Chapter 12

Regulation and Antitrust:

The Role of Government in the Economy

12.1 GOVERNMENT REGULATION TO SUPPORT
BUSINESS AND TO PROTECT CONSUMERS,
WORKERS, AND THE ENVIRONMENT

According to the economic theory of regulation expounded by George Stigler and others, regulation arises from the actions of pressure groups and results in laws and policies in support of business and to protect consumers, workers, and the environment. Some of the policies designed to support business restrict entry and competition. These are licenses, patents, restrictions on price competition, import restrictions (tariffs and quotas), as well as subsidies and special tax treatments to aid such sectors as agriculture, railroads, airlines, and energy. Consumers are protected by regulations requiring truthful disclosure by firms and forbid-ding misrepresentation of products, as well as by laws requiring truth in lending, fairness in evaluating credit applications, clarity in warranties, safety on highways, and many other consumer-protective practices. Workers are protected by laws that specify safety standards, equal employment opportunity, and minimum wages, while regulation of air, water, and other aspects of the environment is carried out by the Environmental Protection Agency.

EXAMPLE 1. Government restrictions on price competition include government-guaranteed parity prices in agriculture and control of trucking freight rates and airline fares (before deregulation) and of ocean shipping rates, as well as restrictions on many other prices and pricing practices. One part of the Robinson-Patman Act, which was passed in 1936 to amend the Clayton Antitrust Act, also restricted price competition by forbidding firms from selling more cheaply to one buyer or in one market than to other buyers or in other markets and from selling at “unreasonably low prices” with the intent of destroying competition or eliminating a competitor. The act sought to protect small retailers (primarily grocery stores and drug stores) from price competition from large chain-store retailers, whose power was based on their ability to obtain lower prices and brokerage concession fees on bulk purchases from suppliers. Judging from the continuous decline in the number of small independent grocers, drug stores, and other retail businesses, and the expansion in the number and size of supermarkets, however, the act was not very successful.


EXAMPLE 2. Some of the laws, regulations, and agencies that protect consumers from unfair business practices are these:

1. The Food and Drug Act of 1906 and the subsequent amendments to it, which forbid adulteration and mislabeling of foods, drugs, and cosmetics. Other requirements are that drugs and chemical additives to foods be proved safe for human use and that herbicides and pesticides be tested for their toxicity.

2. The Federal Trade Commission Act of 1914 and its 1938 amendment, the Wheeler-Lea Act, which protects firms against unfair business practices by competitors and which also protects consumers against such practices as claiming to have slashed prices after having first raised them and other types of false advertising.

3. The Consumer Credit Protection Act of 1968, which requires truth in lending.

4. The Consumer Product Safety Commission, established in 1972, which protects consumers against the risk of injury associated with the use of a product.

5. The Fair Credit Repotting Act of 1971.

6. The Warranty Act of 1975.

7. The National Highway Safety Traffic Administration.

Workers are protected by the Occupational Safety and Health Administration, the Equal Employment Opportunity Commission, and minimum wage laws, among others, while the environment is protected by the Environmental Protection Agency.

12.2 EXTERNALITIES AND REGULATION

According to the public interest theory, government regulation is undertaken to overcome market failures, so that the economic system can operate in a manner consistent with the public interest. One type of market failure is due to externalities. These refer to beneficial or harmful effects received or borne by firms or individuals other than those producing or consuming the product or service. We have external economies and diseconomies of production and consumption. External economies of production are uncompensated benefits received by firms other than those involved in the production of the good or service. External diseconomies of production are uncompensated costs imposed on firms other than those involved in production of the good or service. External economies of consumption are uncompensated benefits received by individuals other than those consuming the good or service. External diseconomies of consumption are uncompensated costs imposed on individual other than those consuming the good or service. Market failures due to externalities can be overcome by prohibitions or regulations, taxes or subsidies, voluntary payments, mergers, or the sale of pollution rights.

EXAMPLE 3. Figure 12-1(a) shows that the best number of hours of typing per evening for individual A is 4 and is given by point EA, at which A’s marginal private benefit (MPBA) and marginal private cost (MPCA) are equal. Evening typing by individual A, however, creates noise and a cost for individual B (who is driven to eat out or go to a movie or a bar). The marginal social cost (MSC) is thus given by the vertical summation of the MPCA and MPCB curves. From society’s point of view, the best level of typing by individual A is 3 hours per evening and is given by point E5, at which MPBA = MSC = $8. The socially optimal level of 3 hours of evening typing is reached when the government imposes a tax of t = $3 per hour of evening typing on individual A. This shifts the MPCA curve up by $3 so that the MPCA + t curve (not shown in the figure) intersects the MPBA curve at point ES , at which MPBA = MSB = MSC. In pan (b), the best number of hours for individual A to work in his or her yard is 6 hours per week and is given by point EA, at which MPBA = MPCA. Individual A’s yardwork, however, generates an external benefit to individual B (i.e., the work increases the value of individual B’s home also). Thus, the marginal social benefit, MSB, equals MPBA + MPBB. Therefore, the best level of yardwork by individual A is 10 hours per week, as shown by point ES , at which MSB = MPCA = MSC = $9. Individual A can be induced to tend the yard for 10 hours per week by giving the person a consumption subsidy of s = $3 per hour. This shifts the MPBA curve up by $3 so that the MPBA + s curve intersects the MPCA curve at point ES, at which MSB = MPCA = MSC. (The same result can be reached by shifting the MPCA – S curve down by $3.)


Fig. 12-1


12.3 PUBLIC UTILITY REGULATION

In some industries, economies of scale operate continuously as output expands, so that a single firm could supply the entire market more efficiently than any number of smaller firms. Such natural monopolies are common in the provision of electric, gas, water, local telephone, and local transportation services (public utilities). In cases such as these, the government usually allows a single firm to supply the entire market but sets P = LAC so that the firm breaks even (i.e., earns only a normal return on investment). Economic efficiency, however, requires that P = LMC. But this would result in a loss, and the company would not supply the service in the long run without a subsidy (see Example 4).

EXAMPLE 4. In Fig. 12-2 the D and MR curves are, respectively, the market demand and marginal revenue curves faced by the public utility company for the service, while the LAC and LMC curves are the company’s long-run average and marginal cost curves. If unregulated, the company’s best level of output in the long run would be 5 million units per time period and is given by point E, at which the LMC and MR curves intersect. For Q = 5 million units, the company would charge $11 (point A on the D curve) so that LAC = $9 (point B on the LAC curve), thereby earning a profit of $2 (line segment AB) per unit and $10 million (the area of rectangle ABCF) in total. To ensure that the public utility company earns only a normal rate of return on investment, the regulatory commission usually sets
P = LAC. This is given by point G, at which P' = LAC = $6 and Q = 10 million units per time period. The best level of output from society’s point of view, however, is 13 million units, given by point H, at which P = LMC = $3. At Q = 13 million, however, the public utility would incur a loss of $2 (line segment HJ) per unit and $26 million per time period. As a result, the company would not supply the service in the long run without a per-unit subsidy of $2 per unit. There are many other difficulties with public utility regulation. (See Problem 12-12.)

12.4 ANTITRUST: GOVERNMENT REGULATION OF MARKET STRUCTURE AND CONDUCT

Starting with the Sherman Act of 1890, a number of antitrust laws were passed to prevent monopoly or undue concentration of economic power, protect the public against the abuses and inefficiencies resulting from monopoly or the concentration of economic power, and maintain a workable degree of competition in the U.S. economy. The Sherman Act (1890) prohibits monopolization and restraints of trade in commerce among the states and with foreign nations. The Clayton Antitrust Act (1914) prohibits price discrimination, exclusive and tying contracts, and intercorporate stock holdings if they substantially lessen competition or tend to create a monopoly, and unconditionally prohibits interlocking directorates. The Federal Trade Commission Act (1914), passed to supplement the Clayton Antitrust Act, makes unfair methods of competition illegal and also established the Federal Trade Commission (FTC) to prosecute violators of the antitrust laws and protect the public against false and misleading advertisements. The Robinson-Patman Act (1936) protects small retailers from unfair price competition from large chain-store retailers, based on the latter’s ability to obtain lower prices and brokerage concession fees on bulk purchases from suppliers, if the intent is to destroy competition or eliminate a competitor. The Wheeler-Lea Act (1938) amended the Federal Trade Commission Act and forbids false or deceptive advertising of foods, drugs, corrective devices, and cosmetics entering interstate commerce. The Celler-Kefauver Antimerger Act (1950) closed a loophole in the Clayton Antitrust Act by making it illegal to acquire not only the stock but also the assets of competing corporations if such a purchase substantially lessens competition or tends to create a monopoly.


Fig. 12-2

12.5 ENFORCEMENT OF ANTITRUST LAWS AND THE DEREGULATION MOVEMENT

Enforcement of antitrust laws has been the responsibility of the Antitrust Division of the Department of Justice and the Federal Trade Commission (FTC). Antitrust violations have been resolved by (1) dissolution and divestiture, (2) injunction, and (3) consent decree [see Problem 12.17(b)] Fines and jail sentences have also been imposed. Starting with the 1945 Alcoa case, the U.S. Supreme Court ruled that size per se is an offense, irrespective of illegal acts. Today, however, both size and some anticompetitive behavior seem to be required for successful prosecution. The Court has generally challenged horizontal mergers between large direct competitors, but has not challenged vertical and conglomerate mergers unless they would lead to increased horizontal market power. The Court has used the Sherman Act to prosecute not only attempts to set up a cartel, but also any informal collusion to share the market, fix prices, or establish price leadership schemes. The Court has ruled that conscious parallelism (i.e., the adoption of similar policies by oligopolists in view of their recognized interdependence) is illegal when it reflects collusion. The Court has also attacked predatory pricing (i.e., selling at below average variable cost in a particular market in order to drive a competitor out or to discourage new entrants) and price discrimination and other price behavior when it substantially lessens competition or tends to create a monopoly. Since the mid-1970s, the government has deregulated airlines and trucking, and reduced the level of regulation for financial institutions, telecommunications, and railroads in order to increase competition and avoid some of the heavy compliance costs of regulation. While the full impact of deregulation has yet to be felt, deregulation seems to have led to increased competition and lower prices, but it has also resulted in some problems.

EXAMPLE 5. In 1974 the Justice Department filed suit against AT&T under Section 2 of the Sherman Antitrust Act for illegal practices to eliminate competitors in the markets for telephone equipment and long-distance telephone service. In 1982, after eight years of litigation and at a cost of $25 million to the government (and $360 million incurred by AT&T to defend itself), the case was settled. By consent decree, AT&T agreed to divest itself of the 22 local telephone companies (which represented two-thirds of its total assets) and relinquish its monopoly on long-distance telephone service. In return, AT&T was allowed to retain Bell Laboratories and its manufacturing arm, Western. Electric, and to enter the rapidly growing fields of cable TV, electronic data transmission, videotext communications, and computers. The agreement also led to an increase in local telephone charges (which had been subsidized by AT&T’s long-distance telephone service) and to a reduction in long-distance telephone charges.

EXAMPLE 6. In 1961 General Electric, Westinghouse, and a number of smaller companies producing electrical equipment pleaded guilty to violations of antitrust laws because of price fixing and division of the market. The companies were fined a total of $2 million and had to pay over $400 million in damages to customers; 7 of their executives were sent to jail, and 23 others received suspended sentences. The conspiracy (which occurred from 1956 to 1959) took the following form: company executives met at conventions or trade associations, and wrote or called to decide which of them would submit the lowest (sealed) bid on a particular contract. The executives involved in the conspiracy knew that they were breaking the law, since they usually met in secret, used code words, did not register at hotels under their own names, sent letters without return addresses, used only first names, etc. While most of the agreements lasted only a short time, and the defendants argued that the profitability of their firms was less during than before the conspiracy, they were found guilty because the prosecution proved that a conspiracy, whether successful or not, had in fact taken place.