Economics 411 Handout 1 Professor Tom K. Lee
Part 1: Review of economics concepts and theories
Market price is the price determined by the actions of all the
buyers and sellers of a market.
Demand price of a product is the maximum amount a consumer is
willing to pay for the last unit of a product.
Two views of a demand curve: positive versus normative views
Consumer surplus is the difference between the maximum amount that
a consumer is willing to pay for the quantity demanded and the
actual payment of the purchase.
The First Law of Demand states that as the market price of a
product increases the quantity demanded of the product
decreases.
Own-price demand elasticity is the percentage change in the
quantity demanded of a product per percentage change in the
market price of the product.
Cross-price demand elasticity is the percentage change in the
quantity demanded of a product per percentage change in the
price of another product.
Supply price of a product is the minimum that one has to pay to
induce a seller to produce and supply the last unit of a
product.
Two views of a supply curve: positive versus normative views
Producer surplus is the difference between the actual amount a
seller receives and the minimum that the seller is willing to
accept for the quantity supplied.
The First Law of Supply states that as the market price of a
product increases the quantity supplied of the product
increases.
Own-price supply elasticity is the percentage change in quantity
supplied of a product per percentage change in the market price
of the product.
Cross-price supply elasticity is the percentage change in the
quantity supplied by all other firms in an industry of
differentiated products per percentage change in the price of
the product of one firm.
Equilibrium price is that price where quantity demanded equals
quantity supplied.
Equilibrium price and quantity determination
The Law of Supply and Demand states that, whenever the market
price deviates from the equilibrium price, there are market
forces that would bring the market price back to the equilibrium
price so that transactions take place at the equilibrium price.
Economics 411 Handout 2 Professor Tom K. Lee
Perfect competition model -many small price-taking buyers
-many small price-taking sellers
-no transaction cost(free entry & exit)
-perfect information
-homogeneous private product
-no externality
Short-run profit maximization conditions of a competitive firm:
-price equals to short-run marginal cost.
-short-run marginal cost is increasing.
-price is no less than average variable cost.
Long-run profit maximization conditions of a competitive firm:
-price equals long-run marginal cost.
-long-run marginal cost is increasing.
-price is no less than minimum long-run average cost.
Zero profit equilibrium conditions of a competitive industry
-price equals long-run marginal cost.
-long-run marginal cost is increasing.
-price equals minimum long-run average cost.
Efficiency of zero profit equilibrium of a competitive industry
A perfectly contestable market is when
-entrant firms and existing firms are symmetric in information,
technology, quality of product and market.
-no sunk costs, i.e. all costs associated with entry are fully
recoverable.
-entry lag is less than the price adjustment lag for existing
firms.
Perfectly contestable market equilibrium is efficient.
Sources of monopoly(market) power -essential input
-economies of scale
-product differentiation
-government regulation
-entry barrier
Lerner’s index of market power is the price-cost margin.
Natural monopoly is a one seller situation where for all relevant
levels of demand the average cost curve is declining.
Entry barrier is the situation when potential entrants have higher
costs for all output levels than existing firms.
Entry barrier(Stigler) is the extra cost of production which must
be borne by entrant firms but is not borne by existing firms.
this could occur in face of market imperfections or
incompleteness.
Limit Pricing is the maximum price a seller can set without having
to face entry.
Predatory pricing is the situation where existing firms will lower
price to drive out entrant firms and when entrant firms exit the
market, the existing firms will raise price up again.
Economics 411 Handout 3 Professor Tom K. Lee
Problems of existing rules for testing predatory pricing
-the Areeda-Turner rule:
A price at or above reasonably anticipated average variable
cost (or better, marginal cost if you can get the data) should
be conclusively presumed legal; otherwise it is illegal.
-the Marginal Cost rule:
Post-entry output greater than pre-entry output is legal only if post-entry price is no less than short-run marginal cost.
-the ATC rule:
Pricing below ATC plus substantial evidence of predatory
intent is illegal.
-the Output Restriction rule:
Post-entry output greater than pre-entry output is illegal.
-the Joskow-Klevorick Two-Stage rule:
Stage one: is market structure likely to have successful
predation? If not, stop; if yes, proceed to stage
two.
Stage two: use one of the above cost-based or pricing behavior
tests.
Pure monopoly model -many small price-taking buyers
-one price-setting seller
-no entry
-no substitutes
-perfect information
-no externality
Total revenue, average revenue and marginal revenue curves
Short-run profit maximizing conditions of a monopoly:
-marginal revenue equals marginal cost.
-change in marginal cost exceeds change in marginal revenue.
-price is no less than average variable cost.
Social costs of a monopoly -Harberger's triangle
-rent-seeking cost
-dynamic cost
-X-inefficiency
Two-part tariff monopoly is a single seller charging a entry fee
and a per unit price of a product to its customers.
All-or-nothing monopoly is a single seller set a price per unit of
a product and a fixed quantity of purchase or no deal.
Monopsony is a one price-setting buyer & many price-taking sellers market situation.
The Structure-Conduct-Performance Model of Industrial Organization
A market consist all products with large cross-price elasticity of
demand and all participants with large cross-price elasticity of
supply.
The n-firm concentration ratio is defined as the share of the
total industry sales accounted for by the n largest firms.
Economics 411 Handout 4 Professor Tom K. Lee
The Herfindahl Hirschman Index of Concentration is defined as the
sum of square of the market share of all firms in an industry.
With a single firm in an industry, HHI attains its maximum
value of 10,000. An HHI value of 1500 is considered to be
critical by the antitrust agencies.
The Collusion Hypothesis states that the more concentrated an
industry is, the less competitive are firms and thus the higher
the price-cost margin. It treats concentration as exogenous.
Demsetz’s Differential Efficiency Hypothesis states that there is
no causality in high concentration and price-cost margin.
Instead concentration of an industry is endogenous. E.g. a few
firms in an industry have a cost advantage will be highly
concentrated and those firms will have high price-cost margin as
well.
Conditions of price discrimination
-market power
-ability to separate consumer groups
-no resale
1st degree price discrimination is the charging of different
prices for different units of a product to each consumer.
2nd degree price discrimination is the charging of different
prices for different blocks of units of a product to each
consumer.
3rd degree price discrimination is the charging of different
prices to different consumers(possibly in different markets).
4th degree price discrimination is the charging of the same price
for a product or service to different consumers, but the cost of
providing the product or service differ across consumers.
The inverse demand elasticity rule
Output effect versus allocative efficiency
Monopolistic competition model
-many small price-taking buyers
-many small price-setting sellers
-product differentiation
-zero transaction cost(free entry & exit)
-perfect information
-no externality
Zero profit equilibrium of a monopolistic competitive industry:
-marginal revenue equals marginal cost
-change in marginal cost exceeds change in marginal revenue
-price equals long-run average cost
Inefficiency of monopolistic competition
-price > marginal revenue = marginal cost
-long-run average cost > minimum long-run average cost
Economics 411 Handout 5 Professor Tom K. Lee
Excess Capacity Hypothesis states that at the zero profit
equilibrium of a monopolistic competitive industry, average cost
is not at the minimum average cost, that is further increase in
output will lower average cost.
Dominant-firm price leadership model and residual demand
Oligopoly: Cournot(quantity) versus Bertrand(price) rivalry
Game theory -number of players
-information sets of players
-preferences of players
-strategy sets of players
-equilibrium concepts, e.g. Nash equilibrium
Prisoners’ Dilemma game
Determinants of cartel stability
-demand elasticity
-number of sellers and/or industry concentration
-degree of product differentiation
-organization cost of cartel/ cost of detecting cheater(s) &
demand & cost uncertainty/ best price sale policy/ ease of
entry/ ease to punish cheaters/ symmetry of cartel members
-interest rate
-antitrust enforcement effort
Entry in normal versus extensive game form and sub-game perfect
equilibrium
Chain-Store Paradox
Part 2: Introduction to antitrust
(CH 1, pp 1-5, CH 4)
Antitrust is public policies to prohibit monopolization, attempt to monopolize (but not monopoly because of patent, copyright laws
and government regulation), and unfair and deceptive trade
practices that may deter competition.
Rationale for antitrust: to promote static and dynamic economic
efficiency.
The wealth of a nation, as defined by Adam Smith, is measured by
how much the consumers consume today and in the future and
not by how much profits firms make.
Antitrust agencies
-Department of Justice: Antitrust Division
-Federal Trade Commission
Private antitrust lawsuits through U.S. District Courts have been
the major form of antitrust enforcement for the last fifty
years. Over 85% of antitrust cases per year are private ones.
They typically involve practices such as tying, exclusive
dealing, dealer termination, and price discrimination. Almost
90% either settled or voluntarily dropped by the plaintiff.
Economics 411 Handout 6 Professor Tom K. Lee
However, the most lengthy and costly cases are government cases.
About two-thirds of DOJ cases have involved horizontal price
fixing, with the second most frequent cases being
monopolization. Most cases ended by consent decree, or orders.
Two rules of antitrust:
-per se rule applies when a business practice has no beneficial
effects but has harmful effects.
-rule of reason applies when per se rule is not applicable. It
consists of two parts, the first being the “inherent effect”
of market shares, and the second being the “evident purpose”
or intent of the business practice.
Part 3: Introduction to AntitrustLaws
(CH 3 pp66-74, CH 7 pp 208-210))
The Sherman Act of 1890:
-Section 1 prohibits contracts, combinations, and conspiracies
in restraint of trade, specifically price-fixing arrangements.
-Section 2 prohibits monopolization, attempts to monopolize, and
combinations or conspiracies to monopolize "any part of the
trade or commerce among several states, or with foreign
nations," specifically for market dominance.
Horizontal restraint of trade is the concerted actions among firms
to reduce potential or actual competition with one another.
(i) Actual and implied horizontal price-fixing is per se
illegal. Collusion to raise prices for the sole purpose of
reducing competition is called “naked” price fixing and
is per se illegal. Agreement on a price range is not
allowed.
(ii) Horizontal agreements that affect prices are illegal per
se, e.g. agreements on common standards for the purpose of
affecting price is illegal.
(iii) Output restriction in which competitors act in
concert to limit supply in order to raise prices is
illegal.
(iv) Competitors’ agreements to divide territory markets or
customers are per se illegal.
(v) Sellers concerted refusal to deal with a known price
cutter, or buyers joint boycott of a high price seller are
per se illegal.
Direct or circumstantial evidences may be sufficient to prove
illegality. Parallel action alone will not be sufficient to
prove violation of antitrust laws. However, if a price leader
raises price in a declining market and in an industry with
overcapacity, and then all firms match the price increase, it
can be construed be sufficient evidence of price fixing.
Economics 411 Handout 7 Professor Tom K. Lee
Vertical restraint of trade is the concerted actions of sellers
and buyers to reduce potential and actual competition either in
the sellers’ market or the buyers’ market or both.
Verticalprice-fixing in which a seller and a buyer agree with respect to price at which the buyer will resell is illegal per se. An example will be retail price maintenance agreement.Maximum retail price maintenance agreement is guided by rule of reason. Manufacture retail suggested price is allowed. In consignment sales to a true agent, a seller is free to set the price at which his products are sold, even though the agent is otherwise an independent business.
Non-price vertical restraints are governed by rule of reason.
(i)Exclusive selling agreements (e.g. exclusive
franchise to a particular dealer in a specified territory) is allowed.
(ii)Territorial and customer restrictions (e.g. orderly
marketing plans are subject to rule of reason,
depending on whether the anticompetitive effect of the
restraint on intra-brand competition is outweighed by the
pro-competitive effect of inter-brand competition
generated by strengthening the seller’s ability to
compete) aresubject to rule of reason.
(iii)Section 3 of the Clayton Act prohibits exclusive dealing agreements in which a buyer has to purchase all its requirements for the product from a seller, if these agreements are likely to substantially lessen competition.
(iv)Sherman Act and Section 3 of the Clayton Act prohibit tying agreements. Tie-in are per se illegal if a seller possesses sufficient market power in the tying product, and coerces a buyer to buy the tied product of substantial value as a condition to buy the tying product, when the buyer can buy the tied product elsewhere at a lower price.
(v)Refusals to deal are usually subject to the rule of reason. However, a seller agrees with some buyers not to sell to another buyer who is a price cutter is per se illegal.
The Clayton Act of 1914:
-Section 2(a) outlaws price discrimination if it substantially
lessens competition. (However, price discrimination of
consumers or buyers who do not resale is legal.)
-Section 2(b) allows “good faith” defense to meet competition,
i.e. to meet but not to beat a low price offer of a rival, or
to charge different prices due to differences in cost of
manufacturing, sale or delivery.(What is the problem here?)
Economics 411 Handout 8 Professor Tom K. Lee
-Section 2(c) forbids hidden form of price discrimination such
as claiming a discount as a brokerage commission.
-Section 2(d) and 2(e) prohibit discriminatory behavior in
providing promotional allowances and services.
-Section 2(f) prohibits a large buyer to extract illegal
concessions from a relatively small seller.
-Section 3 prohibits tying clauses, requirement contracts,
exclusive dealings and territorial restraints that lessen
competition.
-Section 4 allows any person injured in his business or property
due to violation of antitrust laws to sue in any district
court of the United States to recover treble damages, and the
cost of the lawsuit, including a reasonable attorney’s fee.
-Section 4(b) sets a four-year statute of limitations, unless
there is government action pending. The four-year period does
not begin until the victims discover (or should have
discovered) the antitrust violations. In addition, a court of
appeals ruled that “So long as a monopolist continues to use
the power it has gained illicitly to overcharge its customers,
it has no claim on the repose that a statute of limitations is
intended to provide”.
-Section 5(a) makes a judgment in a suit brought by the United
States “prima facie evidence” in a private suit, thus giving
private plaintiffs an advantage as a result of a government
victory without subjecting them to any disadvantage from a
government loss. However, this section shall not apply to
consent judgments or decrees entered before any testimony has
been taken. (This encourages settlement before costly trial.)
-Section 5(b) to 5(h) require the United States to publish for
public comment any proposed consent judgment that would settle
a case in which it is a plaintiff. The Government must
summarize the competitive effects of the settlement. After a
period in which comments may be submitted, the district judge
must determine whether the proposed judgment is in the public
interest. The court can reject a proposed settlement if it
determines that the proposed decree is not in the public
interest. If it is rejected, the case must be tried.
-Section 7 prohibits interlocking directorates, and
mergers between competitors to the extent that they would
substantially lessen competition or tend to create a
monopoly, but exempts labor unions.
Price discrimination in sales of goods of like grade and quality
is illegal only if it is likely to result in substantial injury
to buyers’ competition(injury in the secondary line) or to
sellers’ competition (injury in the primary line).
To prove injury in the secondary line, the buyers must be
competing geographically and be on the same functional line. Economics 411 Handout 9 Professor Tom K. Lee
Primary line injury requires stronger prove of actual or
likely impairment of competition.
In primary line (sellers) injury, a seller sells a substantially
lower price in an area facing competition from other sellers,
but at a substantially higher price in an area facing no
competition may be illegal, but selling at a lower price in good
faith to meet the equally low ( but not lower) price of a
competitor is a good faith defense.
If a direct-buying retailer is charged less than a wholesaler
whose retail customers compete with the favored direct-buying