1

REGULATION AND
ANTITRUST LAW

Chapter Key Ideas

Social Interest or Special Interests?
A. Natural monopoly is regulated by the U.S. Government.
1. A city water supply, telephone service and cable TV service are
often supplied by regulated natural monopolies.
2. Does regulation work in the interest of allthe social interest
or in the interest of the regulatedspecial interests?
B. Antitrust law restricts the actions of monopolies and blocks some
large firms from merging into one firm.
1. PepsiCo and 7-Up wanted to merge, as did Coca-Cola and Dr.
Pepper. The government blocked these mergers.
2. Do these laws serve the social interest or merely satisfy certain
special interests?

Outline
I.

The Economic Theory of Government

A. The economic theory of government explains the economic roles of
governments, the economic choices that they make, and the
consequences of those choices.
1. Governments exist for two reasons:
a) First, they establish and maintain property rights, the
foundation of which all market activity takes place.
b) Second, they provide mechanisms for allocating scarce
resources when the market economy results in inefficiency
a situation called market failure.
2. In the case of market failure, choices made by consumers or
producers are made in self-interest, but these choices fail to
align with the social interest.
a) Market failure presents the government with an opportunity
to correct the inefficient allocation of resources.
b) Economic analysis can reveal whether these social choices
are efficient or inefficient.
B. There are many examples of market failure that create the potential
for government regulation to increase efficiency:
1. Decisions made by firms operating in a monopoly or oligopoly
prevent resources from being allocated efficiently.
2. The market for public goods creates a free-rider problem
because once the good is provided, everyone can enjoy
consuming it without having to pay for it.
a) Producers are unable to make consumers pay for their level
of consumption and so they under-produce the good.
b) The market process does not motivate these producers to
provide sufficient quantities of the good for an efficient
allocation.
3. A lack of defined property rights makes peoples consumption of
common resources inefficient.
a) Common resources are resources that are not owned by
anyone and yet are used by everyone.
b) The market fails to make consumers reflect the opportunity
cost of consumption in their choices.
c) People consume too much of the common resource and the
market allocation is not efficient.
4. A lack of protection of property rights creates external costs and
external benefits.
a) Externalities are created when production or consumption
costs are borne by people not involved with the production
or consumption of the good.
b) The market fails to motivate producers and consumers of
goods that generate externalities to take into account the
opportunity cost of their choices on society.

W H AT I S E C O N O M I C S ?

c) The producers create too much of the good and the

allocation of resources in this market is inefficient.
C. Besides regulating economic behavior of producers and consumers,
the government can also reallocate resources to address concerns
about equity.
1. The government can tax some people and distribute the
revenues to others.
2. This form of income redistribution can only legitimately be
performed by the government, which must make choices.

D. A government operating within a democratic society can be described

and analyzed as a complex organization making resource allocation
decisions in a political marketplace.
1. Economists have developed a public choice theory of the political
market place.
2. Figure 14.1 shows how the
political marketplace can be
described with four decision
making groups interacting
with each other to produce
outcomes.
a) Voters are the
consumers in the
political marketplace
who express their
preferences through
voting, campaign
contributions and
lobbying activities,
supporting those policies
that they perceive will
make them better of
and opposing those
policies that they
perceive will make them
worse of.
b) Firms are also consumers in the political marketplace that
express the preferences of their owners through campaign
contributions and lobbying activities, supporting those policies
that they perceive will make them better of and opposing those
policies that they perceive will make them worse of.
c) Politicians are the entrepreneurs of the political marketplace,
seeking votes for re-election by creating policies that garner a
majority of voters and campaign contributions.
d) Bureaucrats are the hired officials that produce goods for the
political marketplace, seeking job security and advancement by
maximizing the scope and budget of their own programs.
3. Political equilibrium in the market place is the outcome that
results from the choices of the voters, politicians and bureaucrats
when all their choices are compatible and no one group can
improve its position by making a diferent choice.
II. Monopoly and Oligopoly Regulation
A. Government intervenes in monopoly and oligopoly markets in two
ways:
1. Regulation consists of rules administered by government agency
to influence economic activity by determining prices, product

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standards and types, and the conditions under which new firms may
enter an industry.
2. Antitrust law is law that regulates or prohibits certain kinds of
market behavior, such as monopoly and monopolistic practices.
B. The economic theory of regulation is a part of the broader theory of
public choice. There are two components to regulation:
1. Citizens and firms demand regulation that makes them better of.
a) Voters and firms express their demand through the political
activity of voting, lobbying, or making campaign contributions.
b) The larger the consumer or producer surplus per voter or firm,
or the greater the number of voters and firms, then the greater
will be the demand for regulation by voters and firms.
2. Politicians supply regulations that increase campaign contributions
and votes.
a) Regulations that are noticed by and benefit more voters and
firms are favored and supplied by politicians.
b) Regulations which are not noticed by or do not benefit many
voters or firms are not favored or supplied by politicians.
c) The larger the consumer or producer surplus per voter or firm,
or the greater the number of voters or firms, the greater the
supply of regulations produced by politicians.
C. In a political equilibrium, the regulation produced might be in the social
interest or in the self-interest of the regulation producers.
1. The social interest theory of regulation maintains that politicians
supply the regulation that achieves an efficient allocation of
resources.
a) Government relentlessly seeks out and identifies deadweight
loss.
b) Politicians introduce regulation to eliminate it.
2. The capture theory of regulation maintains that regulation is in
the self-interest of the producers.
a) Political organization is a costly activity.
b) Only those groups that stand to gain highly concentrated
benefits will organize politically and try to influence proposed
regulations.
c) The politicians propose regulation with benefits to organized
groups and costs that are dispersed thinly across all citizens.
d) This makes it very unlikely that the voters outside the politically
organized group will be motivated to organize and oppose the
regulation.
III. Regulation and Deregulation
A. The Scope of Regulation

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1. Some of the main U.S. government agencies involved in regulation

includes:
a) Interstate Commerce Commission.
b) Federal Trade Commission.
c) Federal Power Commission
d) Federal Communications Commission
e) Securities and Exchange Commission
f) Federal Maritime Commission
g) Federal Deposit Insurance Corporation
h) Civil Aeronautical Board
i) Copyright Royalty Tribunal
j) Federal Energy Regulatory Commission.
2. Activities regulated have included interstate railroads, trucking,
buses, water, oil, and gas pipelines, airlines, electricity, natural gas,
broadcasting, telecommunications, banking and finance.
3. Regulation reached its peak in the 1970s when about one quarter of
the economy was subject to some type of regulation. Since then,
deregulation of many industries (including broadcasting,
telecommunications, banking and finance, and all forms of
transportation) has occurred.
B. The Regulatory Process
Regulatory agencies difer in many detailed ways, but all have the
following features in common:
1. Each agency is run by bureaucrats who are experts in the industry it
regulates (often recruited from the industry) and who appointed by
the president or by Congress and funded by Congress.
2. Each agency adopts a set of rules and practices designed to control
the prices and other aspects of economic behavior in the industry it
regulates.
3. Firms are generally free to their technology and quantities of inputs.
But they are not free to set their own prices and sometimes, they
are regulated in the quantities they can sell, and the markets they
can serve.
C. Natural Monopoly
A natural monopoly occurs when one firm can supply the entire market
at a lower price than two or more firms can. The government often
regulates natural monopolies.
1. Figure 14.2 shows the demand
curve, MC curve, and ATC
curve of a natural monopoly.
a) A natural monopolys ATC
curve falls throughout the
relevant range of
production.

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b) The falling ATC curve means that the firms MC curve is below its
ATC curve when the MC curve crosses the firms demand curve.
2. Figure 14.2 illustrates how regulating in the social interest can be
achieved using the marginal cost pricing rule, which forces the
monopoly firm to set its price equal to its marginal cost, P = MC.
There are some complicating factors to this pricing rule:
a) Using this regulatory policy will maximize the sum of consumer
and producer surplus, but the firm incurs an economic loss.
b) The firm might be able to cover its economic loss by employing
price discrimination (see Chapter 12). Another example is for
the firm to use a two-part price, such as the hook-up fee cable
TV companies charge their subscribers.
c) The government might pay the firm a subsidy. But the taxes
that generate the revenue for the subsidy create a deadweight
loss in other markets.

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3. Figure 14.3 illustrates how the

deadweight loss from the
marginal cost pricing rule
might be minimized by
allowing the firm to use the
average cost pricing rule,
which sets price equal to
average total cost, P = ATC.
B. Implementing pricing rules is
difficult because the regulator
doesnt know the firms cost
curves. Regulators often use two
practical pricing rules:
1. Rate of return regulation
requires a firm to justify its
price by showing that the price
enables it to earn a specified target percent return on its capital.
a) The target rate of return is determined with reference to what is
normal in competitive industries. This type of regulation is
equivalent to average cost
pricing.
b) However, firm managers
have an incentive to use
more capital than the
efficient quantity so that
total returns increase. They
also have an incentive to
inflate depreciation
charges and incur other
costs for beneficial
amenities that do not
promote efficiency but
deflate reported profits.
c) Figure 14.4 shows the
maximum economic profit
that a firm can earn when
its managers inflate capital costs under rate of return regulation.
2. A price-cap regulation is a
price ceilinga rule that
specifies the highest price the
firm is permitted to set.
a) Price cap regulation gives
managers an incentive to
minimize costs because
there is no limit on the rate
of return they are

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permitted to earn. Figure 14.5 shows the efects of price cap

regulation.
b) The market price equals the cap price and output is the quantity
demanded at the price cap, allowing the firm to earn a normal
profit.
c) This outcome contrasts with that in a competitive market, where
a price ceiling decreases the quantity. A monopoly regulated
using a price cap will increase its output because the price cap
replicates the conditions of a competitive market.
d) Price cap regulation is often combined with earnings sharing
regulation, so if the firms profits rise above a target level, they
must be shared with the firms customers.
C. Whether social interest or capture theory best describes how most
natural monopoly markets are regulated is unclear.
1. A test to determine whether the regulated firm has captured the
regulator and influenced regulation to favor the firm is to compare
the rates of return to capital for regulated industries against that of
the rest of the economy.
a) Table 14.1 shows the
rates of return for
regulated monopolies
in the electricity, gas
and railroad industries
and compares these
rates to the average
rate of return for the
overall economy.
b) While there has been
some variation in rates
of return over time,
there is no overall trend
to show a diference in rates of return exist between regulated
and unregulated industries.
2. Another test is to study
changes in the levels of
producer and consumer
surplus following
deregulation.
a) Table 14.2 shows the
gains (losses) in
producer and consumer
surplus when the
railroad,
telecommunications
and cable TV industries
were deregulated.

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b) These results show that railroad regulation hurt both producers

and consumers, and that regulation in the other two industries
mainly hurt the consumer.

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D. A cartel is a collusive agreement

among a number of firms that is
designed to restrict output and
achieve a higher profit for cartel
members. Cartels are illegal in the
United States and in most other
countries.
1. A cartel that acts like a
monopoly earns maximum
economic profit.
2. However, there is a strong
incentive for each member of a
cartel to cheat on the cartel
arrangement. Figure 14.6 shows
two possible outcomes of cartel
regulation.
a) If the regulation is in the social interest, price and quantity will
equal their competitive levels and the outcome will be efficient.
b) If the cartel captures the regulator, the cartel uses regulation to
prevent cheating to ensure that price and output equal
monopoly levels and the outcome is inefficient.
E. Does Cartel Regulation Reflect the Social Interest Theory or Capture
Theory?
1. If the regulation is in the social interest, the rate of return for the
industry would not decline after the industry is deregulated. If the
regulated firms capture the regulators, then the rate of return for
the industry would decline after the industry is deregulated.
a) Table 14.3 shows the
regulated and
unregulated rates of
return on investment
for the airlines and
trucking industry as
compared to the
economy as a whole.
b) The returns after
deregulation of these
industries decreased
considerably and returned to the economy average.
2. If the regulation is in the social interest, consumer surplus for the
industry would not increase after the industry is deregulated. If the
regulated firms capture the regulators, then consumer surplus for
the industry would increase after the industry is deregulated.
a) Table 14.4 shows the
change in consumer

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F.

95

and producer surplus after the airlines and trucking industries

were deregulated.
b) While consumer surplus increased in both the trucking and
airlines industries, producer surplus decreased in the trucking
industry.
3. The empirical evidence on which theory of regulation prevails is
mixed, but some industries show evidence that the capture theory
of regulation prevails.
Deregulation of many industries occurred in the late 1970s and arose
from three main influences:
1. Economists have more vocally predicted gains from deregulation.
2. The significant hike in energy prices of the early 1970s increased
the cost of regulation borne by consumers.
3. Technological progress has ended many natural monopolies through
increased competition, especially in the telecommunications
industry.

IV. Antitrust Law

A. Antitrust law provides an alternative way in which the government may
influence resource allocation in the marketplace.
B. The significant antitrust laws include:
1. The Sherman Act was the first federal antitrust law and was passed
in 1890.
a) It outlawed any combination, trust, or conspiracy in restraint of
trade.
b) It also prohibited the attempt to monopolize.
2. A wave of merger activities occurred at the start of the 20th
century, motivating Congress to create a stronger antitrust law in
1914 called the Clayton Act.
a) It made illegal specific business practices such as price
discrimination, being a director of competing firms, exclusive
dealing, tying contracts, and acquisition of a competitors shares
if the practices substantially lessen competition or create
monopoly.
b) The Clayton Act has had two major amendments:
i.
the Robinson-Patman Act, passed in 1936
ii. the Cellar-Kefauver Act passed in 1950
3. The Federal Trade Commission was also formed in 1914 to look for
cases of unfair methods of competition and unfair or deceptive
business practices.
C. While price fixing between firms is always illegal under antitrust laws,
there are other practices that generate three antitrust policy debates:
1. Resale price maintenance occurs when a manufacturer agrees
with a retail distributor on the price at which the product will be
resold. Is this an efficient agreement?

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a) It is inefficient if it allows retailers of the goods to operate a

cartel and charge the monopoly price.
b) It is relatively more efficient if it allows the manufacturer to
induce dealers to provide the efficient standard of service in
selling the product.
2. A tying arrangement is an agreement to sell one product only if
the buyer agrees to buy another, diferent product. Is this an
efficient arrangement?
a) It is inefficient if it allows manufacturers to sell one type of
goods that would not otherwise be profitable.
b) It is relatively more efficient if it allows manufacturers to price
discriminate.
3. Predatory pricing is setting a low price to drive competitors out of
business with the intention of setting a monopoly price when the
competition is gone. Is this an efficient practice?
a) It is inefficient in theory if the manufacturer can successfully
charge a monopoly price once the competition is eliminated.
b) However, it is likely to be efficient in practice because unless
there is some barrier to entry, the remaining firm would be
unable to charge a monopoly price after the competition is
eliminated.
D. A Recent Showcase: The United States Versus Microsoft
1. The most recent famous antitrust case was against Microsoft. In
1998, a trial began considering the following charges:
a) Microsoft possesses monopoly power in the market for PC
operating systems and attained that position by exercising
monopoly practices.
b) Microsoft used predatory pricing in the market for web browsers
by ofering its web browser for free.
c) Microsoft used tying arrangements to achieve monopoly in the
web browser market.
d) Microsoft used other anti-competitive practices to strengthen its
monopoly in these two markets. (Some charge that Microsoft
enjoys economies of scale and network economies that create
an efective barrier to entry by competing firms.)
2. But Microsoft counters that it has not violated antitrust law.
a) Although Microsoft enjoys monopoly today, it did not use
monopolistic practices to attain that position. It merely survived
a highly competitive market for operating software.
b) Microsoft is still vulnerable to competition from any newly
developed operating systems (there are no real barriers to
entry).
c) Microsoft claims that incorporating its web browser software
with its operating system software is an attempt to increase
customer value of the operating system software (innovation),

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rather than using a tying arrangement to monopolize the

browser software market.
3. The final court decision found Microsoft not in violation of the antitrust laws, but it was ordered to disclose details of its operating
systems software to other software developers so they could more
efectively compete against Microsoft.
D. Merger Rules
The Federal Trade Commission uses guidelines to determine which
mergers to examine and possibly block.
1. The Herfindahl-Hirschman Index (HHI) is one of those guidelines
(first introduced in Chapter 9).
a) If the original HHI is less than 1,000, a merger is not challenged.
b) If the original HHI is between 1,000 and 1,800, any merger that
raises the HHI by 100 or more is challenged.
c) If the original HHI is greater than 1,800, any merger that raises
the HHI by more than 50 is challenged.
E. Social or Special Interest?
1. The intent of antitrust law has been to protect consumers and
pursue efficiency, but at times the court interpretation of these laws
has favored the interests of producers.
2. On balance, the overall thrust seems to have been toward
efficiency.

Reading Between the Lines

A news article discusses one aspect of re-importation of drugs: Is it legal for
drug companies to restrict their exports to Canada in order to limit the amount
of drugs re-imported back to the United States? The analysis looks at the
market for drugs in Canada and the United States.

New in the Seventh Edition

The sequence of chapters in the seventh edition has changed such that
Chapter 14 replaces Chapter 17 in the sixth edition. The Reading Between the
Lines examines the market power of pharmaceutical firms in the United States.

Te a c h i n g S u g g e s t i o n s
1. Market Intervention: The amazing Federal Register. Get your
students to go to Federal Register Web site at http://www.nara.gov/fedreg/
and click on Todays Table of Contents. They (and you) will be amazed at
the volume and detail of regulatory activity, almost all of which has an
economic dimension and impact.
2. There is no free lunch in regulating firms and industries that
embody market power. Make the issue of industry regulation intriguing

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for the students by emphasizing the following countervailing opportunity

costs that arise in regulating the firms in those industries that are creating
a market failure:
Emphasize the tension between the potential for efficiency in
production inherent with a natural monopoly and the inefficiency
potential from the firm exercising its inherent market power. Be
sure the students understand that economies of scale (or scope) enable
the unregulated natural monopoly to provide products and services at the
lowest possible cost. Yet the lack of competition also enables the firm to
increase producer surplus at the expense of consumer surplus and creates
a significant deadweight loss to society. Regulating this firm is the only way
to ensure that the firm exploits economies of scale or scope without
exploiting consumer surplus.
Emphasize the tension between a manufacturer who wishes to
insure that the consumer is properly informed of all the
characteristics and potential benefits of the product and the
retailer who wishes to minimize the cost of selling the product. Be
sure the students understand that competition can take place within more
dimensions than just between firms operating on the same level of
production. Most manufacturers must sell to retailers who can enhance or
minimize the information that consumers find useful when buying a newly
available or complex product. Disallowing tying arrangements can raise
consumer surplus by keeping prices lower but it can lower consumer
surplus by keeping consumers ignorant of product characteristics for
which they would voluntarily pay a higher price.
Emphasize the tension between real and imagined concerns over
predatory pricing practices. Be sure that the students understand the
limitations of the claim that big businesses routinely price smaller firms
out of the market and then monopolize the market after they have left. To
get the smaller firms to exit, the price that the bigger store charges must
be lower than what the smaller store can maintain with a normal profit.
If the larger store is still able to earn a normal profit, it is charging a
price higher than ATC. Barring any barriers to entry, prevent the larger
store from ofering a lower price decreases consumer surplus,
because the more efficient big store cannot then raise price once the
small stores have left the market.
If the larger store is unable to earn a normal profit, then it is charging
a price lower than ATC. In theory, it might be able to do so due to its
deep pockets, which allow it to borrow money more cheaply to fund
such a losing venture. However, its size advantage in the financial
markets is the very same characteristic that hurts its ability to
predatory price the smaller firms out of business. It must lose money
on a far greater quantity of goods than the smaller stores, meaning it
will bleed losses at a far higher rate than the smaller stores. If the
larger store were successful in driving out its competitors, and if
barriers to entry existed allowing the large store to raise prices to
monopoly levels, it would take a substantial amount of time to make
up for the huge losses incurred. This means that over a long time
period, the firm would earn only normal profit, making predatory

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pricing a much less attractive practice that it appears to be in theory.

Emphasize the tension between combining formerly separate
goods into a product as a monopolizing action (tying
agreements) and combining goods as a form of technological
advancement to enhance consumer surplus (product
innovation). Microsofts defense to antitrust charges alludes to the
inevitable combining of web browsers into computer operating system
software to assure consumer satisfaction.
If Microsoft is truly enhancing its product by incorporating its web
browser with its ubiquitous operating software, breaking up the
company would decrease consumer surplus by slowing product
innovation.
However, if Microsoft is using its market power in one market to
leverage market power in another, more competitive market,
allowing Microsoft to continue tying its web browser to its operating
systems software could decrease consumer surplus in the web
browser software market.
2. Economic Theory of Regulation: Emphasize the tension between
social interest theory and capture theory of regulation.
Point 1: Point out how the political equilibrium is swayed by the
consumers or producers with the most motivation to organize and
spend resources influencing the politicians and bureaucrats supplying
the regulation. Because the producers are fewer in number and have a
high concentration of potential benefits, they are easy to organize into
a special interest lobby. The consumers, on the other hand, are much
greater in number and can expect only thinly spread benefits. They are
less likely to be well organized and more likely to sufer from rational
ignorance.
Point 2: For regulation to achieve efficiency, both price and rate of
return regulation require accurate knowledge of using industry-specific
technology and firm-specific production costs. The only way the
government can adequately assess these issues is to hire former senior
managers from the regulated industries who still have a strong network
of connections to current managers of firms in that industry. This is the
classic case of hiring one fox to provide accurate production data on
the other foxes that may or may not be raiding the chicken coop. How
will the social interest theory answer the question, Who is watching
the watchman?
3. Regulation and Deregulation: The California power debacle. The
special Web feature on this topic is a ready to go case study with which
you can have fun and review the entire section on pricing rules and their
efects.

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The Big Picture

Where we have been
Chapter 14 builds on the students understanding of efficiency introduced
in Chapter 2 and elaborated in Chapter 5. It also builds on natural
monopoly introduced in Chapter 12 and oligopoly and cartels introduced in
Chapter 13. This chapter uses the tension between social interest and
capture theories to explore the implications of antitrust law, which are
elements of the social choice theory introduced in Chapter 16.
Where we are going
Chapter 14 is the first of three chapters dealing with government
intervention in the economy as a result of market failure. Chapter 15
examines externalities and chapter 16 examines social choice economic
analysis.

O v e r h e a d Tr a n s p a r e n c i e s
Transparency

Text figure

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93
94
95
96
97
98

Figure 14.1
Figure 14.2
Figure 14.3
Figure 14.4
Figure 14.5
Figure 14.6
Table 14.5

Transparency title
The Political Marketplace
Natural Monopoly: Marginal Cost Pricing
Natural Monopoly: Average Cost Pricing
Natural Monopoly: Inflating Cost
Price Cap Regulation of Natural Monopoly
Collusive Oligopoly
The Sherman Act of 1890

Electronic Supplements
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PowerPoint Lecture Notes
PowerPoint Electronic Lecture Notes with speaking notes are available
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101

PowerPoint Electronic Lecture Notes for students are available in

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banks are available in Test Generator Software.

Additional Discussion Questions

1. Are you an informed consumer-voter? Get the students to appreciate
the significant challenge of becoming an informed voter and successfully
influencing the governments regulatory process to become more oriented
toward the social interest. Point out the level of efort and amount of
resources needed by using the following example:
Example: Would you become well informed on a regulatory issue if
it saved you (maybe) about $1 per textbook? Tell the students that a
proposed regulation in the textbook industry could impact their lives
through an increase in the price of textbooks.
Assume the following points:
College textbook firms are seeking to ban the resale of textbooks by
secondary textbook firms in order to increase the profitability of selling
new textbooks.

Some book market experts estimate that textbook prices will not be
afected because nearly all professors adopt the latest edition of the
text for their classes anyway (making the last edition near worthless)
and the market trend has been to significantly decrease the time
elapsing between text editions.

But some experts disagree, stating that the trend of shrinking time
periods between editions will reverse itself once the secondary book
market is made illegal. These experts estimate that the average
textbook will increase in price by $1.00.
Ask the following questions:
How would you determine which group of experts to trust? Point out
that a rational student wouldnt want to expend his or her valuable
time and money becoming an informed consumer voter if there really
was nothing to be concerned about in the first place.
If you found that there was a legitimate concern, how would you find
out what to do next? Point out that it is difficult to even know where to
start becoming informed. Search the internet, newspapers and
magazines, watching TV news programs, etc.?
How would you become organized as an effective group of textbook
consumers? How would you organize your efforts effectively? Perhaps
the biggest challenge is to get a disparate group of students together
to act with one voice.

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Who is your federal government representative and how would you

reach him or her? Which government body should you approach with
your concerns? It will become obvious to the class that the average
student doesnt even know the names of their own federal
Congressional representatives, let alone how to go about finding their
addresses and actually contacting them.
Will your voice be heard? Is it worth the effort and cost for one dollar
per textbook? The students should ultimately see the futility in this
efort when they realize that it is easier to just pay a small increase in
textbook fees. Point out that this regulatory issue is only one of
thousands addressed by the federal government each year, meaning
that in reality, they are likely bearing much more in total regulatory
costs than just one more dollar per textbook.
2. How would you define market behavior that is an attempt to
monopolize the market? Get the students to appreciate the difficulty in
diferentiating competitive activities from monopolization activities.
Ask the students to define the market for computer software games.
Point out that Microsoft includes the card game Solitaire on their
Windows computer operating system. Ask if Microsoft is attempting to
monopolize the software game industry by exerting their market power
in the computer operating system software market? Ask them to
explain why the inclusion of Microsoft Explorer with Windows should be
thought of as monopolizing the web browser market.

Ask the students to define the market for car audio components.
Imagine if General Motors, Ford, and Chrysler-Mercedes were to all
install free, high-end car stereo equipment in their automobiles.
Would we want to claim that the Big Three are using the barrier to
entry in domestic car manufacturing that arises from their huge
economies of scale as a means of exerting market power in the car
audio market?

Ask the students to explain why selling output below cost could be
thought of as hurting consumer interests, even in the long run. Point
out that the only way a larger firm can drive out smaller firms from the
industry through below-cost-pricing practices is if the large firm is
willing to sufer far more economic losses than the smaller firms
(because the larger firm must sell a much higher level of output per
period). The only reason that the small firms would not be able to
withstand extended periods of losses longer than the large firm (which
is bleeding cash more heavily than the smaller firms) is if the financial
capital market was sufficiently biased in favor of larger firms (who are
assumed to have deep pockets) to overcome the larger volume of
economic losses the larger firm is sufering.
3. How does one define the market in order to assess market
concentration before and after a proposed merger? This issue was
first addressed in Chapter 12 but is worth reiterating here. Does the market
for personal transportation include just automobiles? Or should it include
pick-up trucks and SUVs? How about motorcycles? What about imports?
Point out that the defining line between within-market products and

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outside-the-market products is a vast gray area. The broader the definition,

the lower the concentration ratio, and the greater the sense of competition
to tame inefficient monopoly practices.
4. Is similarity in prices across firms evidence of price fixing or of
extremely competitive market pressures? Ask the students to
consider the case of four gasoline stations, one on each corner, with each
charging an identical price per gallon. Ask them how they would
distinguish between the claim that they are acting collusively to raise
prices from the claim that they are merely responding to high competitive
pressures that force them all to charge a price equal to average total cost.
Consider the following points:
If direct comparisons to other gasoline station prices in the city reveal a
price premium, this premium may not be legitimate evidence in
support of regulating the gasoline station cartel, as the price of
property on that busy street corner may be higher than property used
by other gas stations, increasing their production costs and the price
necessary to maintain normal profits.

Observing consistent, simultaneous changes in price among all four

gas stations is also insufficient evidence of collusive actions requiring
regulation. It may simply reflect high competitive pressure on each firm
to: i) quickly drop prices in the face of decreasing costs and pass the
cost savings to the consumer to avoid losing market share, and ii)
reflect the absence of economic profits, which implies firms cannot
steal away market share by delaying a necessary price increase in the
face of rising costs.

Comparing the rates of return on capital for the four firms with that of
other gas stations may be legitimate, although there may be
diferences in rates of return across gas stations that are attributable to
characteristics unrelated to the business of selling gasoline.

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Answers to the Review Quizzes

Page 324
1.

2.

3.

1. Governments exist for two reasons: a) they establish and maintain

property rights, the foundation of which all market activity takes place,
and b) they provide mechanisms for allocating scarce resources when
the market economy results in inefficiencya situation called market
failure.
Market failure occurs when the market economy allocates scarce
resources inefficiently. Examples on school campuses include insufficient
parking spaces (a common resource problem), poor quality food services
in the dorms (natural monopoly provider), and noise pollution in the
dorms (poorly defined property rights).
The political marketplace where resources are allocated through a
democratic system where voters and firms (who demand policies that
provide benefits) interact with politicians (who supply policies) and
bureaucrats (who try to increase the size and scope of their programs).
Demanders pay their suppliers with votes (just voters), campaign
donations and lobbying activity (both voters and firms).

Page 325
1.

2.

3.

Consumers and producers express their demand for regulation in the

political market. Each of these groups desires the kind of regulation of an
industry that furthers their own special interests. These two groups
organize into special interest groups and spend resources getting out the
vote, lobbying, and campaigning for regulations that best further their
own interests.
Politicians that supply regulation are trying to appeal to the largest
number of voters so as to achieve or maintain their elected office.
Bureaucrats that supply regulation are trying to maximize their budgets.
These objectives may be in conflict with each other, because the
regulation that may maximize a the budget of a bureaucratic
department may not be supported by the special interest group willing to
bring the most votes or make the most campaign finance contributions.
Political equilibrium is when a regulation arises for which no interest
group finds it worthwhile to use additional resources to press for changes
and no group of politicians finds it worthwhile to ofer diferent
regulations. According to the social interest theory of regulation, political
equilibrium achieves efficiencyregulations are supplied to satisfy the
demand of consumers and producers to maximize total surplus. The
capture theory of regulation predicts that most regulation is aimed at
protecting producers interests to the neglect of consumers interests.
Industries with large producer surplus per firm and well-organized firms
lobby politicians with campaign finance support. The regulations they
seek increase producer surplus and economic profit at the expense of
consumer surplus. Because consumers are numerous and widespread,
they find it too costly to efectively organize a group to defend their
interests by lobbying the politicians on their own behalf.

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Page 332
1.

2.

3.

4.

5.

6.

The Interstate Commerce Commission (ICC) was authorized in 1887 to

control prices, routes and the quality of service of interstate railroads.
Additional federal regulatory agencies were established during the Great
Depression in the 1930s, and again in the 1970s. Regulation reached its
peak in the 1970s when about one quarter of the economy was subject
to some type of regulation.
A natural monopoly that is not regulated produces the quantity that
maximizes profit, where marginal cost equals marginal revenue. It
creates a deadweight because price (marginal benefit) exceeds marginal
cost.
The marginal cost pricing rule eliminates inefficiency and forces the
monopoly to price at marginal cost. This rule is difficult to implement
because the monopoly incurs a loss. The firm must receive some subsidy
equal to its fixed costs in order to stay in business in the long run.
Rate of return regulation requires the natural monopoly firm to justify its
price by showing that the price enables it to earn only a specified target
percent rate of return on its capital. This rate usually set as the rate of
return the firm could expect on its capital under the pressures of a
competitive market. However, managers of the firm have an incentive to
use too much capital needed to boost total returns and to inflate
depreciation charges and hide economic profits.
A price-cap regulation imposes a price ceiling on the firm. This regulation
gives the managers an incentive to keep costs under control, because
they cannot inflate the price to increase returns on capital investment.
The price cap can be set to generate a normal rate of return on capital.
But the regulators do not know the actual cost curves of the firm and
may set the price high enough to allow the firm to earn an economic
profit.
Social interest theory implies that cartel regulation can be used to
ensure a competitive outcome that would increase output and decrease
price as compared to the cartels profit-maximizing prices and
production levels. However, there is evidence that deregulating cartels
has increased consumer surplus. This evidence supports the capture
theory of regulation of cartels.

Page 335
1.

The four acts of Congress that make up our antitrust law and the years of
their enactment are:
a. The Sherman Act of 1890
b. The Clayton Act of 1914
c. The Robinson-Patman Act of 1936
d. The Cellar-Kefauver Act of 1950
2.
Price fixing always is a violation of antitrust law, whether or not the act
was found to be harmful to consumers. If the Justice Department can
prove the existence of price fixing, a defendant can ofer no acceptable
excuse.

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3.

4.

5.

Attempts to monopolize an industry are more difficult to define and are a

matter of interpretation by the courts. The rule of reason seemed to
say that size alone doesnt constitute an attempt to monopolize as in the
1920 U.S. Steel case. But the rule of reason was overturned when size
did matter as in the 1945 Alcoa case. Even in more recent cases, it is
difficult to predict what the court will define as an attempt to
monopolize. Decisions continue to be divided in this area of the law.
Resale price maintenance occurs when a manufacturer agrees with a
distributor on the price at which the product will be resold. Resale price
maintenance agreements are illegal but reseal price maintenance
guidance is not illegal. Resale price maintenance can create inefficiency
if it allows the manufacturer to set the monopoly price for its product.
However it can create efficiency when it enables manufacturers to
induce resellers to give the efficient level of sales service for the
product.
Tying arrangements occur when the seller agrees to sell one product to a
buyer only if the buyer also buys another product. Tying can sometimes
allow the producer to price discriminate and increase its profit. Tying
arrangements can be illegal under the Clayton Act.
Predatory pricing is setting a low price to drive competitors out of
business in order to then set a high, monopoly price. If predatory pricing
occurs, it can lead to monopoly but economists are skeptical that it
occurs often because the firm trades of a sure loss for an uncertain
future profit.
A merger is likely to be approved by the Justice Department as long as
the merger does not raise the HHI index above 1,000 points. If it raises
the HHI to a level between 1,000 and 1,800, the merger would generate
a moderately concentrated industry by FTC definitions, and the merger
would be approved only if it raises the HHI index by a small number of
points (50 to 100 points).

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Answers to the Problems

1. a. The price is 30 cents a bottle.
Elixir Springs is a natural monopoly. It produces the quantity that
makes marginal revenue equal to marginal cost, and it charges the
highest price it can for the quantity produced. The marginal revenue
curve is twice as steep as the demand curve, so it runs from 50 on the
y-axis to 1.25 on the x-axis. Marginal revenue equals marginal cost at 1
million bottles a year. The highest price at which Elixir can sell 1 million
bottles a year is 30 cents a bottle, read from the demand curve.
b. Elixir Springs sells 1 million bottles a year.
c. Elixir maximizes producer surplus.
If Elixir maximizes total surplus, it would produce the quantity that
makes price equal to marginal cost. That is, it would produce 2 million
bottles a year and sell them for 10 cents a bottles. Elixir is a natural
monopoly, and it maximizes its producer surplus.
2. a. The price is 60 cents a bottle.
Cascade Springs is a natural monopoly. It produces the quantity that
makes marginal revenue equal to marginal cost, and it charges the
highest price it can for the quantity produced. The marginal revenue
curve is twice as steep as the demand curve, so it runs from 100 on the
y-axis to 500 on the x-axis. Marginal revenue equals marginal cost at
400,000 bottles a year. The highest price at which Cascade can sell
400,000 bottles a year is 60 cents a bottle, read from the demand
curve.
b. Cascade Springs sells 400,000 bottles a year.
c. Cascade maximizes producer surplus.
If Cascade maximizes total surplus, it would produce the quantity that
makes price equal to marginal cost. That is, it would produce 800,000
bottles a year and sell them for 20 cents a bottles. Cascade is a natural
monopoly, and it maximizes its producer surplus.
3. a. The price is 10 cents a bottle.
Marginal cost pricing regulation sets the price equal to marginal cost,
10 cents a bottle.
b. Elixir sells 2 million bottles.
With the price set at 10 cents, Elixir maximizes profit by producing 2
million bottlesat the intersection of the demand curve (which shows
price) and the marginal cost curve.
c. Elixir incurs an economic loss of $150,000 a year.
Economic profit equals total revenue minus total cost. Total revenue is
$200,000 (2 million bottles at 10 cents a bottle). Total cost is $350,000
(total variable cost of $200,000 plus total fixed cost of $150,000). So
Elixir incurs an economic loss of $150,000 (a revenue of $200,000
minus $350,000).
d. Consumer surplus is $400,000 a year.
Consumer surplus is the area under the demand curve above the price.
Consumer surplus equals 40 cents a bottle (50 cents minus 10 cents)
multiplied by 2 million bottles divided by 2, which is $400,000.

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e. The regulation is in the social interest because total surplus is

maximized. The outcome is efficient.
The outcome is efficient because marginal benefit (or price) equals
marginal cost. When the outcome is efficient, total surplus is
maximized.
4. a. The price is 20 cents a bottle.
Marginal cost pricing regulation sets the price equal to marginal cost,
20 cents a bottle.
b. Cascade sells 800,000 bottles.
With the price set at 20 cents, Cascade maximizes profit by producing
800,000 bottlesat the intersection of the demand curve (which shows
price) and the marginal cost curve.
c. Cascade incurs an economic loss of $120,000 a year.
Economic profit equals total revenue minus total cost. Total revenue is
$160,000 (800,000 bottles at 20 cents a bottle). Total cost is $280,000
(total variable cost of $160,000 plus total fixed cost of $120,000). So
Cascade incurs an economic loss of $120,000 (a revenue of $160,000
minus $280,000).
d. Consumer surplus is $320,000 a year.
Consumer surplus is the area under the demand curve above the price.
Consumer surplus equals 80 cents a bottle (100 cents minus 20 cents)
multiplied by 800,000 bottles divided by 2, which is $320,000.
e. The regulation is in the social interest because total surplus is
maximized. The outcome is efficient.
The outcome is efficient because marginal benefit (or price) equals
marginal cost. When the outcome is efficient, total surplus is
maximized.
5. a. The price is 20 cents a bottle.
Average cost pricing regulation sets the price equal to average total
cost. Average total cost equals average fixed cost plus average variable
cost. Because marginal cost is constant at 10 cents, average variable
cost equals marginal cost. Average fixed cost is total fixed cost
($150,000) divided by the quantity produced. For example, when Elixir
produces 1.5 million bottles, average fixed cost is 10 cents, so average
total cost is 20 cents. The price at which Elixir can sell 1.5 million
bottles a year is 20 cents a bottle.
b. Elixir sells 1.5 million bottles.
c. Elixir makes zero economic profit.
Economic profit equals total revenue minus total cost. Total revenue is
$300,000 (1.5 million bottles at 20 cents a bottle). Total cost is
$300,000 (1.5 million bottles at an average total cost of 20 cents). So
Elixir makes zero economic profit.
d. Consumer surplus is $225,000 a year.
Consumer surplus is the area under the demand curve above the price.
Consumer surplus equals 30 cents a bottle (50 cents minus 20 cents)
multiplied by 1.5 million bottles divided by 2, which is $225,000.
e. The regulation creates a deadweight loss, so the outcome is inefficient.
The regulation is not in the social interest.

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6. a. The price is 40 cents a bottle.

Average cost pricing regulation sets the price equal to average total
cost. Average total cost equals average fixed cost plus average variable
cost. Because marginal cost is constant at 20 cents, average variable
cost equals marginal cost. Average fixed cost is total fixed cost
($120,000) divided by the quantity produced. For example, when
Cascade produces 600,000 bottles, average fixed cost is 20 cents, so
average total cost is 40 cents. The price at which Cascade can sell
600,000 bottles a year is 40 cents a bottle.
b. Cascade sells 600,000 bottles.
c. Cascade makes zero economic profit.
Economic profit equals total revenue minus total cost. Total revenue is
$240,000 (600,000 bottles at 40 cents a bottle). Total cost is $240,000
(600,000 bottles at an average total cost of 40 cents). So Cascade
makes zero economic profit.
d. Consumer surplus is $180,000 a year.
Consumer surplus is the area under the demand curve above the price.
Consumer surplus equals 60 cents a bottle (100 cents minus 40 cents)
multiplied by 600,000 bottles divided by 2, which is $180,000.
e. The regulation creates a deadweight loss, so the outcome is inefficient.
The regulation is not in the social interest.
7. a. The price is $500 a trip, and the quantity is 2 trips a day.
Regulation in the social interest is marginal cost pricing. Each airline
charges $500 a trip and produces the quantity at which price equals
marginal cost. Each airline makes 1 trip a day.
b. The price is $750 a trip, and the number of trips is 1 trip a day (one by
each airline on alternate days).
If the airlines capture the regulator, the price will be the same as the
price that an unregulated monopoly would charge. An unregulated
monopoly produces the quantity and charges the price that maximizes
profitthat is, the quantity that makes marginal revenue equal to
marginal cost. This quantity is 1 trip a day, and the highest price that
the airlines can charge for that trip (read from the demand curve) is
$750.
c. Deadweight loss is $125 a day.
Deadweight loss arises because the number of trips is cut from 2 to 1 a
day and the price is increased from $500 to $750. Deadweight loss
equals (2 minus 1) trip multiplied by ($750 minus $500) divided by 2.
Deadweight loss is $125 a day.
d. If there are only a few large producers and many consumers, public
choice theory predicts that regulation will protect the producers
interest and politicians will be rewarded with campaign contributions.
But if there is a significant number of small producers with large costs
or if the cost of organizing consumers is low, regulation will be in the
social interest.
8. a. The price is 5 cents a call, and the number is 500 calls a day.
Regulation in the social interest is marginal cost pricing. Each
telephone company charges 5 cents a call and produces the quantity at

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which price equals marginal cost. Each phone company produces 250
calls a day.
b. The price is 17.5 cents a call, and the number of calls is 250 a day.
Each phone company produces 125 calls a day.
If the telephone companies capture the regulator, the price will be the
same as the price that an unregulated monopoly would charge. An
unregulated monopoly produces the quantity that maximizes profit
that is, the quantity that makes marginal revenue equal to marginal
costand charges the highest price (read from the demand curve). The
quantity that maximizes profit is 250 calls a day, and the highest price
that the telephone companies can charge for 250 calls (read from the
demand curve) is 17.5 cents a call.
c. Deadweight loss is $15.625 a day.
Deadweight loss arises because the number of calls is cut from 500 to
250 a day and the price is increased from 5 cents to 17.5 cents.
Deadweight loss equals (500 minus 250) calls multiplied by (17.5 cents
minus 5 cents) divided by 2. Deadweight loss is $15.625 a day.
d. Whether the regulation will be in the social interest or the producer
interest will depend on which regulation will generate the more votes
or campaign contributions for the politicians. If the producer demand
for regulation ofers the politicians the greater return, the regulation
will be in the producer interest. But if consumers votes will give the
politicians the greater return, the regulation will be in the social
interest.
9. Regulation consists of rules administered by government agency to
influence economic activity by determining prices, product standards and
types, and the conditions under which new firms may enter an industry.
Antitrust law regulates or prohibits price fixing and the attempt to
monopolize. Regulation applies mainly to natural monopoly and antitrust
law to oligopoly. Regulation of electric utilities is an example of regulation.
The ruling against Microsoft is an example of the application of the
antitrust law.
10. The first part of the Sherman Act, which outlaws all forms of price-fixing,
has been applied consistently and firmly. The second part of the Sherman
Act, which outlaws attempts to monopolize, has been applied with varying
degrees of firmness. Price fixing is clear, easy to define, and once
discovered, clearly violates the Act. Attempts to monopolize are vague and
varied, hard to define, and ambiguous even when detected. This diference
in the clarity of the violation probably accounts for the diference in the
way the law has treated the two parts of the Act.

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