AP Microeconomics – Chapter 18
Outline
I. Learning Objectives—In this chapter students should learn:
A. The core elements of the major antitrust (antimonopoly) laws in the United States.
B. Some of the key issues relating to the interpretation and application of antitrust laws.
C. The economic principles and difficulties relating to the setting of prices (rates)
charged by so-called natural monopolies.
D. The nature of “social regulation,” its benefits and costs, and its optimal level.
II. Antitrust Policy, Industrial Regulation, and Social Regulation
A. Antitrust policy—laws and government actions designed to prevent monopoly and
promote competition.
B. Industrial regulation—government regulation of firms’ prices (or “rates”) within
certain industries.
C. Social regulation—government regulation of the conditions under which goods are
produced, the physical characteristics of goods, and the impact of the production
and consumption of goods on society.
III. Antitrust Laws
A. The underlying purpose of antitrust policy is to prevent monopolization, promote
competition, and achieve allocative efficiency.
B. In the decades following the Civil War, corporations began to develop “trusts” or
monopolies in industries such as petroleum, meatpacking, railroads, sugar, lead,
coal, whiskey, and tobacco.
C. The economic case against monopoly:
1. With pure competition, each firm maximizes profit by producing where P=MC,
achieving allocative efficiency where marginal benefit = marginal cost.
Monopolies maximize profit by reducing output, producing where MC=MR, but
charging a higher price. This violates allocative efficiency, because society would
benefit by increasing production (the benefit is greater than the cost of
production).
2. The monopoly’s higher price transfers income from the consumer to the
monopolist. This causes consumer resentment, because it is caused by the
decision to restrict output, not by an increase in the cost of production.
D. Questionable tactics were used by some of these trusts, and popular sentiment turned
against them. Two mechanisms for dealing with monopolies were developed.
1. Regulatory agencies were formed to control “natural” monopolies.
2. Antitrust legislation was passed to inhibit or prevent the growth of monopolies in
other industries.
E. The Sherman Act (1890) is the cornerstone of antitrust legislation.
1. It contains two major provisions:
a. It is illegal for contracts or combinations to restrain trade among states or with
foreign nations.
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AP Microeconomics – Chapter 18
Outline
b. Those who monopolize or attempt to monopolize any part of trade among
states or with foreign nations are guilty of a misdemeanor.
2. Today, the United States Department of Justice, the Federal Trade Commission,
injured private parties, or state attorneys general can bring suits against alleged
violators of the act.
3. Firms found violating either provision of the act could be ordered dissolved by the
courts, or prohibited from engaging in the unlawful practices. Fines and
imprisonment were possible, and injured parties could sue for treble damages.
F. The Clayton Act (1914) strengthened the Sherman Act, which was often not explicit
enough to be effective.
1. It outlaws price discrimination when it is not based on production costs and if it
reduces competition.
2. It forbids exclusive or tying contracts, in which a producer forces buyers of one of
its products to acquire other products from the same producer.
3. It forbids acquisition of stock in competing corporations if it lessens competition.
4. It prohibits interlocking directorates, where directors of one firm are also on the
board of a competing firm, if the effect reduces competition.
G. The Federal Trade Commission Act (1914) created the Federal Trade Commission
(FTC), an agency designed to enforce antitrust laws.
1. FTC investigates unfair competitive practices and, when appropriate, issues
cease-and-desist orders.
2. The Wheeler-Lea Act (1938) gives the FTC power to police “deceptive acts or
practices in commerce” in order to protect the public from unfair and deceptive
business practices.
H. The Celler-Kefauver Act (1950) amended Section 7 of the Clayton Act, which
prohibits firms from acquiring the stock of competitors when this would reduce
competition. This section had a loophole whereby firms could acquire the physical
assets rather than stock of a competing company, and the Celler-Kefauver bill closed
this loophole.
IV. Antitrust Policy: Issues and Impacts
A. There are two distinct approaches to the application of antitrust law—one based on
the structure of an industry and the other on the behavior of firms in an industry.
Three landmark cases reveal the dilemma.
1. In 1911, the Supreme Court found Standard Oil guilty of monopolizing the
petroleum industry through abusive and anticompetitive actions. However, it
left open the question of whether every monopoly violated Section 2 of the
Sherman Act.
2. The 1920 Supreme Court decision in the U.S. Steel case led to the application of the
“rule of reason.” The Court decided that not every monopoly is illegal if the firm
involved did not gain that power unreasonably.
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AP Microeconomics – Chapter 18
Outline
3. In the 1945 Alcoa case, the Court held that even though a firm’s behavior might be
legal (Alcoa had control over bauxite reserves, the raw material needed for
aluminum), mere possession of monopoly power (90 percent of the aluminum
market) violated antitrust laws.
4. These three cases point to a continuing controversy in antitrust policy: Should
industries be judged by their behavior or structure?
a. Structuralists claim that firms with a very large market share will behave like
monopolists, and this economic performance is undesirable.
b. Behavioralists argue that the relationship between structure and performance
is unclear; if a firm has achieved its large market share as a result of
economies of scale, should it be punished?
5. In recent years, the rule of reason has been more dominant. In 1982, the
government dropped its 13-year-long case against IBM, deciding that IBM had
not unreasonably restrained trade. More recently, the government alleged that
Microsoft violated the Sherman Act, not because of its dominance in the
industry, but because of its behavior.
B. Defining the relevant market is important in antitrust Court decisions.
1. Courts use the 90-60-30 rule to determine whether a monopoly exists: 90 percent
market share—definitely; 60 percent—probably; 30 percent—definitely not.
2. If the market is defined broadly, then a firm’s market share will appear to be
smaller.
3. If the market is defined narrowly, then a firm’s market share may seem large.
4. In the Alcoa case, the court used a narrow definition of the relevant market—the
aluminum ingot market.
5. The court defined the market broadly in the 1956 DuPont cellophane case to
include all “flexible packaging materials,” such as waxed paper and aluminum
foil, and therefore DuPont, which had a monopoly in cellophane, was not found
to violate the law.
C. Enforcement of antitrust laws varies according to the political philosophy of the
presidential administration in power.
1. Aside from executive action, firms can file suit, as AMD did against Intel in 2005.
2. The overriding philosophical consideration for executive branch action is the
extent to which the government should intervene in the economy.
3. The active antitrust perspective asserts that competitive forces are inadequate to
insure efficiency and fairness to consumers and competing firms. Active and
strict enforcement of antitrust law is favored.
4. The laissez-faire perspective holds that the market will correct for any abuses of
monopoly power by creating profit incentives that attract new and stronger
competitors. Through the process of creative destruction, new products and
processes will replace those held by current monopolies. There is no reason to
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AP Microeconomics – Chapter 18
Outline
enforce antitrust policy, as the long-run competitive process will effectively
undermine monopolies.
D. The effectiveness of antitrust laws is difficult to judge. The government has generally
been lenient in applying antitrust laws to firms that have grown “naturally.”
1. Antitrust laws have generally not been applied unless a firm has very high market
share and there is evidence the firm used abusive conduct to achieve or maintain
its market dominance. In 1982, AT&T was charged with violating the Sherman
Act by engaging in several anticompetitive actions to keep its monopoly in
telephone communications. In an out-of-court settlement, AT&T agreed to divest
itself of its 22 regional phone-operating companies, but was allowed to keep its
long-distance service operations.
2. In 2000, a federal district court found Microsoft guilty of violating the Sherman
Act. The court’s remedy was to split Microsoft into two companies and to
prohibit each from in engaging in anticompetitive behavior. Microsoft appealed
the decision to a higher court, and in 2002, the Court of Appeals upheld the
finding of abusive monopoly but imposed behavioral restrictions, rather than
splitting the company.
3. Mergers are treated differently, depending on the type of merger and the effect
on competition.
a. Horizontal mergers are between companies selling similar products in the
same market (Chase Manhattan and Chemical Bank, Boeing and McDonnell
Douglas, Exxon and Mobil).
b. Vertical mergers are between firms at different stages of the production
process in the same industry (PepsiCo’s merger with Pizza Hut, Taco Bell,
and Kentucky Fried Chicken, which it supplied with beverages; PepsiCo
spun off the restaurants in 1997).
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AP Microeconomics – Chapter 18
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c. Conglomerate mergers are between firms in unrelated industries (Walt Disney
Company and American Broadcasting Company, and America Online and
Time Warner).
4. The Herfindahl index is used as a guideline by the federal government to decide
whether the merger will be allowed.
a. Recall from Chapter 11 that this index is the sum of the squared market shares
of the firms in the industry; 10,000 would be the index for a pure monopoly
(100 squared).
b. Generally, the post-merger index must be above 1800 and significantly
changed by the merger for the government to challenge a horizontal merger.
c. Other factors, such as economies of scale, the degree of foreign competition,
the ease of entry of new firms, and whether one of the merging firms is under
major financial stress, are also considered. Horizontal mergers between
Staples and Office Depot, WorldCom and Sprint, and Hughes (DirecTV) and
Echostar (DISH Network) have been blocked.
5. Vertical mergers are usually ignored unless they are between two firms who are
each in highly concentrated industries. A proposed merger between Barnes &
Noble and Ingram Book Company was abandoned when it appeared that the
FTC was going to take action; the merger would have enabled Barnes & Noble to
set the wholesale price of books charged to their retail competitors such as
Borders and Amazon.
6. Conglomerate mergers have generally been permitted.
7. Price fixing is treated strictly. Evidence of price fixing—or even a conspiracy to fix
prices—can elicit antitrust action. Such violations are called per se violations
because they are illegal in and of themselves; they are not subject to the rule of
reason.
8. CONSIDER THIS … Of Catfish and Art
a. ConAgra and Hormel paid $21 million to settle their roles in nationwide pricefixing of catfish.
b. Archer Daniels Midland (ADM) paid $430 million to resolve the government’s
antitrust action after admitting to fixing the prices of citric acid, an additive
to livestock feed, and high-fructose corn syrup.
c. UCAR International was fined $110 million for scheming with competitors to
fix prices and divide up the graphite electrode market.
d. The auction houses at Sotheby’s and Christy’s conspired over a 6-year period
to fix commission rates.
e. Samsung, Hynix Semiconductor, Infineon, and Micron were fined $645 million
for fixing prices of dynamic random access memory chips (DRAMs).
f. British Airlines and Korean Air were fined $300 million each for conspiring to
fix fuel surcharges on passenger tickets and cargo.
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AP Microeconomics – Chapter 18
Outline
g. Five manufacturers of liquid crystal displays (LCDs) were fined more than
$860 million for fixing the prices of displays they sold to Dell for computers.
h. Three international cargo airlines were fined $214 million for conspiring to fix
international airline cargo rates.
9. The government generally permits price discrimination because it rarely reduces
competition.
10. The federal government also has strictly enforced the Clayton Act’s prohibition of
tying contracts. The government has stopped movie distributors from forcing
theaters to buy the projection rights to a full package of films as a condition of
showing a blockbuster movie. Tying contracts, such as Microsoft “bundling” its
Internet Explorer browser with its Windows operating software, were declared
illegal.
E. Has antitrust policy been effective in achieving its goal of promoting competition and
efficiency?
1. Antitrust policy has not been effective in restricting the rise or breaking up
monopolies or oligopolies resulting from internal expansion.
2. Antitrust laws have been more effective against predatory or abusive monopoly
power, but the effectiveness has been slowed because of the long legal process.
4. Antitrust policy has been effective in blocking anticompetitive mergers and
prosecuting price fixing and tying contracts.
F. Most economists conclude that antitrust policy has been moderately effective in
promoting competition and efficiency. Others, though, believe that with the era of
rapidly changing technology, American antitrust policy is anachronistic.
V. Industrial Regulation
A. Natural Monopoly
1. A natural monopoly exists when economies of scale are so extensive that a single
firm can supply the entire market at lower average total cost than could a
number of competing firms. Examples include public utilities, such as electricity,
water, and natural gas. In such cases, it is more efficient to have only one
producer.
2. Two possible alternatives exist for protecting society in such cases.
a. Public ownership is one solution, as occurs with the Postal Service, local water
systems, and many local mass transit systems.
b. Public regulation (industrial regulation) has been the option utilized most
extensively in the United States. Regulatory commissions regulate the rates
charged by monopolies.
3. The rationale (public interest theory) for public ownership or industrial regulation
is that uncontrolled monopoly power can be abused. The goal of industrial
regulation is to allow the public to benefit from the lower costs of a natural
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AP Microeconomics – Chapter 18
Outline
monopoly, while avoiding the reduction in output associated with an
unregulated monopoly.
4. Regulators seek to establish rates that will cover production costs and yield a fair
return of normal profit to the enterprise (P = ATC).
B. Problems with Industrial Regulation
1. An unregulated firm has the profit incentive to reduce its production costs. If a
regulated firm lowers its operating costs, the increase in profits will lead the
commission to lower its rates, so as to reduce profit.
2. Higher production costs are passed on to the consumers in the form of higher
rates. A regulated firm might give higher salaries to its workers without an
increase in marginal productivity.
3. Although a natural monopoly reduces costs through economies of scale, industrial
regulation fosters considerable X-inefficiency.
4. Industrial regulation can lead to continuing monopoly power after the conditions
of natural monopoly are gone.
a. Technological changes create potential competition for the regulated industry
(trucks compete with trains; cell phones compete with landline phones).
b. Regulators, by blocking entry or extending regulation to competitors, may
perpetuate a monopoly where a natural monopoly would erode. The
beneficiaries of outdated regulation are the regulated firms and their
employees; the losers are customers and potential entrants.
C. Legal Cartel Theory
1. Proponents of this theory contend that regulators guarantee a return to the
regulated firms while blocking entry and dividing up the market—activities that
would be illegal in unregulated markets.
3. Occupational licensing is an example of this theory in certain labor markets.
VI. Deregulation
A. Deregulation came about in the 1970s and 1980s as a result of the greater acceptance
of the legal cartel theory, increasing evidence of inefficiency in regulated industries,
and the contention that government was regulating potentially competitive
industries.
B. Airline, trucking, banking, railroad, natural gas, television broadcasting, electricity,
and telecommunications industries have been largely deregulated.
C. Although some criticize deregulation, on balance it appears to have benefited
consumers and the economy.
1. Benefits to society through lower prices, lower costs, and increased output have
come primarily from airlines, railroads, and trucking.
2. Deregulation has led to technological advances in new and improved products.
D. Deregulation in the electricity industry has generated significant controversy.
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AP Microeconomics – Chapter 18
Outline
1. The industry is most deregulated at the wholesale level, allowing wholesalers to
build facilities and sell electricity to distributors at unregulated prices.
2. Some states have also deregulated retail electricity prices and, for the most part,
electricity rates have fallen for consumers.
3. In California, where wholesalers were deregulated and retailers regulated, a
dramatic increase in wholesale prices in 2001 resulted in substantial financial
losses for retail providers, as they were legally prevented from raising retail
prices to cover the higher costs. The problem was exacerbated by the fraudulent
activities of energy-trader Enron.
VII. Social Regulation
A. Social regulation differs from industrial regulation in that it is concerned with the
conditions under which production occurs, the impact of production on society, and
the physical qualities of the goods produced. Table 18.2 lists the main federal
regulatory commissions engaged in social regulation.
B. Distinguishing Features
1. Social regulation applies to many or all industries and affects many people.
2. Social regulation involves government in the details of production. Regulation
often dictates the design of products, the conditions of employment, and the
nature of the production process.
3. Social regulation has expanded rapidly in last two decades. As society has become
more affluent, it has focused more attention on product quality, pollution,
working conditions, and equality of economic opportunity.
C. The Optimal Level of Social Regulation
1. While most economists agree on the need for social regulation, there is
disagreement on the optimal level of regulation.
2. In Support of Social Regulation
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AP Microeconomics – Chapter 18
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a. Although the cost of social regulation is high, the appropriate test is to
determine whether the benefit exceeds the cost (safer workplaces, less
pollution, safer products, and reduced discrimination).
b. The benefits are difficult to measure and are often realized only after time has
passed, so society tends to underestimate the benefits of a policy.
c. There are continuing problems that can best be addressed through additional
social regulation (greater regulation of certain food products, health care
services, and insurance).
3. Criticisms of Social Regulation
a. Many standards cause marginal costs to exceed marginal benefits, leading to
overregulation.
b. Many regulations are poorly written, resulting in regulation beyond the
original intent.
c. Decisions are sometimes made on the basis of inadequate information.
d. Many rules have unintended side-effects, such as lighter, fuel-efficient cars
having higher fatality rates.
e. Overzealous workers who believe too much in regulation work for these
agencies.
D. Two Reminders
1. There are costs to social regulation; it can produce higher prices, stifle competition,
and reduce competition.
2. Social regulation can increase economic efficiency and society’s well-being by
improving working conditions, removing unsafe products, and reducing
pollution.
VIII. LAST WORD: United States v. Microsoft
A. In May 1998, the federal Justice Department, 19 states, and the District of Columbia
filed charges against Microsoft under the Section 2 of Sherman Antitrust Act,
arguing Microsoft had taken a series of actions designed to maintain its “Windows”
monopoly.
B. Microsoft denied the charges, arguing that it had achieved success through product
innovation and lawful business practices. It also pointed out that monopoly was
transitory because of rapid technological advances.
C. In June 2000, the district court ruled Microsoft a monopoly, with 95 percent of the
market share for software to operate Intel-compatible personal computers.
D. Although being a monopoly is not illegal, the court stated that Microsoft had violated
the Sherman Act by using anticompetitive means to maintain and broaden its
monopoly power. The court ruled that by tying Internet Explorer to Windows and
providing the browser at no charge, Microsoft acted illegally in competing against
Netscape’s Navigator and Sun’s Java programming language.
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AP Microeconomics – Chapter 18
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E. The court ordered Microsoft to be split into two companies which were prohibited
from entering into joint ventures with one another.
F. In 2001, the Court of Appeals ruled that Microsoft had illegally maintained its
monopoly, but reversed the decision to break up Microsoft. The final settlement
required billions of dollars in fines and compensation to competitors and enacted
several behavioral remedies.
1. Microsoft is prevented from retaliating against any firm that competes with
Microsoft by developing, selling, or using software that competes with Microsoft
Windows or Internet Explorer.
2. Microsoft is required to establish uniform royalties and licensing terms for any
computer manufacturer wanting to include Windows on its personal computers.
3. Microsoft must allow manufacturers to remove Microsoft icons and replace them
with others on the Windows desktop.
4. Microsoft must provide technical information so that other companies can develop
software that is compatible with Windows and other Microsoft products.
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