Microeconomics Chapter 12

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.

Predatory Pricing

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.

Concentration Ratio

A four-firm concentration ratio is the percentage of industry sales sold by the four largest firms in the industry. Other similar measures, that indicate the degree of market power and competitiveness, are often used.

Average Cost Pricing

A price, set by a regulator of a natural monopoly, equal to average cost at the corresponding quantity demanded.

Marginal Cost Pricing

A price, set by a regulator of a natural monopoly, equal to marginal cost at the corresponding quantity demanded.

Why do we need antitrust laws? What is the goal of antitrust laws?

Antitrust laws are designed to maintain competitive markets that provide the lowest prices and most efficient level of output. During the latter part of the nineteenth century, Standard Oil bought refineries and oil companies throughout the country. Standard Oil eventually controlled almost ninety percent of the petroleum industry. Standard Oil then formed a "trust," a cooperative agreement and basically a cartel, with most of the remaining independent oil firms. (A trust was a combination of firms jointly setting prices and outputs.) Next, the trust closed some refinery operations, reduced output, and increased prices. The origins of antitrust law were the legal efforts to prevent such activities from occurring and ultimately to eliminate the power of a trust to engage in future similar actions.

Why would there ever be doubt about using antitrust law to force monopolistic or oligopolistic markets to be competitive?

Companies may have become monopolies because they were innovative and creative and are meeting consumers' needs. Oligopolies may exist because of economies of scale that permit production of goods at lower costs than more competitive structures. In other words, there are a variety of possible outcomes where the dominating firm or firms respond in ways in which economically efficiency is enhanced, even though the outcomes could theoretically be improved.

Can you explain why prices below average variable costs or below marginal cost might be predatory pricing?

Firms would not produce a level of output where price is below marginal cost or where price is below variable average cost if they are profit-maximizing in the short run. However, if the firm saw that it could discourage competitors and then raise its price and lower output to maximize profits and earn economic profits after competing firms were forced out of the market, it might do so.

What would a group of competing firms, perhaps trucking firms or airlines, do if they could influence the regulation of their industries?

If the regulated firms can influence regulation, they would obviously prefer higher prices and producing amounts that maximize profits. In addition, firms may try to prevent price competition and entry into the industry in order to protect economic profits.

How does a monopoly choose its price and output? How does this compare to the price and output in a competitive industry? Which one benefits consumers more?

Just like any other firm, the monopoly is assumed to maximize its profits by setting marginal revenue equal to marginal cost and producing at that level of output while setting the price as high as possible on the demand curve at that level of output. However, the resulting price may be higher and output lower than in a competitive market, making consumers worse off in the case of a monopoly.

Antitrust Law

Legislation that restricts deliberate formation of monopolies and prevents firms from engaging in anticompetitive practices.

Suppose that Amazon wants to increase its market share in the streaming video market by merging with Hulu, claiming that this will expand the services available to customers and lower the costs of providing these services. Do you think this merger is likely to be challenged by the Federal Trade Commission? What methods might the FTC use to decide?

The Federal Trade Commission uses the concentration index approach; currently, they use the sum of squares of firms' market shares before and after the merger and how much the merger would increase the market concentrations and thus lower competition. If the merger substantially increases market concentrations, it is likely to be challenged. As of May 2016, the streaming video market has three major players: Netflix with 53% share, Amazon with 25% and Hulu with 13%. To calculate the concentration index, you need the sum of the squares of market shares, (53)2+(25)2+ (13)2 = 3603, which is already greater than 2500 and therefore already considered a highly concentrated market. After the merger, the market would become even more concentrated and the index would increase to (53)2+(38)2= 4253, more than 200 points. Therefore, it is very likely to be challenged.

Who enforces antitrust laws? What are the consequences of violating antitrust laws?

The acts are enforced by the U.S. Department of Justice, the Federal Trade Commission, and private suits by individuals and businesses that have been harmed. Violations of the laws can result in fines, prison sentences, civil penalties, prohibitions, and the regulation of future business behavior. Criminal and civil cases are brought by the Department of Justice. Civil enforcement is sought by the Federal Trade Commission. Private parties can pursue suits for monetary damages. States can also bring cases under state antitrust laws for cases that occur only within a single state.

Suppose a company produces a computer operating system that the vast majority of personal, educational, and businesses users purchase. Should antitrust law be used to divide the company into smaller divisions that would compete with one another?

The company has grown into a monopoly because it is doing what consumers demand. It may well earn economic profits for some time and may produce at less than an economically efficient output. The trade-off is the provision of a new effective product with the possibility that for some time the firm may not offer the product at an economically efficient price or output level.

Compare the alternative methods of setting prices for regulated, natural monopolies and make an argument as to which is the best alternative.

The dilemma is the trade-off between maintaining the economically efficient amount of production and allowing firms to earn normal profits so that they will stay in the industry. Average cost pricing is often a compromise - better than a monopoly's price, but not as efficient as marginal cost pricing. Other solutions are to allow firms to earn revenue from some other source, and then require marginal cost pricing. The desired result is enough revenue to provide normal profits and incentives for the firms to produce the allocatively efficient amounts.

What is the purpose of government regulation of natural monopolies? Explain in your own words.

The goal of regulation of natural monopolies is to allow a monopoly to exist when cost conditions are such that a single large firm can produce at lower costs. That is the case in most industries that we consider to be public utilities: natural gas, water, sewage, electricity, and in some instances, phone service. The regulatory agencies try to ensure that the firms produce levels of output that approximate the economically efficient levels of output.

Suppose two firms want to merge in order to save costs. Charter Communications and Time Warner Cable are recent examples in the cable TV and broadband internet industry. Also suppose that they will be able to lower costs of providing services by 30 percent. Should antitrust law stop the merger? Why or why not? Should Ford and BMW merge? Should CNN and Fox News?

The issues are the cost savings versus the increased market power that can be used by the resulting merged company. The analysis of the trade-offs is not easy to make. Clearly there are gains and increased technical efficiencies from this type of a merger. However, if the merger significantly decreases competition and makes an implicit or explicit cartel a much more likely outcome, allocative efficiency will suffer.

What is the purpose of antitrust law? Explain in your own words

The purpose of antitrust law is to increase economic efficiency by influencing market structure. Antitrust law is intended to both discourage monopolies when the effects are anticompetitive and reduce the ability of oligopolies to collude. Ultimately, the goal of antitrust law is to increase the likelihood that market outcomes will be closer to those of a perfectly competitive industry.

Assume a firm creates an effective new software application (the so-called "killer" application). Sales of the application increase rapidly and soon the firm is a large, profitable monopoly. Should antitrust law be used to change the market outcome? Why or why not?

The rewards of the new application function as an incentive for firms to create new products - the "killer" applications. However, the reason the applications are called "killer" is that the competition will be killed. The conflict in this case is that the market is working to encourage innovation, but once the monopoly is created, the outcome will not be economically efficient. If, however, the firm knows in advance that it will not make monopoly profits, it may not be motivated to create the application in the first place.

Can you suggest one possible part of an antitrust law that would enhance efficiency? Suggest something other than simply making single powerful companies illegal. What might be a cost of such a law?

There are a number of possible answers, most of which are discussed below. One obvious answer is to prevent mergers. A second might be to make price agreements among companies illegal. The costs of such laws include the administrative costs, but more important in the case of mergers is the prevention of some mergers that might increase competition or lower costs or enhance quality of the output.

What should antitrust law do when two major firms representing substantial portions of a market propose to merge? The firms argue that combining the two firms will allow the firms to provide the same total services at lower cost and improve the quality more rapidly with the combined research and development division.

There are advantages of the lower costs, but the disadvantage is the increased likelihood of higher prices and lower output. The answer ultimately depends upon how easy entry is and how much competition remains in the industry.

What if new methods of distributing movies online to personal computers are created? A number of companies are offering the service. The company that produces the dominant operating system enters the market by creating its own built-in software. It is automatically included as part of its operating system and does not create a separate identifiable charge. Other movie software can still be used and is compatible. What difference does it make if other movie software is no longer compatible? If the dominant operating system company is guilty of violating antitrust law, what is the proper remedy?

There are not easy answers. The company has a monopoly in operating systems, perhaps because it is an effective system. The advantages to users are that it is widely used and there are many applications. However, to expand the monopoly to another product does not make sense. The firm should not be allowed to provide the movie distribution system as part of its operating system. If the company makes competing movie distribution software incompatible with its operating system, there is a further loss of competition. A number of possible solutions might work. Prohibit the company from producing movie distribution software. Require that the company sell movie distribution software separately. Require that the company offer the alternative competing movie distribution software. Split the firm into two companies - an operating system company and a movie distribution software (and other applications) company.

Which outcome is the preferred one? The competitive result or the monopoly result?

There is not an obvious answer. The dilemma, of course, is that the monopoly faces lower average costs and could produce the product using fewer resources. However, it will not produce the economically efficient amount - it will not be allocatively efficient and may not be technically efficient.

Explain what will happen to economic efficiency when two firms agree to set prices and produce a mutually agreeable level of output.

When firms agree to set prices and produce a mutually agreeable level of output, economic efficiency will likely be reduced. We know this because firms wouldn't bother trying to agree on a price unless they were trying to increase it. They can only increase price by also agreeing to produce less. If they were willing to produce more at a lower price without the agreement, we know that the marginal cost of those units would be less than the marginal benefit (the price consumers were willing to pay), so economic efficiency falls.

Compare the outcomes (prices, outputs, profits, and economic efficiencies) of a competitive market and one in which the producers are able to act and set prices as though they were a monopoly. Why would antitrust law try to accomplish?

When markets are competitive, firms accept the market price and will produce more, putting downward pressure on price until price is equal to each firm's marginal cost. If marginal cost is above average total cost, firms will enter, increasing supply until price is equal to the minimum of average cost. If price is equal to average total cost, economic profits are zero. A monopolist and firms attempting to act like a monopolists would restrict quantity so that marginal cost is equal to marginal revenue and since price is greater than marginal revenue, price will be above marginal cost. This means that the monopolist will make positive economic profit. Given that price is above marginal cost for the monopoly, the outcome will not be allocatively efficient. Antitrust law should try to create a more competitive industry in which price is closer to marginal cost and the industry comes closer to allocative efficiency.

Why would firms that propose mergers claim that a merger will make them more efficient and lower their costs? How does this influence the decision by the Federal Trade Commission and Department of Justice to approve the merger?

While it might seem that it does not benefit firms to claim that they could be more efficient by merging, it is exactly what the Federal Trade Commission and the Department of Justice are looking for to justify a merger. So it will be in the interest of firms that want to get the approval of the Federal Trade Commission and the Department of Justice to convince those institutions of the benefits of the merger to the consumer - that is, the possibility of having a lower price and higher quantity of output produced after the merger is formed.