declared price fixing & market allocation of shares of output illegal. The Clayton Act, Federal Trade Commission (FTC) Act, the Robinson-Patman Act, the Celler-Kefauver Act helped define additional violations. These additional acts prohibit price discrimination, tying agreements, exclusive dealing, territorial restrictions, mergers & interlocking directorships if these actions “substantially lessen competition” or “tend to create a monopoly”.

Who Enforced These Laws?

The United States of America’s Department of Justice & the Federal Trade Commission. Also, private lawsuits can also help with enforcement. Violations of the laws can result in fines, prison sentences, civil penalties, prohibitions, & the regulation of future business behavior.

What is Price Fixing?

Maintaining prices at a certain level by agreement between competing sellers. Usually a level above the price that would be provided by the market.

Merger Rules

When are Mergers Not Allowed?

When the merger or acquisition results in an unreasonable restraint of trade/competition, the event becomes illegal. This is known as the “Rule of Reason”.

It is also important to define the appropriate market in which a company competes. If Coca Cola’s market was defined as fizzy drinks, their market share would be much higher than if their market was defined as all bottled/canned drinks. It’s also important to distinguish between national or local markets.

If the concentration ratio is relatively high after a merger, firms have a lot of market power.

Part of the consideration of whether a merger is allowed is based on how timely & easy entry is, and whether or not that entry will prevent actions to raise prices & lower outputs.

When are Mergers Allowed?

If mergers can generate lower costs by better using capital & other resources, then it’s desirable for the entire economy.

If a company grows large & dominates an entire industry simply because it is better at what it does than any other firm, antitrust does not interfere.

What are Concentration Indexes?

Measures of existing concentration & the amount of change in concentration used as initial pieces of evidence as to whether or not a merger will do harm. A four-firm concentration ratio is the percentage of industry sales sold by the 4 largest firms in the industry.

What is the Herfindahl-Hirschman Index (HHI)?

A market concentration index that sums the squares of the market shares of all the firms in the market. This reflects the market power of the 4 largest firms, gives greater weight to the largest firms, & includes the effects of the concentration outside the 4 largest firms.

Other Issues

What is Predatory Pricing?

Lowering prices to drive competitors out of a market, increasing own market power, and eventually reducing output & raising prices.

What is Price Discrimination?

Selling the same product at different prices to different buyers, in order to maximize profits.

What are Tying Agreements?

Forcing consumers to buy two products at the same time since products are tied to each other.

What are Exclusive Contracts?

Limiting a distributor from selling the products of a different manufacturer & preventing a manufacturer from buying inputs from a different supplier.

What are Network Economies?

As more & more people use a product, the value of the product to the consumer goes up. This is the case for most social media websites.

Regulating Natural Monopolies

What is a Natural Monopoly?

A firm that can produce at a lower average cost per unit of output than a number of smaller firms producing a similar amount of total output. Electricity, water, phone lines & cable televisions are good examples. This usually happens when most of the costs of production is fixed, there are large economies of scale or if the firm is extremely innovative.

AC3 = Natural Monopolists Average Cost Curve

Policy Options

  • Permit the monopoly to exist and establish a regulatory agency to improve on the monopoly outcome.
  • Marginal Cost Pricing: A price, set by the regulator, equal to marginal cost at the corresponding quantity demanded. However, this is usually below the average cost curve & the firm will make economic losses.
  • Average Cost Pricing: A price, set by the regulator, equal to average cost at the corresponding quantity demanded. However, this isn’t allocatively efficient.
  • Once the price is set at either the average or marginal cost, the price will become the marginal revenue.

Problems with Average Cost Pricing

If price is set equal to average cost, a regulated firm knows that it will be reimbursed for all costs & will lose the incentive to reduce its costs.

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