Chapter 28 Regulation and in a Globalized Economy Introduction Price fixing can occur in any industry when it is possible for firms to collude. Fashion-modeling agencies have become the subject of an antitrust investigation by the U.S. Department of Justice for possible price-fixing. Slide 28-2 Learning Objectives Learning Objectives Distinguish between economic regulation and social regulation Recognize practical difficulties that arise when regulating the prices charged by natural monopolies Explain the main rationales for government regulation of industries that are not inherently monopolistic Identify alternative theories aimed at explaining the behavior of regulators Understand the foundations of antitrust laws and regulations Discuss basic issues that arise in efforts to enforce antitrust laws Slide 28-3 Slide 28-4 1
Chapter Outline Chapter Outline Forms of Industry Regulation Regulating Natural Monopolies Antitrust Enforcement Regulating Nonmonopolistic Industries Incentives and Costs of Regulation Slide 28-5 Slide 28-6 Did You Know That... Forms of Industry Regulation Among other things, the USDA regulates the size of holes in Swiss cheese? Government oversight of business is generally designed to promote efficiency, but that it can have unintended effects? Economic regulation governs the pricing and provision of goods and services Social regulation is concerned with the occupational, health, and safety aspects of industry. Slide 28-7 Slide 28-8 2
Forms of Industry Regulation Forms of Industry Regulation The focus of economic regulation: Natural monopolies Rate regulation is used to prevent electric utilities from earning monopoly profits The focus of economic regulation: In nonmonopolistic industries, there are regulations covering financial markets, transportation firms, and communications networks Slide 28-9 Slide 28-10 Regulating Natural Monopolies Profit Maximization and Regulation Through Marginal Cost Pricing Recall Panel (a) Natural monopolies result when a single firm has the ability to produce the industry s output at a lower per-unit cost than other firms attempting to produce less than total industry output. Network effects can produce natural monopolies Dollars per unit P m F A Q m MR D LMC LAC Quantity per Time Period Slide 28-11 Figure 28-2, Panel (a) Slide 28-12 3
Profit Maximization and Regulation Through Marginal Cost Pricing Profit Maximization and Regulation Through Marginal Cost Pricing Panel (b) Average Cost Pricing Regulatory Goal: P = ATC Dollars per unit AC 1 P 1 Losses C B D LMC LAC Dollars per Unit P 1 = AC 1 Set price at P 1 where ATC = D Output = Q 2 P = ATC Normal rate of return LMC LAC Figure 28-2, Panel (b) Q 1 Quantity per Time Period Slide 28-13 D Q 2 Quantity per Time Period Slide 28-14 Regulating Natural Monopolies Policy Example: Power Outages as an Outcome of Regulation Methods of rate regulation Cost-of-service regulation Regulation based on allowing prices to reflect only the actual cost of production and no monopoly profits Rate-of-return regulation Regulation that seeks to keep the rate of return in the industry at a competitive level by not allowing excessive prices to be charged Some forms of regulation give electric utilities an incentive to freeze current rates. To do so, they may skimp on maintenance measures. Deferred maintenance of equipment and trimming of trees contributed to the widespread power blackout of August 2003. Slide 28-15 Slide 28-16 4
Regulating Nonmonopolistic Industries Rationales for government oversight in nonmonopolistic industries: Market failure arising from externalities The need for consumer protection arising from asymmetric information Regulating Nonmonopolistic Industries The Lemons Problem The possibility that asymmetric information can result in low product quality for an entire industry Used Cars Credence Goods Slide 28-17 Slide 28-18 Regulating Nonmonopolistic Industries Incentives and Costs of Regulation Implementing consumer protection regulation: Liability laws Direct mandates on business behavior, such as safety regulations in transportation and pharmaceuticals Creative response and feedback effects: results of regulation Creative Response Behavior on the part of a firm that allows it to comply with the letter of the law but violates the spirit, significantly lessening the law s effects Slide 28-19 Slide 28-20 5
Incentives and Costs of Regulation Incentives and Costs of Regulation Creative response and feedback effects: results of regulation Feedback Effect Changing behavior after the regulation that offset the regulation Example Parents allowing their children to eat candy in cities where the water is fluoridated Capture Hypothesis Predicts that the regulators will eventually be captured by the special interests of the industry being regulated Slide 28-21 Slide 28-22 Example: A Cigarette Manufacturer Who Wants to Be Regulated Incentives and Costs of Regulation The Food and Drug Administration has sought to gain regulative authority over the tobacco industry. One company, Philip Morris, has encouraged Congress to grant the FDA this oversight, thinking that it would improve the public image of cigarettes. Share-the-Gains, Share-the-Pains Theory The regulators must take account of the demands of three groups: legislators, members of the regulated industry, and consumers of the regulated industry s product or service Slide 28-23 Slide 28-24 6
Incentives and Costs of Regulation The total explicit cost of federal regulation compliance in the U.S. is estimated to be between $500 billion and $600 billion per year. Using regulation to maintain relatively competitive markets The Sherman Antitrust Act of 1890 The Clayton Act of 1914 The Federal Trade Commission Act of 1914 and 1938 Amendment The Robinson-Patman Act of 1936 Slide 28-25 Slide 28-26 Sherman Antitrust Act of 1890 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. Sherman Antitrust Act of 1890 Section 2 Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons to monopolize any part of the trade or commerce shall be guilty of a misdemeanor. Slide 28-27 Slide 28-28 7
Clayton Act of 1914 Passed to remove the vagueness of the Sherman Act Robinson-Patman Act of 1936 Amended Section 2 of the Clayton Act Designed to protect independent retailers and wholesalers from unfair discrimination by chain stores Slide 28-29 Slide 28-30 Exemptions from antitrust laws All labor unions Public utilities Professional baseball Cooperative activities among American exporters Exemptions from antitrust laws Hospitals Public transit and water systems Suppliers of military equipment Joint publishing arrangement in a single city with two or more newspapers Slide 28-31 Slide 28-32 8
Antitrust Enforcement As more U.S. firms seek to merge with companies in other countries, the international dimensions of antitrust policy become more important. In the European Union, there are restrictions against any business combination that would enhance the market dominance of one firm. Monopolization The possession of monopoly power in the relevant market and the willful acquisition or maintenance of that power, as distinguished from growth or development as a consequence of a superior product, business acumen, or historical accident Slide 28-33 Slide 28-34 Antitrust Enforcement Antitrust Enforcement Monopoly power Market Share Test The percentage of a market that a particular firm controls The relevant market The relevant product market The relevant geographic market Slide 28-35 Slide 28-36 9
Antitrust Enforcement Antitrust Enforcement Determining when a firm has sought to acquire or to maintain market power: Versioning Bundling Product Versioning Selling a product in slightly altered forms to different groups of consumers An example is selling software in professional and standard versions Slide 28-37 Slide 28-38 Antitrust Enforcement Product bundling Offering two or more products for sale as a set Some types of bundling are tie-in sales, which require a consumer to purchase one product in order to obtain another Issues and Applications: A Model Case of Collusive Price Fixing? Fashion-modeling agencies negotiate and arrange the relationships between models and photography studios. For years, all agencies had used identical terms regarding the premiums paid by photographers and the percentages paid to models. The U.S. Department of Justice is investigating these price-fixing agreements. Slide 28-39 Slide 28-40 10
Summary Discussion of Learning Objectives Summary Discussion of Learning Objectives Government Regulation of Business Either Economic or Social Practical Difficulties in Regulating the Prices Charged by Natural Monopolies Marginal cost pricing results in losses Regulation aims to provide zero economic profit Rationales for Regulating Nonmonopolistic Industries: Market Failure Asymmetric Information Slide 28-41 Slide 28-42 Summary Discussion of Learning Objectives Summary Discussion of Learning Objectives Regulators Incentives and the Costs of Regulation Capture hypothesis Share-the gains; share the pains Foundations of antitrust: Sherman Act (1890) Clayton Act (1914) Federal Trade Commission Act (1914) Robinson-Patman Act (1936) Slide 28-43 Slide 28-44 11
Summary Discussion of Learning Objectives Issues in Enforcing Antitrust Laws Enforcement is through Supreme Court interpretations Market share test and relevant market End of Chapter 28 Regulation and in a Globalized Economy Slide 28-45 12