Principles of Microeconomics Scarcity and Social Provisioning Chapter 17 Monopoly and Antitrust Policy

CHAPTER 17 . MONOPOLY AND ANTITRUST POLICY INTRODUCTION TO MONOPOLY AND ANTITRUST POLICY ' Figure . Oligopoly versus Competitors in the Marketplace . Large corporations , such as the natural gas producer Kinder Morgan , can bring economies of scale to the marketplace . Will that benefit consumers ?

Or is more competition better for consumers ?

Credit modification of work by Derrick Creative Commons ) MORE THAN COOKING , HEATING , AND COOLING If you live in the United States , there is a slightly better than chance your home is heated and cooled using natural gas . You may even use natural gas for cooking . However , those uses are not the primary uses of natural gas in the US . In 2012 , according to the US . Energy Information Administration , home heating , cooling , and cooking accounted for just 18 of natural gas usage . What accounts for the rest ?

The greatest uses for natural gas are the generation of electric power ( 39 ) and in industry ( 30 ) Together these three uses for natural gas touch many areas of our lives , so why would there be any opposition to a merger of two natural gas firms ?

After all , a merger could mean increased efficiencies and reduced costs to people like you and me . In October 2011 , Kinder Morgan and El Paso Corporation , two natural gas firms , announced they were merging . The announcement stated the combined firm would link nearly every major production region with markets , cut costs by eliminating duplication in pipelines and other assets , and that the savings could be passed on to consumers . The objection ?

The 21 , billion deal would give Kinder Morgan control of more than miles of pipeline , making the new firm the third largest energy producer in North America . As the third largest energy producer , and the public Wondered whether the cost savings really would be passed on to consumers , or would the merger give Kinder Morgan a strong oligopoly position in the natural gas marketplace ?

PRINCIPLES or ECONOMICS 455 That brings us to the central question this chapter poses What should the balance be between corporate size and a larger number of competitors in a marketplace ?

We will also consider what role the government should play in this balancing act . CHAPTER Introduction to Monopoly and Antitrust Policy In this chapter , you will learn about Corporate Mergers Regulating Behavior Regulating Natural Monopolies The Great Deregulation Experiment he previous chapters on the theory of the firm identified three important lessons First , that competition , by providing consumers with lower prices and a variety of innovative products , is a good thing second , that production can dramatically lower average costs and third , that markets in the real world are rarely perfectly competitive . As a consequence , government must determine how much to intervene to balance the potential benefits of production against the potential loss of competition that can occur when businesses grow in size , especially through mergers . For example , in 201 , AT and proposed a merger . At the time , there were only four major mobile phone service providers . The proposal was blocked by both the Justice Department and the . The two companies argued that the merger would benefit consumers , who would be able to purchase better telecommunications services at a cheaper price because the newly created firm would be able to produce more efficiently by taking advantage of economies of scale and eliminating duplicate . However , a number of activist groups like the Consumer Federation of America and Public Knowledge expressed fears that the merger would reduce competition and lead to higher prices for consumers for decades to come . In December 2006 , the federal government allowed the merger to proceed . By 2009 , the new AT was the eighth largest company by revenues in the United States , and by that measure the largest telecommunications company in the world . Economists have spent and will still spend years trying to determine whether the merger of AT and South , as well as other smaller mergers of telecommunications companies at about this same time , helped consumers , hurt them , or did not make much difference . This chapter discusses public policy issues about competition . How can economists and governments determine when mergers of large companies like AT and should be allowed and when they should be blocked ?

The government also plays a role in policing behavior other than mergers , like prohibiting certain kinds of contracts that might restrict competition . In the case of natural monopoly , however , trying to preserve competition probably will not work very well , and so government will often resort to regulation of price or quantity of output . In recent decades ,

456 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER there has been a global trend toward less government intervention in the price and output decisions of businesses .

CORPORATE MERGERS LEARNING OBJECTIVES By the end of this section , you will be able to Explain antitrust law and its significance Calculate concentration ratios Calculate the Index ( Evaluate methods of antitrust regulation corporate merger occurs when two formerly separate firms combine to become a single firm . When one firm purchases another , it is called an acquisition . An acquisition may not look just like a merger , since the newly purchased firm may continue to be operated under its former company name . Mergers can also be lateral , where two firms of similar sizes combine to become one . However , both mergers and acquisitions lead to two formerly separate firms being under common ownership , and so they are commonly grouped together . REGULATIONS FOR APPROVING MERGERS Since a merger combines two firms into one , it can reduce the extent of competition between firms . Therefore , when two firms announce a merger or acquisition where at least one of the firms is above a minimum size of sales ( a threshold that moves up gradually over time , and was at million in 2013 ) or certain other conditions are met , they are required under law to notify the Federal Trade Commission ( The panel of Figure ( a ) shows the number of mergers submitted for review to the each year from 1999 to 2012 . Mergers were very high in the late , diminished in the early , and then rebounded somewhat in a cyclical fashion . The hand panel of Figure ( shows the distribution of those mergers submitted for review in 2012 as measured by the size of the transaction . It is important to remember that this total leaves out many small mergers under 50 million , which only need to be reported in certain limited circumstances . About a quarter of all reported merger and acquisition transactions in 2012 exceeded 500 million , while about 11 percent exceeded billion . In 2014 , the took action against mergers likely to stifle competition in markets worth billion in sales . The laws that give government the power to block certain mergers , and even in some cases to break up large firms into smaller ones , are called antitrust laws . Before a large merger happens , the antitrust regulators at the and the Department of justice can allow the merger , prohibit it , or allow it if certain conditions are met . One common condition is that the merger will be allowed if the firm

453 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 350 300 5000 , 250 I ' 200 150 100 50 09 So go was ( go hue ego go ?

Ber . 69 ' go Size of Transaction ( a ) Number of mergers for by the Federal Trade ( of for mergers for CommIssIon , 19992012 In 2012 ( In of dollars ) Figure . Number and Size of Mergers . a ) The number of mergers in 1999 and 2000 were relatively high compared to the annual numbers seen from . While 2001 and 2007 saw a high number of mergers , these were still only about half the number of mergers in 1999 and 2000 . In 2012 , the greatest number of mergers submitted for review was for transactions between 100 and 150 million . agrees to sell off certain parts . For example , in 2006 , bought the consumer health division , which included brands like mouthwash and cold . As a condition of allowing the merger , Johnson was required to sell off six brands to other firms , including heartburn relief medication , cream , and diaper rash medication , to preserve a greater degree of competition in these markets . The government approves most proposed mergers . In a economy , firms have the freedom to make their own choices . Private firms generally have the freedom to expand or reduce production set the price they choose open new factories or sales facilities or close them hire workers or to lay them off start selling new products or stop selling existing ones If the owners want to acquire a firm or be acquired , or to merge with another firm , this decision is just one of many that firms are free to make . In these conditions , the managers of private firms will sometimes make mistakes . They may close down a factory which , it later turns out , would have been profitable . They may start selling a product that ends up losing money . A merger between two can sometimes lead to a clash of corporate personalities that makes both firms worse off . But the fundamental belief behind a economy is that firms , not governments , are in the best position to know if their actions will lead to attracting more customers or producing more efficiently . Indeed , government regulators agree that most mergers are beneficial to consumers . As the Federal Trade Commission has noted on its website ( as of November , 2013 ) Most mergers actually benefit

PRINCIPLES or ECONOMICS 459 competition and consumers by allowing firms to operate more At the same time , the recognizes , Some mergers are likely to lessen competition . That , in turn , can lead to higher prices , reduced availability of goods or services , lower quality of products , and less innovation . Indeed , some mergers create a concentrated market , while others enable a single firm to raise The for the antitrust regulators at the and the Department of justice is to figure out when a merger may hinder competition . This decision involves both numerical tools and some judgments that are difficult to quantify . The following Clear it Up helps explain how antitrust laws came about . WHAT IS . ANTITRUST LAW ?

In the closing decades of the , many industries in the US . economy were dominated by a single firm that had most of the sales for the entire country . Supporters of these large firms argued that they could take advantage of economies of scale and careful planning to provide consumers with products at low prices . However , critics pointed out that when tion was reduced , these firms were free to charge more and make permanently higher profits , and that Without the goading of competition , it was not clear that they were as efficient or innovative as they could be . In many cases , these large firms were organized in the legal form of a trust , in which a group of formerly independent firms were consolidated together by mergers and purchases , and a group of trustees then ran the companies as if they were a single firm . Thus , when the US . government passed the Sherman Antitrust Act in 1890 to limit the power of these trusts , it was called an antitrust law . In an early demonstration of the law power , the Supreme Court in 1911 upheld the government right to break up Standard Oil , which had controlled about 90 of the country oil refining , into 34 pendent firms , including , Mobil , and Chevron . In 1914 , the Clayton Antitrust Act outlawed mergers and acquisitions ( Where the outcome would be to substantially lessen competition in an industry ) price discrimination ( Where different customers are charged different prices for the same product ) and tied sales ( where purchase of one product the buyer to purchase some other product ) Also in 1914 , the Federal Trade Commission ( was created to define more specifically what competition was unfair . In 1950 , the Act extended the Clayton Act by restricting vertical and conglomerate mergers . In the century , the and the US . Department ofjustice continue to enforce antitrust laws . THE CONCENTRATION RATIO Regulators have struggled for decades to measure the degree of monopoly power in an industry . An early tool was the concentration ratio , which measures what share of the total sales in the industry are accounted for by the largest firms , typically the top four to eight firms . For an explanation of how high market concentrations can create in an economy , refer to Monopoly . Say that the market for replacing broken automobile windshields in a certain city has 18 firms with the market shares shown in Table , where the market share is each firm proportion of total sales in that market . The concentration ratio is calculated by adding the market shares of the four largest firms in this case , 16 10 40 . This concentration ratio would not be considered especially high , because the largest four firms have less than half the market .

460 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER If the market shares in the market for replacing automobile Windshields are Smooth as Glass Repair Company 16 of the market The Auto Glass Doctor Company 10 of the market Your Car Shield Company of the market Seven firms that each have of the market 42 of the market , combined Eight firms that each have of the market 24 of the market , combined Then the concentration ratio is 16 10 40 . Table . Calculating Concentration Ratios from Market Shares The concentration ratio approach can help to clarify some of the fuzziness over deciding when a merger might affect competition . For instance , if two of the smallest firms in the hypothetical market for repairing automobile windshields merged , the concentration ratio would not implies that there is not much worry that the degree of competition in the market has notably diminished . However , if the top two firms merged , then the concentration ratio would become 46 ( that is , 26 ) While this concentration ratio is modestly higher , the firm concentration ratio would still be less than half , so such a proposed merger might barely raise an eyebrow among antitrust regulators . Visit this Website to read an article about with the . El ' I , THE INDEX A concentration ratio is a simple tool , which may reveal only part of the story . For example , consider two industries that both have a concentration ratio of 80 . However , in one try five firms each control 20 of the market , while in the other industry , the top firm holds 77 of the market and all the other firms have each . Although the concentration ratios are tical , it would be reasonable to worry more about the extent of competition in the second the largest firm is nearly a in the first . Another approach to measuring industry concentration that can distinguish between these two cases is called the ( The , as it is often called , is calculated by ming the squares of the market share of each firm in the industry , as the following Work it Out shows .

PRINCIPLES or ECONOMICS 461 CALCULATING Step . Calculate the for a monopoly with a market share of 100 . Because there is only one firm , it has 100 market share . The is 1002 . Step . For an extremely competitive industry , with dozens or hundreds of extremely small competitors , the value of the might drop as low as 100 or even less . Calculate the for an industry with 100 firms that each have of the ket . In this case , the is 100 ( 12 ) 100 . Step . Calculate the for the industry shown in Table . In this case , the is 162 102 82 ( 62 ) 32 ) 744 . Step . Note that the gives greater weight to large firms . Step . Consider the example given earlier , comparing one industry where five firms each have 20 of the market with an industry where one firm has 77 and the other 23 firms have each . The two industries have the same ratio of 80 . But the for the first industry is ( 202 ) while the for the second industry is much higher at 772 23 ( 12 ) Step . Note that the in the second industry drives up the measure of industrial concentration . Step Review Table which gives some examples of the concentration ratio and the in Various tries in 2009 . You can find market share data from multiple industry sources . Data in the table are from ( for wireless ) The Wall Street ( for automobiles ) Worldwide ( for computers ) and the US . Bureau of Transportation Statistics ( for airlines ) Industry Ratio Wireless 91 Largest five , AT , Sprint , Mobile , 63 Largest five , Ford , Honda , Chrysler 74 Largest five , Dell , Apple , Airlines 44 536 Largest five Southwest , American , Delta , United , Airways Table . Examples of Concentration Ratios and in the Economy , 2009 In the , the followed these guidelines If a merger would result in an of less than , the would probably approve it . If a merger would result in an of more than , the would probably challenge it . If a merger would result in an between and , then the would scrutinize the plan and make a decision . However , in the last several decades , the antitrust enforcement authorities have moved away from relying as heavily on measures of ratios and to determine whether a merger will be allowed , and instead carried out more analysis on the extent of competition in different industries . NEW DIRECTIONS FOR AN Both the concentration ratio and the index share some weaknesses . First , they begin from the assumption that the market under discussion is , and the only question is measuring how sales are divided in that market . Second , they are based on an implicit assumption that competitive conditions across industries are similar enough that a broad measure of concentration in the market is enough to make a decision about the effects of a merger . These

462 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER , however , are not always correct . In response to these two problems , the antitrust regulators have been changing their approach in the last decade or two . Defining a market is often controversial . For example , in the early had a dominant share of the software for computer operating systems . However , in the total market for all computer software and services , including everything from games to scientific programs , the share was only about 14 in 2014 . A narrowly defined market will tend to make concentration appear higher , while a broadly defined market will tend to make it appear smaller . There are two especially important shifts affecting how markets are defined in recent decades one centers on technology and the other centers on globalization . In addition , these two shifts are connected . With the vast improvement in communications technologies , including the development of the Internet , a consumer can order books or pet supplies from all over the country or the world . As a result , the degree of competition many local retail businesses face has increased . The same effect may operate even more strongly in markets for business supplies , where ness websites can allow buyers and suppliers from anywhere in the world to find each other . Globalization has changed the boundaries of markets . As recently as the , it was common for measurements of concentration ratios and to stop at national borders . Now , many industries find that their competition comes from the global market . A few decades ago , three companies , eral Motors , Ford , and Chrysler , dominated the auto market . By 2014 , however , these three firms were making less than half of auto sales , and facing competition from car such as , Honda , Volkswagen , and . When are calculated with a global perspective , concentration in most major lower than in a purely domestic context . Because attempting to define a particular market can be difficult and controversial , the Federal Trade Commission has begun to look less at market share and more at the data on actual competition between businesses . For example , in February 2007 , Whole Foods Market and Wild Oats Market announced that they wished to merge . These were the two largest companies in the market that the government defined as premium natural and organic supermarket However , one could also argue that they were two relatively small companies in the broader market for all stores that sell or specialty food products . Rather than relying on a market definition , the government antitrust regulators looked at detailed evidence on profits and prices for specific stores in different cities , both before and after other stores entered or exited . Based on that evidence , the Federal Trade Commission decided to block the merger . After two years of legal battles , the merger was eventually allowed in 2009 under the conditions that Whole Foods sell off the Wild Oats brand name and a number of individual stores , to preserve competition in certain local markets . For more on the difficulties of defining markets , refer to Monopoly . This new approach to antitrust regulation involves detailed analysis of specific markets and , instead of defining a market and counting up total sales . A common starting point is for antitrust regulators to use statistical tools and evidence to estimate the demand curves and supply curves faced by the firms that are proposing the merger . A second step is to specify how competition occurs in this specific industry . Some possibilities include competing to cut prices , to raise output , to build a brand name through advertising , and to build a reputation for good service or high

PRINCIPLES OF ECONOMICS 463 ity . With these pieces of the puzzle in place , it is then possible to build a statistical model that mates the likely outcome for consumers if the two firms are allowed to merge . Of course , these models do require some degree of subjective judgment , and so they can become the subject of legal disputes between the antitrust authorities and the companies that wish to merge . KEY CONCEPTS AND SUMMARY A corporate merger involves two private firms joining together . An acquisition refers to one firm ing another firm . In either case , two formerly independent firms become one firm . Antitrust laws seek to ensure active competition in markets , sometimes by preventing large firms from forming through mergers and acquisitions , sometimes by regulating business practices that might restrict competition , and sometimes by breaking up large firms into smaller competitors . A concentration ratio is one way of measuring the extent of competition in a market . It is calculated by adding the market is , the percentage of total the four largest firms in the market . A Index ( is another way of measuring the extent of petition in a market . It is calculated by taking the market shares of all firms in the market , squaring them , and then summing the total . The forces of globalization and new communications and information technology have increased the level of competition faced by many firms by increasing the amount of competition from other regions and countries . SELF CHECK QUESTIONS . Is it true that both the concentration ratio and the Index can be affected by a merger between two firms that are not already in the top four by size ?

Explain . Is it true that the concentration ratio puts more emphasis on one or two very large firms , while the Index puts more emphasis on all the firms in the entire market ?

Explain . Some years ago , two intercity bus companies , Greyhound Lines , and Transportation System , wanted to merge . One possible definition of the market in this case was the market for intercity bus service . Another possible definition was the market for intercity transportation , including personal cars , car rentals , passenger trains , and commuter air . Which definition do you think the bus companies preferred , and why ?

As a result of globalization and new information and communications technology , would you expect that the definitions of markets used by antitrust authorities will become broader or narrower ?

REVIEW QUESTIONS . What is a corporate merger ?

What is an acquisition ?

What is the goal of antitrust policies ?

How is a concentration ratio measured ?

What does a high measure mean about the extent of competition ?

464 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER . How is a Index measured ?

What does a low measure mean about the extent of competition ?

Why can it be difficult to decide what a market is for purposes of measuring competition ?

CRITICAL THINKING QUESTIONS Does either the concentration ratio or the directly measure the amount of competition in an industry ?

Why or why not ?

What would be evidence of serious competition between firms in an industry ?

Can you identify two highly competitive industries ?

PROBLEMS . Use Table to calculate the concentration ratio for the US auto market . Does this indicate a concentrated market or not ?

Ford Chrysler Table . Global Auto Manufacturers with Top Four Market Share , une 2013 . Source ) Use Table and Table to calculate the Index for the auto market Would the approve a merger between and Ford ?

Honda Kia Subaru Volkswagen Table . Global Auto Manufacturers with additional Market Share , une 2013 . Source ) acquisition when one firm purchases another antitrust laws laws that give government the power to block certain mergers , and even in some cases to break up large firms into smaller ones concentration ratio an early tool to measure the degree of monopoly power in an industry

465 PRINCIPLES OF ECONOMICS measures what share of the total sales in the industry are accounted for by the largest firms , typically the top four to eight firms concentration ratio the percentage of the total sales in the industry that are accounted for by the largest four firms Index ( approach to measuring market concentration by adding the square of the market share of each firm in the industry market share the percentage of total sales in the market merger when two formerly separate firms combine to become a single firm SOLUTIONS Answers to Questions . Yes , it is true . The example is easy enough since the market shares of all firms are included in the calculation , a merger between two of the firms will change the . For the concentration ratio , it is quite possible that a merger between , say , the fifth and sixth largest firms in the market could create a new firm that is then ranked in the top four in the market . In this case , a merger of two firms , neither in the top four , would still change the concentration ratio . No , it is not true . The includes the market shares of all firms in its calculation , but the squaring of the market shares has the effect of making the impact of the largest firms relatively bigger than in the or ratio . The bus companies wanted the broader market definition ( the second definition ) If the narrow definition had been used , the combined bus companies would have had a on the market for intercity bus service . But they had only a sliver of the market for intercity transportation when everything else was included . The merger was allowed . The common expectation is that the definition of markets will become broader because of greater competition from faraway places . However , this broadening does necessarily mean that antitrust authorities can relax . There is also a fear that companies with a local or national monopoly may use the new opportunities to extend their reach across national borders , and that it will be difficult for national authorities to respond .

REGULATING BEHAVIOR LEARNING OBJECTIVES By the end of this section , you will be able to Analyze restrictive practices Explain tying sales , bundling , and predatory pricing Evaluate a situation of possible and restrictive practices he antitrust laws reach beyond blocking mergers that would reduce competition to include a wide array of practices . For example , it is illegal for competitors to form a cartel to collude to make pricing and output decisions , as if they were a monopoly firm . The Federal Trade Commission and the Department of Justice prohibit firms from agreeing to fix prices or output , rigging bids , or sharing or dividing markets by allocating customers , suppliers , or lines of commerce . In the late , for example , the antitrust regulators prosecuted an international cartel of vitamin manufacturers , including the Swiss firm , the German firm , and the French firm . These firms reached agreements on how much to produce , how much to charge , and which firm would sell to which customers . The vitamins were then bought by firms like General Mills , and Proctor and Gamble , which pushed up the prices more . pleaded guilty in May 1999 and agreed both to pay a fine of 500 million and to have at least one top executive serve four months of jail time . Under antitrust laws , monopoly itself is not illegal . If a firm has a monopoly because of a newly patented invention , for example , the law explicitly allows a firm to earn profits for a time as a reward for innovation . If a firm achieves a large share of the market by producing a better product at a lower price , such behavior is not prohibited by antitrust law . RESTRICTIVE PRACTICES Antitrust law includes rules against restrictive that do not involve outright agreements to raise price or to reduce the quantity produced , but that might have the effect of ing competition . Antitrust cases involving restrictive practices are often controversial , because they delve into specific contracts or agreements between firms that are allowed in some cases but not in others .

PRINCIPLES or ECONOMICS 467 For example , if a product manufacturer is selling to a group of dealers who then sell to the general public it is illegal for the manufacturer to demand a minimum resale price maintenance agreement , which would require the dealers to sell for at least a certain minimum price . A minimum price tract is illegal because it would restrict competition among dealers . However , the manufacturer is legally allowed to suggest minimum prices and to stop selling to dealers who regularly undercut the suggested price . If you think this rule sounds like a fairly subtle distinction , you are right . An exclusive dealing agreement between a manufacturer and a dealer can be legal or illegal . It is legal if the purpose of the contract is to encourage competition between dealers . For example , it is legal for the Ford Motor Company to sell its cars to only Ford dealers , for General Motors to sell to only dealers , and so on . However , exclusive deals may also limit competition . If one large retailer obtained the exclusive rights to be the sole distributor of televisions , computers , and audio equipment made by a number of companies , then this exclusive contract would have an effect on other retailers . Tying sales happen when a customer is required to buy one product only if the customer also buys a second product . Tying sales are controversial because they force consumers to purchase a product that they may not actually want or need . Further , the additional , required products are not necessarily advantageous to the customer . Suppose that to purchase a popular , the store required that you also purchase a portable of a certain model . These products are only loosely related , thus there is no reason to make the purchase of one contingent on the other . Even if a customer was interested in a portable , the tying to a particular model prevents the customer from having the option of selecting one from the numerous types available in the market . A related , but not identical , concept is called bundling , where two or more products are sold as one . Bundling typically offers an advantage for the consumer by allowing them to acquire multiple products or services for a better price . For example , several cable companies allow customers to buy products like cable , internet , and a phone line through a special price available through bundling . Customers are also welcome to purchase these products separately , but the price of bundling is usually more appealing . In some cases , tying sales and bundling can be viewed as . However , in other cases they may be legal and even common . It is common for people to purchase season tickets to a sports team or a set of concerts so that they can be guaranteed tickets to the few contests or shows that are most popular and likely to sell out . Computer software manufacturers may often bundle together a number of different programs , even when the buyer wants only a few of the programs . Think about the software that is included in a new computer purchase , for example . Recall from the chapter on Monopoly that predatory pricing occurs when the existing firm ( or firms ) reacts to a new firm by dropping prices very low , until the new firm is driven out of the market , at which point the existing firm raises prices again . This pattern of pricing is aimed at deterring the entry of new firms into the market . But in practice , it can be hard to figure out when pricing should be considered predatory . Say that American Airlines is between two cities , and a new airline starts between the same two cities , at a lower price . If American Airlines cuts its price to match the new entrant , is this predatory pricing ?

Or is it just market competition at work ?

A commonly posed rule is that if a firm is selling for less than its average variable is , at a price where it should be shutting there is evidence for predatory pricing . But calculating in the real world what costs are variable and what costs are fixed is often not obvious , either .

463 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER The antitrust case embodies many of these gray areas in restrictive practices , as the next Clear it Up shows . DID ENGAGE IN AND RESTRICTIVE PRACTICES ?

The most famous restrictive practices case of recent years was a series of lawsuits by the US . government against that were encouraged by some of competitors . All sides admitted that program had a position in the market for the software used in general computer operating systems . All sides agreed that the software had many satisfied customers . All sides agreed that the capabilities of computer software that was compatible with software produced by and that produced by other expanded dramatically in the 19905 . Having a monopoly or a is not necessarily illegal in and of itself , but in cases where one company controls a great deal of the market , antitrust regulators look at any allegations of restrictive practices with special care . The antitrust regulators argued that had gone beyond profiting from its software innovations and its dominant position in the software market for operating systems , and had tried to use its market power in operating systems software to take over other parts of the software industry . For example , the government argued that had engaged in an form of exclusive dealing by threatening computer makers that , if they did not leave another firm ware off their machines ( specifically , Internet browser ) then would not sell them its operating system software . was accused by the government antitrust regulators of tying together its Windows operating system software , where it had a monopoly , with its Internet Explorer browser software , where it did not have a monopoly , and thus using this bundling as an tool . was also accused of a form of predatory pricing namely , giving away certain additional software products for free as part of Windows , as a way of driving out the competition from other makers of software . In April 2000 , a federal court held that behavior had crossed the line into unfair competition , and mended that the company be broken into two competing firms . However , that penalty was overturned on appeal , and in November 2002 reached a settlement with the government that it would end its restrictive practices . The concept of restrictive practices is continually evolving , as firms seek new ways to earn profits and government regulators define what is permissible and what is not . A situation where the law is ing and changing is always somewhat troublesome , since laws are most useful and fair when firms know what they are in advance . In addition , since the law is open to interpretation , competitors who are losing out in the market can accuse successful firms of restrictive practices , and try to win through government regulation what they have failed to accomplish in the market . Officials at the Federal Trade Commission and the Department ofjustice are , of course , aware of these issues , but there is no easy way to resolve them . KEY CONCEPTS AND SUMMARY Firms are blocked by antitrust authorities from openly colluding to form a cartel that will reduce put and raise prices . Companies sometimes attempt to find other ways around these restrictions and , consequently , many antitrust cases involve restrictive practices that can reduce competition in certain circumstances , like sales , bundling , and predatory pricing .

PRINCIPLES OF ECONOMICS 469 SELF CHECK QUESTIONS Why would a firm choose to use one or more of the practices described in Regulating Behavior ?

REVIEW QUESTIONS What is a minimum resale price maintenance agreement ?

How might it reduce competition and when might it be acceptable ?

What is exclusive dealing ?

How might it reduce competition and when might it be acceptable ?

What is a sale ?

How might it reduce competition and when might it be acceptable ?

What is predatory pricing ?

How might it reduce competition , and why might it be difficult to tell when it should be illegal ?

CRITICAL THINKING QUESTIONS Can you think of any examples of successful predatory pricing in the real world ?

If you were developing a product ( like a Web browser ) for a market with significant barriers to entry , how would you try to get your product into the market successfully ?

bundling a situation in which multiple products are sold as one exclusive dealing an agreement that a dealer will sell only products from one manufacturer minimum resale price maintenance agreement an agreement that requires a dealer who buys from a manufacturer to sell for at least a certain minimum price restrictive practices practices that reduce competition but that do not involve outright agreements between firms to raise prices or to reduce the quantity produced tying sales a situation where a customer is allowed to buy one product only if the customer also buys another product SOLUTIONS Answers to Questions Because outright collusion to raise profits is illegal and because existing regulations include gray areas which firms may be able to exploit .

REGULATING NATURAL MONOPOLIES LEARNING OBJECTIVES By the end of this section , you will be able to Evaluate the appropriate competition policy for a natural monopoly Interpret a graph of regulatory choices Contrast and price cap regulation ost true monopolies today in the are regulated , natural monopolies . A natural oly poses a difficult challenge for competition policy , because the structure of costs and demand seems to make competition unlikely or costly . A natural monopoly arises when average costs are declining over the range of production that satisfies market demand . This typically happens when fixed costs are large relative to variable costs . As a result , one firm is able to supply the total quantity demanded in the market at lower cost than two or more splitting up the ural monopoly would raise the average cost of production and force customers to pay more . Public utilities , the companies that have traditionally provided water and electrical service across much of the United States , are leading examples of natural monopoly . It would make little sense to argue that a local water company should be broken up into several competing companies , each with its own separate set of pipes and water supplies . Installing four or five identical sets of pipes under a city , one for each water company , so that each household could choose its own water provider , would be terribly costly . The same argument applies to the idea of having many competing companies for delivering electricity to homes , each with its own set of wires . Before the advent of wireless phones , the argument also applied to the idea of many different phone companies , each with its own set of phone wires running through the neighborhood . THE CHOICES IN REGULATING A NATURAL MONOPOLY So What then is the appropriate competition policy for a natural monopoly ?

Figure illustrates the case of natural monopoly , with a market demand curve that cuts through the tion of the average cost curve . Points A , and illustrate four of the main choices for regulation . Table outlines the regulatory choices for dealing with a natural monopoly .

PRINCIPLES OF ECONOMICS Price Quantity Figure . Regulatory Choices in Dealing with Natural Monopoly . A natural monopoly will maximize profits by producing at the quantity where marginal revenue ( equals marginal costs ( and by then looking to the market demand curve to see what price to charge for this quantity . This monopoly will produce at point A , with a quantity of and a price of . If antitrust regulators split this company exactly in half , then each half would produce at point , with average costs of and output of . The regulators might require the firm to produce where marginal cost crosses the market demand curve at point However , if the firm is required to produce at a quantity of and sell at a price of , the firm will suffer from losses . The most likely choice is point , where the firm is required to produce a quantity of and charge a price of . 471 Quantity Price Total Revenue Marginal Revenue Total Cost Marginal Cost Average Cost Table . Regulatory Choices in Dealing with Natural Monopoly . Total Revenue is given by multiplying price and quantity . However , some of the price values in this table have been rounded for ease of presentation .

472 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER The first possibility is to leave the natural monopoly alone . In this case , the monopoly will follow its normal approach to maximizing profits . It determines the quantity where , which happens at point at a quantity of . The firm then looks to point A on the demand curve to find that it can charge a price of for that quantity . Since the price is above the average cost curve , the natural monopoly would earn economic profits . A second outcome arises if antitrust authorities decide to divide the company , so that the new firms can compete . As a simple example , imagine that the company is cut in half . Thus , instead of one large firm producing a quantity of , two firms each produce a quantity of . Because of the ing average cost curve ( AC ) the average cost of production for each of the companies each producing , as shown at point , would be , while the average cost of production for a larger firm producing would only be . Thus , the economy would become less productively efficient , since the good is being produced at a higher average cost . In a situation with a average cost curve , two smaller firms will always have higher average costs of production than one larger firm for any quantity of total output . In addition , the antitrust authorities must worry that splitting the natural monopoly into pieces may be only the start of their problems . If one of the two firms grows larger than the other , it will have lower average costs and may be able to drive its competitor out of the market . Alternatively , two firms in a market may discover subtle ways of coordinating their behavior and keeping prices high . Either way , the result will not be the greater competition that was desired . A third alternative is that regulators may decide to set prices and quantities produced for this industry . The regulators will try to choose a point along the market demand curve that benefits both consumers and the broader social interest . Point illustrates one tempting choice the regulator requires that the firm produce the quantity of output where marginal cost crosses the demand curve at an output of , and charge the price of , which is equal to marginal cost at that point . This rule is appealing because it requires price to be set equal to marginal cost , which is what would occur in a perfectly competitive market , and it would assure consumers a higher quantity and lower price than at the monopoly choice A . In fact , efficient allocation of resources would occur at point , since the value to the consumers of the last unit bought and sold in this market is equal to the marginal cost of ing it . Attempting to bring about point through force of regulation , however , runs into a severe difficulty . At point , with an output of , a price of is below the average cost of production , which is , and so if the firm charges a price of , it will be suffering losses . Unless the regulators or the ment offer the firm an ongoing public subsidy ( and there are numerous political problems with that option ) the firm will lose money and go out of business . Perhaps the most plausible option for the regulator is point that is , to set the price where AC crosses the demand curve at an output of and a price of . This plan makes some sense at an intuitive level let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit , so that it can continue operating , but prevent the firm from raising prices and earning abnormally high monopoly profits , as it would at the monopoly choice A . Of course , determining this level of output and price with the political pressures , time constraints , and limited information of the real world is much harder than identifying the point on a graph . For more on the problems that can arise from a centrally determined price , see the discussion of price floors and price ceilings in Demand and

PRINCIPLES or ECONOMICS 473 VERSUS PRICE CAP REGULATION Indeed , regulators of public utilities for many decades followed the general approach of attempting to choose a point like in Figure . They calculated the average cost of production for the water or electricity companies , added in an amount for the normal rate of profit the firm should expect to earn , and set the price for consumers accordingly . This method was known as regulation . regulation raises difficulties of its own . If producers are reimbursed for their costs , plus a bit more , then at a minimum , producers have less reason to be concerned with high they can just pass them along in higher prices . Worse , firms under regulation even have an incentive to generate high costs by building huge factories or employing lots of staff , because what they can charge is linked to the costs they incur . Thus , in the and , some regulators of public utilities began to use price cap regulation , where the regulator sets a price that the firm can charge over the next few years . A common pattern was to require a price that declined slightly over time . If the firm can find ways of reducing its costs more quickly than the price caps , it can make a high level of profits . However , if the firm can not keep up with the price caps or suffers bad luck in the market , it may suffer losses . A few years down the road , the regulators will then set a new series of price caps based on the firms performance . Price cap regulation requires delicacy . It will not work if the price regulators set the price cap low . It may not work if the market changes dramatically so that the firm is doomed to ring losses no matter what it , if energy prices rise dramatically on world markets , then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago . But if the regulators compare the prices with producers of the same good in other areas , they can , in effect , pressure a natural monopoly in one area to compete with the prices being charged in other areas . Moreover , the possibility of earning greater profits or of having an average rate of profit locked in every year by provide the natural monopoly with incentives for efficiency and innovation . With natural monopoly , market competition is unlikely to take root , so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly , government regulation will need to play a role . In attempting to design a system of price cap regulation with and incentive , government regulators do not have an easy task . KEY CONCEPTS AND SUMMARY In the case of a natural monopoly , market competition will not work well and so , rather than allowing an unregulated monopoly to raise price and reduce output , the government may wish to regulate price or output . Common examples of regulation are public utilities , the regulated firms that often provide electricity and water service . regulation refers to government regulation of a firm which sets the price that a firm can charge over a period of time by looking at the firms accounting costs and then adding a normal rate of profit . Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance . In this case , the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected .

474 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER SELF ' QUESTIONS . Urban transit systems , especially those with rail systems , typically experience significant economies of scale in operation . Consider the transit system Whose data is given in the Table . Note that the quantity is in millions of riders . Demand Quantity Price 10 Marginal Revenue 10 Marginal Cost Average Cost Table . Draw the demand , marginal revenue , marginal cost , and average cost curves . Do they have the normal shapes ?

From the graph you drew to answer Question , would you say this transit system is a natural monopoly ?

justify . REVIEW QUESTIONS If public utilities are a natural monopoly , What would be the danger in them ?

If public utilities are a natural monopoly , What would be the danger in splitting them up into a number of separate competing firms ?

What is regulation ?

What is price cap regulation ?

CRITICAL THINKING QUESTIONS In the middle of the twentieth century , major cities had multiple competing city bus companies . Today , there is usually only one and it runs as a subsidized , regulated monopoly . What do you suppose caused the change ?

Why are urban areas willing to subsidize urban transit systems ?

Does the argument for subsidies make sense to you ?

PRO Use Table to answer the following questions .

PRINCIPLES OF ECONOMICS 475 If the transit system was allowed to operate as an unregulated monopoly , what output would it supply and What price would it charge ?

If the transit system was regulated to operate with no subsidy ( at zero economic profit ) What approximate output would it supply and what approximate price would it charge ?

If the transit system was regulated to provide the most efficient quantity of output , what output would it supply and what price would it charge ?

What subsidy would be necessary to insure this efficient provision of transit services ?

regulation when regulators permit a regulated firm to cover its costs and to make a normal level of profit price cap regulation when the regulator sets a price that a firm can not exceed over the next few years SOLUTIONS Answers to Questions . Yes , all curves have normal shapes . 12 Revenue 10 Demand Cost Average Cost Dollars Quantity Figure . Yes it is a natural monopoly because average costs decline over the range that satisfies the market demand . For example , at the point Where the demand curve and the average cost curve meet , there are economies of scale .

THE GREAT DEREGULATION EXPERIMENT LEARNING By the end of this section , you will be able to Evaluate the effectiveness of price regulation and antitrust policy Explain regulatory capture and its significance at all levels across the United States have regulated prices in a wide range of industries . In some cases , like water and electricity that have natural monopoly characteristics , there is some room in economic theory for such regulation . But once politicians are given a basis to intervene in markets and to choose prices and quantities , it is hard to know where to stop . DOUBTS ABOUT REGULATION OF PRICES AND QUANTITIES Beginning in the , it became clear to of all political leanings that the existing price regulation was not working well . The United States carried out a great policy discussed in government controls over prices and quantities produced in airlines , railroads , trucking , intercity bus travel , natural gas , and bank interest rates . The Clear it Up discusses the outcome of deregulation in one industry in . WHAT ARE THE RESULTS OF AIRLINE DEREGULATION ?

Why did the pendulum swing in favor of deregulation ?

Consider the airline industry . In the early days of air travel , no airline could make a profit just by passengers . Airlines needed something else to carry and the Postal Service that something with airmail . And so the first US . government regulation of the airline industry happened through the Postal Service , when in 1926 the Postmaster General began giving airlines permission to certain routes based on the needs of mail the airlines took some passengers along for the ride . In 1934 , the Postmaster General was charged by the antitrust authorities with colluding with the major airlines of that day to monopolize the nation airways . In 1938 , the Civil Aeronautics Board ( CAB ) was created to regulate and routes instead . For 40 years , from 1938 to 1978 , the CAB approved all fares , controlled all entry and exit , and specified which airlines could which routes . There was zero entry of new airlines on the main routes across the country for 40 years , because the CAB did not think it was necessary . In 1978 , the Airline Deregulation Act took the government out of the business of determining and schedules . The new law shook up the industry . Famous old airlines like Pan American , Eastern , and went bankrupt and . Some new airlines like People Express were then vanished .

PRINCIPLES or ECONOMICS 477 The greater competition from deregulation reduced by about over the next two decades , saving billions of dollars a year . The average used to take off with just half its seats full now it is full , which is far more efficient . Airlines have also developed systems , where planes all into a central hub city at a certain time and then depart . As a result , one can between any of the spoke cities with just one there is greater service to more cities than before deregulation . With lower fares and more service , the number of air doubled from the late to the start of the increase that , in turn , doubled the number of jobs in the airline industry . Meanwhile , with the watchful oversight of government safety inspectors , commercial air travel has to get safer over time . The US . airline industry is far from perfect . For example , a string of mergers in recent years has raised concerns over how competition might be compromised . One difficulty with government price regulation is what economists call regulatory capture , in which the firms supposedly being regulated end up playing a large role in setting the regulations that they will follow . When the airline industry was being regulated , for example , it suggested appointees to the regulatory board , sent lobbyists to argue with the board , provided most of the information on which the board made decisions , and offered jobs to at least some of the people leaving the board . In this situation , consumers can easily end up being not very well represented by the regulators . The result of regulatory capture is that government price regulation can often become a way for existing competitors to work together to reduce output , keep prices high , and limit competition . THE EFFECTS OF DEREGULATION Deregulation , both of airlines and of other industries , has its negatives . The greater pressure of petition led to entry and exit . When firms went bankrupt or contracted substantially in size , they laid off workers who had to find other jobs . Market competition is , after all , a sport . A number of major accounting scandals involving prominent corporations such as , national , and led to the Act in 2002 . was designed to increase confidence in financial information provided by public corporations to protect investors from accounting fraud . The Great Recession which began in late 2007 and which the economy is still struggling to recover from was caused at least in part by a global financial crisis , which began in the United States . The key component of the crisis was the creation and subsequent failure of several types of lated financial assets , such as collateralized mortgage obligations ( a type of security ) and credit default swaps ( insurance contracts on assets like that provided a payoff even if the holder of the did not own the ) Many of these assets were rated very safe by private credit rating agencies such as Standard , Moody , and Fitch . The collapse of the markets for these assets precipitated the financial crisis and led to the failure of Brothers , a major investment bank , numerous large commercial banks , such as , and even the Federal National Mortgage Corporation ( Mae ) which had to be is , taken over by the federal government . One response to the financial crisis was the Act , which attempted major reforms of the financial system . The legislation purpose , as noted on is To promote the financial stability of the United States by improving accountability and transparency in the

473 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER financial system , to end too big to fail , to protect the American taxpayer by ending bailouts , and to protect consumers from abusive financial services practices . We will explore the financial crisis and the Great Recession in more detail in the chapters of this book , but for now it should be clear that many Americans have grown disenchanted with deregulation , at least of financial markets . All economies operate against a background of laws and regulations , including laws about enforcing contracts , collecting taxes , and protecting health and the environment . The policies discussed in this blocking certain mergers , ending restrictive practices , imposing price cap regulation on natural monopolies , and the role of government to strengthen the incentives that come with a greater degree of competition . MORE THAN COOKING , HEATING , AND COOLING What did the Federal Trade Commission ( decide on the Kinder Morgan El Paso Corporation merger ?

After careful examination , federal officials decided there was only one area of significant overlap that might provide the merged firm with strong market power . The approved the merger , provided Kinder Morgan divest itself of the overlap area . grass purchased Kinder Morgan Interstate Gas Transmission , Pipeline , two processing facilities in Wyoming , and Kinder Morgan 50 percent interest in the Rockies Express Pipeline to meet the requirements . The was attempting to strike a balance between potential cost reductions resulting from economies of scale and of market power . Did the price of natural gas decrease ?

Yes , rather significantly . In 2010 , the wellhead price of natural gas was per thousand cubic foot in 2012 the price had fallen to just . Was the merger responsible for the large drop in price ?

The answer is uncertain . The larger contributor to the sharp drop in price was the overall increase in the supply of natural gas . More and more natural gas was able to be recovered by fracturing shale deposits , a process called fracking . Fracking , which is controversial for environmental reasons , enabled the recovery of known reserves of natural gas that previously were not economically feasible to tap . Kinder Morgan control of miles of pipeline likely made moving the gas from to end users smoother and allowed for an even greater benefit from the increased supply . KEY CONCEPTS AND SUMMARY The economy experienced a wave of deregulation in the late and early , when a ber of government regulations that had set prices and quantities produced in a number of industries were eliminated . Major accounting scandals in the early and , more recently , the Great sion have spurred new regulation to prevent similar occurrences in the future . Regulatory capture occurs when the industries being regulated end up having a strong over what regulations exist . SELF CHECK QUESTIONS Use the following information to answer the next three questions . In the years before Wireless phones , when telephone technology required having a wire running to every home , it seemed plausible that telephone service had diminishing average costs and might need to be regulated like a natural monopoly . For most of the twentieth century , the national phone company was AT , and the company functioned as a regulated monopoly . Think about the deregulation of

PRINCIPLES OF ECONOMICS 479 the telecommunications industry that has happened over the last few decades . This is not a research assignment , but a thought assignment based on What you have learned in this chapter . What real world changes made the deregulation possible ?

What are some of the benefits of the deregulation ?

What might some of the negatives of deregulation be ?

REVIEW QUESTIONS . What is deregulation ?

Name some industries that have been deregulated in the United States . What is regulatory capture ?

Why does regulatory capture reduce the persuasiveness of the case for regulating industries for the benefit of consumers ?

CRITICAL THINKING QUESTIONS . Deregulation , like all changes in government policy , always has pluses and minuses . What do you think some of the minuses might be for airline deregulation ?

Do you think it is possible for government to outlaw everything that businesses could do wrong ?

If so , why does government not do that ?

If not , how can regulation stay ahead of rogue businesses that push the limits of the system until it breaks ?

REFERENCES Bishop , Todd . 2014 . Exec Admits New Reality Market Share No Longer 90 It 14 . Accessed March 27 , Catan , Paso Merger to Face Antitrust Scrutiny , Wall Street . October 19 , 2011 . Collins , A . Energy to Acquire Kinder Morgan Assets for The Middle Market , Accessed August . Phillips . Why Natural Accessed August ?

De la , 2012 , August 20 ) Kinder Morgan to Sell Assets to for The New York Times . August 20 , 2012 . The Federal Trade Commission . The Federal Trade Commissions ( Accessed 480 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER March 27 , Kinder Morgan to Buy El Paso for USA Today . October 17 , 201 . Kinder Morgan . 2013 ) Investor Accessed August . Mark . 2014 . There Be No Wireless Wars Without The Blocked Merger , So Where Does That Leave ?

Accessed March 12 , 20 . Energy Information Administration ( a ) Natural Gas Consumption by End Accessed May 31 , Energy Information Administration ( Natural Gas Accessed June 28 , The Wall . 2015 . Auto Accessed April 10 , regulatory capture when the firms supposedly being regulated end up playing a large role in setting the regulations that they will follow and as a result , they capture the people doing the regulation , usually through the promise of a job in that regulated industry once their term in government has ended . SOLUTIONS Answers to Questions . Improvements in technology that allowed phone calls to be made via microwave transmission , communications satellites , and other wireless technologies . More consumer choice . Cheaper phone calls , especially long distance . phone service in many cases . Cheaper , faster , and data transmission . technologies like free calling and video calling . More choice can sometimes make for difficult knowing if you got the best plan for your situation , for example . Some phone service providers are less reliable than AT used to be .