Government Intervention in Markets

1
Lecture 19
2
Government Intervention in Markets

• Except for taxes, have thus far ignored effects
  of government policies on market outcomes
• Major areas of government intervention
• antitrust law
• regulation

3
Antitrust Law

• laws that make monopolization, collusion, and
  certain pricing tactics illegal
• economic justification
• since welfare loss exists with price searchers,
  could potentially gain by reducing monopoly power
  or by restricting monopolistic pricing

4
Limiting Market Power The Antitrust Laws

• Sherman Act (1890)
• Section 1
• Prohibits contracts, combinations, or
  conspiracies in restraint of trade
• Explicit agreement to restrict output or fix
  prices
• Implicit collusion through parallel conduct

5
Limiting Market Power The Antitrust Laws
Examples of Illegal Combinations

• 1996
• Archer Daniels Midland (ADM) pleaded guilty to
  price fixing for lysine -- three sentenced to
  prison in 1999
• 1999
• Roche A.G., BASF A.G., Rhone-Poulenc and Takeda
  pleaded guilty to price fixing of vitamins --
  fined more than 1 billion

6
Limiting Market Power The Antitrust Laws

• Sherman Act (1890)
• Section 2
• Makes it illegal to monopolize or attempt to
  monopolize a market
• example Microsoft case

7
Limiting Market Power The Antitrust Laws

• Clayton Act (1914)
• section 2
• outlaws price discrimination that substantially
  reduces competition
• section 7
• makes illegal mergers that substantially lessen
  competition or tend to create a monopoly

8
Limiting Market Power The Antitrust Laws

• Federal Trade Commission Act (1914, amended 1938,
  1973, 1975)
• Created the Federal Trade Commission (FTC)
• Prohibitions against deceptive advertising,
  labeling, agreements with retailer to exclude
  competing brands

9
Limiting Market Power The Antitrust Laws

• Antitrust laws are enforced three ways
• Antitrust Division of the Department of Justice
• A part of the executive branch--the
  administration can influence enforcement
• Fines levied on businesses fines and
  imprisonment levied on individuals

10
Limiting Market Power The Antitrust Laws

• Antitrust laws are enforced three ways
• Federal Trade Commission
• Enforces through voluntary understanding or
  formal commission order

11
Limiting Market Power The Antitrust Laws

• Antitrust laws are enforced three ways
• Private proceedings
• Lawsuits for damages
• Plaintiff can receive treble damages

12
Regulation

• Rationale
• public interest view
• can reduce welfare loss associated with monopoly
  by regulating prices below monopoly levels
• can promote economic efficiency by eliminating or
  reducing negative third party effects
  (externalities)

13
Regulation

• rationale
• capture view
• regulatory mechanism is used by special interests
  to gain an advantage
• producers, having lower costs of organizing, are
  more likely to influencing legislators/regulators
  so end up capturing the regulatory process

14
Regulation

• traditional or economic regulation
• general
• regulations that fix prices and/or limit the
  number of sellers
• natural monopolies and utility regulation
• in the past, argued that utilities like
  telephone, gas, and electric are natural
  monopolies
• may only be true for some aspects of these
  businesses
• with a natural monopoly, economies of scale lead
  to one firm surviving in the market
• firm will take advantage of monopoly position and
  charge monopoly price which results in a welfare
  loss

15
Regulation

• natural monopolies and utility regulation

• policy dilemma want to enjoy cost savings
  associated with economies of scale but avoid the
  welfare loss associated with monopoly pricing

16
Regulation

• natural monopolies and utility regulation
• rate regulaton solution
• set price MC
• since MChave to leave the industry in the long run
• hard to know what marginal cost is
• firm has reduced incentive to minimize cost
• firm may have incentive to pad cost if it makes
  management better off

17
Regulation

• natural monopolies and utility regulation
• rate regulation solution
• set price ATC
• sustainable since firm covers its opportunity
  cost (earns zero economic profit)
• ATC is easier to measure than is MC
• still have reduced incentive to minimize cost
• PMC so still have some welfare loss

18
Regulation of a Monopolist
Price

• An unregulated monopolist with the costs
  indicated here will produce where MR MC
  (Q0) . . .

and charge
price P0.
P0

• From an efficiency viewpoint, this output is
  too small and the price is too high. Can you
  explain why?

• If a regulatory agency forced the monopolist
  to reduce its price to P1 (Average Cost
  pricing) . . .

LRATC
P1
the monopolist would expand
output to Q1.
MC
P2

• Ideally, we would like output to be expanded
  to Q2

where P MC (Marginal Cost pricing), but
regulatory agencies do not usually attempt
to keep prices as low as P2. Can you explain
why?
D
MR
Q0
Q1
Q2
Quantity / Time .
19
Regulation

• Regulation in Practice
• An alternative pricing technique---rate-of-return
  regulation allows the firms to set a maximum
  price based on the expected rate or return that
  the firm will earn
• equivalent to average cost pricing if allowed
  rate of return is the typical market return
• using this technique requires hearings to arrive
  at the respective figures.
• The hearing process creates a regulatory lag that
  may benefit producers (1950s 60s) or consumers
  (1970s 80s).

20
Regulation

• natural monopolies and utility regulation
• alternatives to rate regulation of natural
  monopolies
• have government run enterprise
• reduced incentive to operate efficiently since
  managers are not residual claimants
• government may want to maximize profit rather
  than minimize welfare loss
• auction off monopoly rights
• while only one firm ex-post, can take advantage
  of competition ex-ante
• firms would be willing to bid as low as PATC

21
Regulation

• alternatives to rate regulation of natural
  monopolies
• auction off monopoly rights
• advantages
• --- avoids problem of estimating costs
• --- firm still has incentive to minimize cost
  once it
• obtains contract
• problems
• --- need sufficient number of bidders to get
• competitive outcome (with few bidders may
• collude and rig bids)
• --- risk associated with fixed assets
• --- incentive to ceat on quality
• --- hold-up problems

22
Regulation

• social regulation
• general
• regulations that restrict the quality of products
  and services
• rationale
• public interest
• consumers may be harmed by unsafe products or
  by incompetent suppliers of services (quacks)
• too costly for consumers to know quality of all
  products and services
• if government can collect information at a lower
  cost than consumers and uses it to ban low
  quality goods and services, consumers may benefit

23
Regulation

• social regulation
• rationale
• public interest
• in absence of regulation, low quality is
  constrained by competition among sellers and
  repeat purchase mechanism
• capture
• sellers may be concerned with low quality sellers
  tarnishing industry brand name
• existing sellers can gain from restricting entry
  of new producers or products into the market

24
Regulation

• social regulation
• costs of social regulation
• restricted choices for consumers
• sometimes prefer lower quality (and a lower
  price)
• requiring high quality leads some to choose less
  desirable substitutes or no service at all
• moral hazard problems
• as increase safety of products, reduce incentive
  to guard against loss
• unintended effects
• costs of verifying compliance
• costs of running regulatory agencies

25
Regulation

• social regulation
• examples
• state-level professional licensing
• many professions, from barbers to morticians,
  are licensed
• public interest case for licensing varies
  across occupations
• many professions ask to be licensed
• suggests capture may be occuring
• current practitioners almost always
  grandfathered in when a profession is licensed
• local building codes
• externality argument
• federal product safety regulation

26
Regulation

• regulation of intellectual property
• patents
• grants monopoly right to produce and sell a good
  for 17 years
• intended to encourage innovation
• chance for monopoly profits encourages innovation
• protects against free riding on research and
  development
• creates a welfare loss
• traditional welfare loss associated with monopoly

27
Regulation

• regulation of intellectual property
• patents
• additional possible loss from wasteful activities
  to obtain monopoly rights
• rent seeking
• noteoutright bribes efficient

28
Regulation

• Rent Seeking
• Firms may spend to gain monopoly power
• lobbying
• advertising
• building excess capacity
• the incentive to engage in monopoly practices is
  determined by the profit to be gained.
• example
• 1996 Archer Daniels Midland (ADM) successfully
  lobbied for regulations requiring ethanol be
  produced from corn
• Why only corn?

29
EndLecture 19