ECN 112 Chapter 17 Lecture Notes
17.1 Regulation
Regulation is rules administered by a government agency to influence economic activity
by determining prices, product standards and types, and the conditions under which new
firms may enter an industry. Deregulation is the process of removing restrictions on
prices, product standards and types, and entry conditions.
A. The Changing Scope of Regulation
Regulation has evolved over the past 120 years in the United States.
1. The Interstate Commerce Commission, the first federal regulatory agency, was
organized in 1887 to regulate interstate railroads. It now regulates several other
industries, including oil pipelines and water carriers.
2. Since the 1930s, the number of regulatory agencies greatly increased (at both the
state and federal levels). By the 1970s, almost one quarter of all industry was
regulated. In the last 20 years, there has been a tendency for deregulation.
B. The Regulatory Process
1. Regulatory agencies have certain characteristics including:
a. Governmental appointment of bureaucrats to manage the agencies.
b. Government funding of the agencies.
c. Adoption of operating practices for controlling prices and other regulated aspects of
the firm.
2. Regulatory agencies allow firms to choose production technology but do not allow the
firms to set prices, output, or markets served.
C. Economic Theory of Regulation
1. Public Interest Theory
Public interest theory is the theory that regulation seeks an efficient use of
resources.
2. Capture Theory
Capture theory is the theory that regulation helps producers to maximize economic
profit. It assumes that the cost of regulation is high, and as a result, regulation will
increase the surplus of small, easily identifiable groups with low organization costs.
D. Natural Monopoly
1. A natural monopoly is an industry in which one firm can supply the market at a lower
cost than two or more firms can.
2. A natural monopoly’s average total cost curve slopes downward because as the
number of customers served increases, the large fixed cost is spread over a larger
number of households.
E. Public Interest or Private Interest Regulation?
1. Marginal Cost Pricing
A marginal-cost pricing rule sets price equal to marginal cost to achieve an efficient
output in a regulated industry.
a. Because output is efficient, this regulation is public interest regulation
b. The regulated firm incurs an economic loss because the price is less than average
total cost. If the firm cannot find a way to earn a profit (perhaps by using a two-part
tariff or price discrimination), the government has to decide whether or not to
subsidize the firm.
c. If the government levies a tax to fund the subsidy, society experiences a
deadweight loss. The regulator must determine which deadweight loss is greater:
the one created by taxation or the one created by the inefficient use of resources.
2. Average Cost Pricing
An average-cost pricing rule sets price equal to average total cost to enable a
regulated firm to cover its costs
a. Average cost pricing generates a deadweight loss. This outcome is considered
efficient if the deadweight loss is less than the loss from collecting the taxes to
finance a subsidy under marginal cost pricing.
3. Rate of Return Regulation
Rate of return regulation sets the price at a level that enables a regulated firm to
earn a specific target percent return on its capital.
a. If costs are correctly assessed, the regulated price equals average total cost.
b. With rate of return regulation, firms have the incentive to exaggerate their costs
because higher costs are passed on to consumers as higher prices. So, rate of
return regulation can generate an inefficient outcome.
4. Price Cap Regulation
Price cap regulation specifies the highest price that a firm is permitted to set—a price
ceiling.
a. A correctly set price cap can lower the price and increase the output.
b. Earnings sharing regulation requires firms make refunds to customers when
profits rise above a target level. Earnings sharing regulation is often combined with
price cap regulation in case the regulator set the price cap too high.
F. Oligopoly Regulation
A cartel, which can occur in oligopolistic markets, engages in illegal activity to limit output,
raise price, and increase economic profit.
1. According to public interest theory, the oligopoly is regulated so that a competitive
outcome occurs and resources are efficiently used.
2. According to capture theory, the cartel will influences the regulator so that output is
restricted to its monopoly level.
17.2 Antitrust Law
Antitrust law, enacted by Congress and enforced by the judicial system, is the body of law
that regulates and prohibits certain kinds of market behavior, such as monopoly and
monopolistic practices.
A. The Antitrust Laws
1. The Sherman Act, passed in 1890, was the first U.S. antitrust law. Section 1 of the
Sherman Act outlaws “every contract, … or conspiracy in restraint of trade.” Section 2
makes illegal “an attempt to monopolize.”
2. The Clayton Act, passed, in 1914, along with its two amendments, the RobinsonPatman Act (1936) and the Celler-Kefauver Act (1950), prohibit specific business
practices “only if they substantially lessen competition or create monopoly.” The
practices are:
a. Price discrimination.
b. Tying arrangements.
c. Requirements contracts.
d. Exclusive dealing.
e. Territorial confinement.
f. Acquiring a competitor’s shares or assets
g. Becoming a director of a competing firm.
B. Three Antitrust Policy Debates
1. Resale Price Maintenance
Resale price maintenance is an agreement between a manufacturer and a distributor
on the price at which a product may be sold.
a. Resale price maintenance is inefficient when it enables dealers to operate a cartel
and charge the monopoly price.
b. Resale price maintenance might be efficient if it enables a manufacturer to induce
dealers to provide the efficient standard of service in selling a product.
2. Tying Arrangements
A tying arrangement is an agreement to sell one product only if the buyer agrees to
buy another, different product.
a. There is no simple test of whether a firm is engaged in tying or whether, by so
doing, it has created inefficiency.
3. Predatory Pricing
Predatory pricing is setting a low price to drive competitors out of business with the
intention of setting a monopoly price when the competition has gone.
a. Economists are skeptical that predatory pricing occurs often because the firm would
be exchanging a high and certain loss for a temporary and uncertain gain.
C. A Recent Antitrust Showcase: The United States Versus Microsoft
1. The Case against Microsoft.
The government charged Microsoft with the following:
a. Possessing monopoly power in the PC operating system market.
b. Using predatory pricing and tying arrangements to achieve a monopoly in the
market for Web browsers.
c. Using other anticompetitive practices to restrict competition.
2. Microsoft’s Response
Microsoft challenged these charges and claimed that it was vulnerable to competition
and that integrating Internet Explorer with Windows provided greater consumer value.
3. The Outcome
The court agreed that Microsoft was in violation of the Sherman Act and ordered that it
be split into two firms. But Microsoft successfully appealed this ruling and in the final
judgment Microsoft was ordered to disclose details about its operating system so that
its competitors could compete more effectively.
D. Merger Rules
The Department of Justice uses guidelines based on the Herfindahl-Hirschman index
(HHI) to help decide whether or not to challenge mergers within a market.
1. An HHI between 1,000 and 1,800 shows a market is moderately concentrated. The
Department of Justice challenges any merger in this range that will raise the HHI by
more than 100 points.
2. An HHI greater than 1,800 shows a highly concentrated market. The Department of
Justice challenges a merger in this range if the merger will raise the HHI by 50 points.