Imperfect Competition
"The Federal Trade Commission, in reviewing the merger of Exxon Corp. and
Mobil Corp. last year, noted that big oil companies often set their prices based on
competitor' prices rather than their own costs.
Overview
In the battlefield we call the market, where buyers and sellers are battling over price and looking for market
power and the ability to move prices in their favor, victory goes to those with a better knowledge.1 In this unit we
look more closely at firms to see what happens when they gain the power to influence price and what
government can do to protect us from the abuse of power.i
At one end of the market power spectrum, we have the world of perfect competition, where power rests with the
buyers. This is a wonderful world for buyers, one where firms produce exactly what people want – and they do it
at the lowest possible cost. You know what this feels like if you have ever walked the streets of New York City
and seen the vendors hawking T-shirts on countless street corners and street fairs. They have no influence over
price, and if they raise their price above the 'going' price of 3 for $10, their customers will disappear. Their
success is dependent upon how well they control costs – or on their ability to separate themselves from the other
sellers and gain some market power and enter into the world we call imperfect competition.
Imperfect competition confers on firms the ability to influence price, and this shifts the gains from market
transactions in favor of the seller who get higher prices and fatter profits.
Pursuing a “short run” monopoly, the economist Joseph Schumpeter wrote in 1942, is what profitseeking enterprises do—in the process, driving significant innovation and economic growth. In the
1970s, the business-school discipline of strategy arose as the study of how to build and defend these
short-run monopolies—a sort of mirror image of the antitrust classes long found in law schools.
“Strategy is antitrust with a minus sign in front of it” … strategy tries to maximize what antitrust tries to
minimize.ii
This is why firms work so hard at differentiating their products, sometimes by creating a niche market. An
example would be Abercrombie and Fitch whose chief executive identified the company's target market as an
"18 to 22 college guy who has a good body and is aspirational.”iii
At the other end of the market power spectrum is Monopoly - a market where there is only one seller. Monopoly
means the firm IS the market, so a monopolist does not need to worry about other sellers because barriers to
entry are high enough to keep them out of the market. With the competition gone, these firms exercise their
power, but interestingly, the decision rule for perfect competitors and monopolists is the same; expand
production as long as MR > MC and maximize profit when MR = MC.iv Firms, regardless of market power, will
continue to expand production as long as the decision adds more to revenues than costs.
This does not, however, suggest that market structure does not affect market outcomes. The three important
features of the monopoly market structure are:
1
1.
2.
3.
output is lower than in competitive markets
prices are higher than in competitive markets
economic profit exists
These differences all stem from the fact that in a competitive environment, firms would enter if the existing firms
were making a profit, but in the case of a monopoly there is no entry to put downward pressure on prices and
profit. The source of this market power is scarcity created by a barrier to entry.
One indicator of the potential profit earned by a company from limiting competition is the fee paid by Coke to
URI for its monopoly on drink sales on campus. Coke is able to pay the fee out of the higher prices it receives as
a result of Pepsi's absence - precisely why Adam Smith identified competition as necessary to protect consumers
from price-gauging that transfers $s from consumers to producers and why government’s step in to protect
consumers with antitrust laws and business regulations.
In between monopoly and perfect competition we have monopolistic competition where there are a large number
of firms selling slightly differentiated products, and oligopoly where there are a few large sellers employing a
variety of strategies to get the upper hand in the competition - something we examine in this unit. We also
discuss how advances in information technology may alter the balance of power between buyers and sellers, with
the winners being those whose harness the power of the new technology more effectively.
Origins of market power and barriers to entry
In the competitive world economic profit acts as a magnet attracting resources to an industry until the additional
supply drives down prices and eliminates profit. Here we will look at some barriers to entry that create market
power.
Legal restrictions: If you have looked for a cab in NYC then you know all too well the impact of legal
restrictions. NYC specifies the number of medallions that can be issued to taxis, and as a result it is hard to find a
taxi in New York and it is not a cheap ride. Those of you who want to be a lawyer will benefit from the bar
exam, which is a legal restriction, and if you want a plumber or electrician, they will have to have their license
from the state. Patents are a special case of legal restrictions that protect intellectual property. An inventor who
obtains a patent is given 20 years to earn any returns on the invention by not allowing anyone else to duplicate
the invention - in essence reducing competition. Patents are issued under the authority of the US Constitution
that gives Congress the power to "promote the progress of science and the useful arts, by securing for limited
times to authors and inventors the exclusive right to their respective writings and discoveries." You could also
include here tariffs that restrict the importing of goods and services into the US.
Control over key resources / inputs: If you have a desktop computer and are shopping around for an operating
system, you will probably have to deal with Microsoft that controls about 90% of the market in 2013. And things
are even tougher if you are looking for rare earth minerals because China controls about 95% of that market.
Two important historical examples of this barrier are Standard Oil and DeBeers. In 1870 John D. Rockefeller’s
oil company was operating in an industry where competition kept prices and profits down. To eliminate the
cutthroat competition, Rockefeller established the Standard Oil Trust in 1881 that came to dominate the market
and turned Rockefeller into one of the world's wealthiest people.
In the 1880s, diamonds from South Africa’s enormous mines began to flood the market and competition among
numerous suppliers kept prices and profits down. Cecil Rhodes formed DeBeers and began buying up other
South African suppliers, enough so that by the 1890s DeBeers effectively controlled the world’s supply – a
position it would maintain for decades.
De Beers proved to be the most successful cartel arrangement in the annals of modern commerce. While
other commodities, such as gold, silver, copper, rubber, and grains, fluctuated wildly in response to
economic conditions, diamonds have continued, with few exceptions, to advance upward in price every
year since the Depression. Indeed, the cartel seemed so superbly in control of prices -- and unassailable
-- that, in the late 1970s, even speculators began buying diamonds as a guard against the vagaries of
inflation and recessionv
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Also included here would be exclusive deals with suppliers that would make it difficult for a new player to gain
access to key inputs and exclusive deals with distributors that would make it difficult to get the product to the
customer. Bottlenecks in the supply process also create monopoly power. A good example would be El Paso
Corporation's ability to raise the price of oil in California during its energy crisis in 2000-2001. Oil prices were
substantially higher in CA than TX, more than could be justified by and transport costs, and this was the result of
El Paso Corporation’s control of the only pipeline into California. No surprise, given the fact demand is inelastic;
it was accused of reducing the supply as a means of driving prices higher in CA.
Imperfect information can also act as a barrier to entry. Information flows are imperfect and good information is
costly which can create barriers to entry. Firms will be able to keep a competitive edge because key information
is not readily available, and while this is more likely to have been a significant barrier in the past, even today at
the center of Coca Cola's success is the secret formula. Consumers may also possess imperfect information,
which means new firms must "prove" their product, which they will do with large-scale advertising.
Characteristics of the production process can also act as a barrier to entry. Potential competitors would be
discouraged from entry into industries where the average cost falls as output increases, which is why they call
these a natural monopoly. One example could be Microsoft Office where the marginal cost of another disc
containing the software is minimal, but the costs of creating and marketing the product are substantial. As
Microsoft expands output its average cost falls, making it very difficult for a new competitor to be able to enter
and compete on price once Microsoft has a large market.vi
The beer industry offers example of where economies of scale exist in marketing and advertising. In recent years
many local or regional microbreweries have opened, but they have BIG problems competing nationally with the
largest breweries because of large advertising costs that can be spread over much larger volumes by the national
brands. Absolutely large capital investments can also act as a potential barrier to entry, and a good example is the
computer chip making industry where factories can cost billions - enough to keep out many potential
competitors. When there are large capital costs, differentials in the cost of capital create significant differentials
in production costs, and the differentials favor established firms. A reputation has substantial value, allowing an
established firm to negotiate better rates on its financing, lower wages for its labor, and obtain better deals from
the suppliers of its raw materials. This is one of the sources of Wal-Mart’s success.vii
Strategic behaviors by firms can also create barriers to entry. Limit pricing describes a situation where a firm
sets the price below a profit maximizing level, but above a level where a new entrant would be able to make a
profit. Predatory pricing involves setting a price below cost with the hope of driving out competitors, and once
the competitors are gone, then the predator is free to exert market power and raise prices. This was a charge
made against Microsoft in the antitrust case in 1998, and. It was also the situation in 1996 when easyJet, a new
entrant into the market, alleged that once easyJet began offering the service KLM, a market leader, responded by
lowering the price on the Amsterdam-London run by more than 50%. KLM's price was below easyJet's, and
below its costs, which is reflected in a KLM memo referring to the need "to stop the growth and development of
easyJet and make sure that this newcomer will not be able to secure a solid position in the Dutch market." When
this behavior involves international trade, when goods are imported at prices below the cost of production, this is
called dumping and there are restrictions against this practice. In 1998 US steel companies were claiming foreign
steel producers were dumping steel and asked Congress for protection, which they received in 2001, and in the
EU in 2013 solar panel producers in the EU receives protection from Chinese firms accused of dumping.viii
Excess capacity resulting from strategic overinvestment, meanwhile, can act as a signal to potential competitors
that they will be in for a bitter price war if they enter. The existence of the excess capacity means firms already
in the industry only need to cover their variable cost in their pricing, at least in the short-run, so any new entrant
will be greeted with the first round of a dangerous downward price spiral likely to be won by the established
firms with the deeper pockets - larger bank accounts or access to funds.ix
Mergers and acquisitions also can generate market power. It was impossible for even a casual observer of the
news in the late 1990s and early 2000s to be unaware of the mega mergers making headlines. It seemed every
day we would hear of the BIGGEST merger of its type. In the automobile industry the big one was the merger of
Chrysler and Daimler Benz, yet we also saw Volkswagen purchase Rolls Royce and Ford purchase Jaguar. In the
financial sector the first trillion-dollar banks were made possible with the mega mergers of Citicorp and
Travelers Group, NationsBank Corp and BankAmerica Corp, and Banc One and First Chicago. At the end of the
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boom, in early 2000, there was the real surprise move - the merger of the old, established media titan TimeWarner and the Internet upstart, AOL. Things slowed a bit during the Internet stock market bust and US
recession, but it picked up again by 2003 with Bank of America taking over Fleet Bank for $47 billion, while
Oracle took over PeopleSoft. More recently in 2013 the Supreme Court allowed a merger between United and
US Air over the objections of those who cited it would reduce competition on 1000+ routes, and in 2014 there
was a proposed merger between Time Warner and Comcast, the two largest companies in the cable industry that
was opposed on the grounds their control of the market would allow them more power over prices.x
Price discrimination
Pricing power, what we call market power, greatly affects the balance of power between buyers and sellers in the
market place and firms use a number of strategies to create pricing power. Included in the list would be
advertising, branding, and price discrimination, all designed to break the link between demand and price by
convincing potential buyers there is something “special” about their product, even if it is only an illusion.xi For
example, if you believe it is not just a coffee, it is a Starbucks experience, or they are not just jeans, but True
Religion jeans, and Starbucks and True Religion have market power and you can see that in their prices. General
Electric’s Chief Information Officer (CIO) obviously understood given this statement "to make more of our
business be products and services that are noncommodity."xii Corporations spend billions in advertising to create
brands and connect people with their products, and in recent years they have added some new weapons to their
arsenal and some new strategies. They have also made a strategic change in their marketing by directly to
targeting children to bond them to their products, and it is no surprise that children have lost in the field of battle.
The typical American child is now immersed in the consumer marketplace to a degree that dwarfs all
historical experience. … Kids can recognize logos by 18 months, and before reaching their second
birthday, they're asking for products by brand name. By three or three and a half, experts say, children
start to believe that brands communicate their personal qualities, for example that you're cool, or strong,
or smart. Even before starting school, the likelihood of having a television in their bedroom is 25%, and
viewing time is just over two hours a day. Upon arrival at the schoolhouse steps, the typical first grader
can evoke 200 brands. .... A 2001 Nickelodeon study found that the average 10-year-old has
memorized 300 to 400 brands. Among eight to 14-year-olds, 92% of requests are brand specific, and
89% of kids agree that, “when I find a brand I like, I tend to stick with it.xiii
Once firms have established pricing power, they can add to their revenues and profits by separating markets and
setting different prices. For example, assume that you sell coffee and you have done your research and found that
there are two groups – 2,000 people who that will spend $5 on a cup of coffee and 5,000 who will spend only $2
per cup. If you could only charge one price, then at a price of $5 you would generate $10,000 in revenue
($5*2,000), while at a price of $2 you would generate $14,000 ($2*(2000+5000). Clearly the $2 price is better,
but there is even a better solution. If you could separate the buyers and charge two prices, then total revenue
would rise to $20,000 ($5*2,000 + $2*5,000). This is called price discrimination – charging different people
different prices for the same product – and we will now look at three forms of price discrimination.
1st degree price discrimination occurs when each customer is charged a different price. In the days before ecommerce this was not often an option because of the substantial costs associated with tailoring a product to an
individual, but information technology (IT) makes it possible - and profitable. Harrah's does profiles on its big
gamblers and tracks them at their tables to see how they are doing and tries to avoid them getting to the point of
quitting. To determine a person's pain threshold they use data on average incomes in the neighborhood the
person lives, and when the gambler approaches the threshold they are coaxed into leaving the table with some
complementary "gifts." Instead of an angry customer, Harrah's has a customer who appreciates the attention and
looks forward to more gambling. If you call Capital One to drop their credit card, they look at your record to
decide if they want to keep you, and if they do, they then decide what to offer. Airlines, the masters at using IT,
now have software that searches the records of all those on cancelled flights and then identifies the customers
who have brought the company the most money in the past, and gives them better treatment. In each case the
companies have used information gleaned from their IT investments to individualize prices.xiv
Investment in IT in the production process also allows firms to better cater to the individual needs and desires of
potential demanders. These IT investments allow a merging of two powerful forces - mass production with those
long production runs and low average costs (think the Ford Model T) and customized work that caters to the
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needs of the individual buyer what is called mass-customization.xv One of the first companies in the masscustomization movement was Dell computers. On their web site you will find pull down menus to build a
machine with your specifications.
2nd degree price discrimination occurs when each customer is presented with a menu of prices for a set of
related products. This is a practice we have all encountered in the market place and it is nothing new as we can
see in this description of railroad pricing by nineteenth century French economist Emile Dupuit.
It is not because of the few thousand francs which would have to be spent to put a roof over the thirdclass carriage or to upholster the third-class seats that some company or other has open carriages with
wooden benches . . . What the company is trying to do is prevent the passengers who can pay the
second- class fare from traveling third class; it hits the poor, not because it wants to hurt them, but to
frighten the rich . . . And it is again for the same reason that the companies, having proved almost cruel
to the third-class passengers and mean to the second-class ones, become lavish in dealing with firstclass customers. Having refused the poor what is necessary, they give the rich what is superfluous.xvi
This sounds a bit like flying these days as business class is beginning to look like a better deal, as coach becomes
a pretty unpleasant ride. The automobile industry provides classic examples of versioning. When purchasing a
Honda or BMW you have many "versions" to pick from - the Accord, the Civic, or the CR-V for Honda and the
3-series, 5-series, and 7-series for BMW - and many variations within each style. The same is true with books
where you can purchase hard cover and paperbacks, and with movies where you can go to the theater or watch
DVDs at home. In both cases you spend more for the first releases - the hardcover and the theatre.
To succeed with the versioning, sellers must be able to develop a new "version" of their product without
cannibalizing their existing market. An example would be the debate in 2007 about the lag in release times
between theatres and DVDs. Mark Cuban was arguing for simultaneous release, but theatre executives worried
about people not going to the movies if they could watch at home. Success requires sellers to identify some
characteristic of the good to use as the basis for segmenting the market.
Some examples of versioning described in detail in Varian and Shapiro’s book Information Rules, are:
•
•
•
•
•
Time - stock prices can be obtained free on many sites with a time-delay, while those who want real time
stock quotes will pay a fee for the information. It is also used with movies that come out in the theaters
before they are available on DVD
Image resolution - you can purchase high-resolution images, or pay nothing for low-resolution images.
Speed - you will pay more for a ten page-per-minute printer than a five page-per-minute printer, so a printer
company will sell both versions even if they are identical - which they have been shown to be in at least
some instances.
Features and function - you can get more 'bells-and-whistles" with the high-end version - and you pay for
these bells and whistles.
Technical support - you buy the same product, but you pay for the technical support in the higher price of
that version of the product.
Another example of versioning would be Wal-Mart's decision to go upscale, but only on its web site. The
decision to move into upscale items is not unlike what BMW has done by moving downscale when they
introduced the 1-series. Just as the low end BMW introduces customers to the BMW so they will stay with the
company as they age and get wealthier, Wal-Mart hopes its customers will stay with it as they move upscale
rather than shifting to others such as Target.xvii
3rd degree price discrimination occurs when groups of customers are charged different prices for the same
thing. This sounds easy enough in theory, but it is quite difficult in practice. Imagine yourself in a store and
every time a customer enters you need to size them up, separate them into different groups, and decide on the
price to charge each group. For some tips you might check out the "pros" at this type of price discrimination - the
airlines with their sophisticated revenue management systems (RMS). In general, what the airlines are trying to
do is separate out business flyers from other flyers since demand of the business flyers is less responsive to
prices. Business travelers need to get somewhere at some time and there are no alternatives, while for tourists
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earlier or later flights are options – as are a train or car as an option – and they might not make the trip if the
price is too high.
But how do you identify the business customers since you can’t ask them because they would lie to reduce their
fare. One way to separate the groups would be to charge more for last-minute flights business travelers would be
booking, and charge lower fares to those who can give long advance notice who are likely to be tourists. Another
option would be to give lower rates to those traveling over a weekend and staying Saturday night. Business
travelers want to be home on the weekend, so the discounts wouldn’t cannibalize the high-priced business seats.
For the person who loves to travel and has a business meeting on Monday can probably travel Saturday and stay
two extra nights for less money than flying on Monday.
Universities have also adopted yield management systems designed to maximize the impact of their financial
aid. They know some students really want to attend and are willing to pay anything, while others might need a
little coaxing with some financial aid, but they need to know which group you are in. I will not give out trade
secrets, but I can assure you requests for early admission tend to reveal your hand and lower the chances of
financial aid. And what about those expensive speeding tickets? It turns out there are really two prices – the
stated price and the price if you go to court.
motorists who receive costly speeding tickets are typically granted large fine reductions just for
appearing in court, even when they offer no evidence of mitigating circumstances. Why, he wondered,
should a brief court appearance cut a speeding fine by two-thirds or more?xviii
The answer is that a single, lower price would essentially not deter the high-income drivers from speeding, so the
higher list price is charged with “discounts” given to those who go to court. And we know from our discussion of
opportunity costs, that those with high-paying jobs are unlikely to take the time to go to court, while the
unemployed will.
Amazon gained some unwanted press when it used technology to identify different groups. Two people who
show up to buy a book online are willing to pay different prices; you just do not know how to identify them.
Amazon, though, knew something about each person showing up on its web site. With cookies, Amazon could
separate the market into those who had been online customers before and those who were new to the site, and
then charge them different prices. Who would you charge the higher price? Before answering this question, we’ll
look more closely at the three conditions that affect the success / failure of 3rd degree price discrimination.
First, you must be able to keep the markets separate, which is one of the reasons why age, race, and gender were
so popular as the bases for separating markets. As it gets more difficult to legally use these criteria, firms search
for other differentiators – and coffee offers a good example of successful price discrimination. Starbucks did a
masterful job of separating out the wealthier coffee drinkers, or those working on sending the signal they were
successful, by offering a coffee experience with unintelligible names and comfortable chairs to sit at while
leisurely enjoying the coffee, which would not appeal to the worker rushing to work. There are also the freetrade coffee shops. Wealthier customers, in addition to having more time to drink coffee, probably also have the
luxury of doing something to help the environment and promote social justice. So sell free-trade coffee in your
store, which attracts the wealthier customer willing to pay a higher price, and the price differential is far greater
than the additional cost since the coffee's share of the total cost of a cup of coffee is rather small. You find a
similar pattern with groceries. Organic foods, meanwhile, would also appeal to this market so you have a way of
separating out the two markets.
Second, there must be restrictions on transactions between markets. If a person buying at a low price in one
market can resell it to the person willing to pay a higher price in the second market, then a seller's ability to set
different prices would be eliminated. Separation would not be difficult to accomplish for movies, but it would be
difficult for textbooks since you could always make a deal with those who could buy it at a low price. The
process of buying where prices are low and selling where they are high is called arbitrage, and some people
make BIG money at it. To reduce / eliminate re-sales firms have come up with a number of strategies.
Warranties are one such strategy, as are adulterations of the product. An example of the latter would be drinking
and rubbing alcohol. There could also be some contractual arrangements such as the University's agreement not
to resell computers it purchases at discounted academic rates.
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Third, demand in the sub markets must be different or the optimal price would be the same in both markets. If
demand is different, then sellers charge a higher price where elasticity of demand is lower – where demand is
less responsive to price changes. If buyers "have to have it" then they will be charged accordingly. If they need
to be persuaded, however, they can be persuaded by lower prices.
Returning to Amazon, the company decided there was a different demand for new and repeat customers, and
decided to charge lower prices for new customers because their demand would be more price sensitive This
became public when a customer cleaned out the cookies on his computer and found out Amazon’s quoted price
changed. Amazon had used the information from the cookies to alter its price, to charge its returning customers
more because it felt they would not be deterred by price - a decision that they reversed after some very negative
press.
In 2007 there was a controversy concerning price discrimination in prescription drugs. Canada’s national health
care system helps keep drug prices lower in Canada than in the US, a price differential that went virtually
unchallenged for years because the two markets remained separated. Either it was too costly to travel to Canada
for drugs, or people in the US did not know about the price differences. This all changed with the Internet that
allowed inexpensive online searches - and with those searches came Americans ordering their drugs from
Canada.
Closer to home, why does a steak always cost more when it is served at dinner than at lunch? Demand at lunch is
much more elastic than demand at dinner. Luncheon customers usually eat out more often so they have better
information on prices and thus would be more likely shift to lower-price restaurants. It is also true that a night
out for dinner involves other costs - baby sitters, driving, and parking - and as a result the cost of the entree is a
smaller part of the dinner than the lunch. This would tend to reduce the price elasticity of demand at dinner.
Manufactures' discount coupons for grocery stores and locating factory outlet malls far from cities are two more
examples of price discrimination. In the case of coupons, there are some customers who are more priceconscious, and they would use the coupons, while most would not use them and end up paying the full price. As
for the outlets, the companies locate the outlet malls away from urban areas so those willing to spend time
traveling, who by doing so indicate their sensitivity to price, get the lower price. The same would be true of
seasonal sales that separate out those who really need something now from those who could wait.
The importance of elasticity of demand on the optimal pricing decision is not lost on sellers, and you can see this
in advertising. Sellers work hard to avoid a situation where their product is seen as a "commodity," since this
means consumers see many substitutes and demand would be elastic. Most advertising is therefore designed to
identify specific characteristics of a particular product that set it apart from its competitors. This is why you hear
so much about branding these days.xix Even URI got into this with its branding exercise. What these companies
are trying to do form a bond between the consumer and the company that in essence eliminates competition in
the minds of a customer. Once this has been done, you know the result - higher prices.
There are additional means companies use to "bond" buyers to their products, to differentiate their product in the
minds of buyers, and now we will look at some of them.
Switching costs, lock-in, bundling, and economies of scale
How does one create the differentiation and "bond" a customer to it? One example is AmeriServe, a company
selling paper supplies to fast food stores. If there were ever a competitive business, this would be it since a
napkin is a napkin, but AmeriServe was able to make their napkins "special." AmeriServe put a computer in each
store and soon it had established a database on the stores' sales that allowed it to determine demand for paper
goods. The fast food stores would lose this service if they went with an alternative supplier, and as a result you
would pay a premium for AmeriServe's napkins. Don't you forget this concept as you head into the labor
market.xx
Another example comes from GE whose CIO described the contribution of IT to its profit by differentiating its
products.xxi
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each of our big infrastructure businesses has a major service component. In every one of our
infrastructure businesses we do something called remote monitoring and diagnostics, where we attach
sensors to our equipment. So there are sensors in every locomotive, every gas turbine, every aircraft
engine, every turbo compressor.
We've got software that resides with our customers or in our own shops, depending on how the
customer wants to play it, that analyzes that data and is able in many cases to predict problems before
they occur. We can prevent outages from occurring. That's one very big piece, and IT obviously plays a
very big role.
What AmeriServe and GE succeeded in doing was raising the buyers' switching costs. The idea is quite simple,
when you are making a choice today, the choice you make will have a substantial impact on future choices. For
example, if you are going to buy a computer, you will also buy word processing and spreadsheet software. When
making the choice for the first time, you will explore the options and compare the features and prices of the main
competitors. In this environment demand might very well be price-sensitive, but when you buy the second
computer what you care most about is the ability of the new computer to understand your existing files. You also
have invested heavily in training on the old software, and thus customers have been "locked-in." In this
environment you see companies keeping the introductory price low and making money on upgrades.
The cell phone industry offers another example of the power of switching costs. For starters, those 2-year
contracts and hefty early termination fees substantially raise switching costs, as did the non-portability of your
phone number. If you changed carriers you could not keep your phone number, a procedure supported by the
industry because it significantly increased switching costs, but in 2004 the government forced companies to
allow switchers to keep their numbers. The result was a drop in prices, which gives a measure of the value of
those switching costs. Two final classic examples of the lock-in effect are the markets for computer printers and
razors. In these markets the companies keep the price of the printer low and make money on the ink, and they
keep the price of razors low and make money on the blades.
You also expect companies selling high end products to introduce low-end versions of their products. Mercedes
and BMW did this in an effort to target younger buyers with the hope of keeping them - a strategy that makes
sense if there are switching costs, if as buyers get older and wealthier they are predisposed to continue buying
more expensive versions of their BMW because they like the vehicles and have developed a network of support
technicians and mechanics.
Another very common technique to raise switching costs and "lock-in" customers are loyalty programs - the
most widely recognized being the airline industry's frequent flyer miles programs. To be successful, however,
these loyalty programs should be based on either nonlinear pricing or milestones. Nonlinear pricing means the
reward rate actually changes as you make more purchases. For example consider two options for structuring a
reward. The first is a linear reward structure where each purchase generates bonus points equal to 10% of the
purchase price. If you are buying two $100 lamps and competing stores honored the 10% reward, you would not
care where you purchased the lamps because the reward would be the same - 20 points on the purchase of $200.
The second is a nonlinear reward structure where you get 10 points for $100 in purchases and 22 points for
$200 in purchases Under the nonlinear reward structure, however, buying the entire purchase at one store would
mean a reward of 22 points, so you would buy both from one store.
Another way to increase loyalty would be to include milestones similar to those used by the airlines. As you
make the choice of airlines to fly from Providence to San Francisco you know all airlines will give you points
related to the length of the flight, and because they all fly essentially the same route, the number of bonus miles
are not affected by the choice of an airline. The airlines know this so they adopted milestones - those 25,000
points you need to accumulate to get a free flight anywhere in the US. This would tend to keep you flying the
same airlines to build up those points.
Pricing strategies should also reflect economies of scale - both supply-side and demand-side types. Supply-side
economies of scale exist when average cost declines as output increases. This would be true in the case of
Microsoft that spends BIG money on development of its office software system, but where the marginal cost of a
CD is virtually nothing. A similar situation exists in the silicon chip industry where it costs billions to set up a
plant, but the cost of producing each chip is low. In an industry with this type of cost structure bigger is better,
8
and the larger firms will drive out smaller firms because of their cost advantage. For this reason you can expect
to see a brutal price war as firms jockey to dominate this market what we call a natural monopoly.
Demand-side economies of scale also provide incentive for firms to expand production. Three classic examples
would be the fax machine, e-mail, and phone. The problem is all three are valuable because others also use the
same technology. A phone is of little value if you are the only one with one, while the value of the fax machine
depends upon the number of faxes in a network - which is why demand-side economies are called the network
effect.xxii “The more connections you have, the more nodes, the more people, the more valuable it will be,"xxiii
which is why viral loop sites such as Facebook, My Space, and Ning have been so hot at different times.
The implication for a pricing strategy in the presence of strong network effect, where early adopters will value
the product less than later adopters, is to keep the price low in the beginning and then eventually raise it as the
market expands. This is called "penetration pricing." Two good examples of strategies based on this principle
appeared in Fortune articles. The first was eBay's strategy of entering Asia; the second was Samsung's
competition with Sony.
Asia is Whitman's new focus, and the strategy is straightforward: Get in first and fast. She learned a
tough lesson in Japan four years ago when eBay launched an online trading business there five months
after Yahoo. Given the business's first-mover advantage (people want to trade on the platform that has
the most buyers and sellers), eBay couldn't compete.
At Samsung, speed equals success, and disaster lurks in every overlooked detail or missed deadline. ...
profits in the Digital Age are directly linked to being first to market. A delay in delivery takes us one
step closer to being a commodity, and when it comes to commodities, the low-cost Chinese
manufacturers will eat your lunch noodles.
If we combine the supply-side and demand-side economies, then it will be extremely difficult for a start-up
company to challenge the firm that "wins" the market and establishes market dominance.
IT's role in changing the competitive balance
The battle between consumers and producers over ownership of economic profit is changing dramatically as a
result of innovations in information technology (IT), which is similar to what we saw in WW I when advances in
technology (machine guns) made existing military strategies (charging infantry) obsolete. Unfortunately,
strategies were slow to adapt and the result was unprecedented casualties. We see a similar situation today with
the growth of the Internet. A good example of the Internet’s ability to influence choices is the 2008 presidential
election. Virtually no one gave Barack Obama any chance of beating the Clinton machine, let alone becoming
president - but he did - partly because his campaign was far ahead of any of the others in using the Internet to
organize and raise funds. Another example would be music. I grew up in an environment where we bought our
music on albums and then CDs, but the Internet has changed that, and Apple benefitted greatly from being one of
the first to identify a new music business model – selling songs on I-tunes.
In the market place where information is power, consumers have also found a way to harness the power of the
Internet to their advantage. We now have consumers capable of doing comparison-shopping to find the lowest
price from the comfort of their own home. If consumers successfully use this technology then there could be an
enormous shift of wealth from producers to consumers who will bask in lower prices. In 2012 the New York
Times ran a story about an individual who has successfully haggled over prices because he entered the store
knowing competitors’ prices.
Thanks to the Internet and shopping comparison apps, price-wise shoppers are haggling…If retailers
balk, some shoppers walk. … The shifting of the balance of power has many stores scrambling for
pricing strategies …
J.C. Penny has introduced a streamlined system: daily prices, lower month-long specials and clearance
prices. Mango, the fashion retailer, has cut all prices by one-fifth. Stein Mart, the specialty chain, has
reduced its coupons. Supervalu, the grocery chain, has sworn off heavy promotions and lowered some
prices. Even Walmart has pledged to match competitors’ prices if it sets its own too high.xxiv
9
The result has been a shift in power in favor of buyers who are now seeing lower average markups. In Chile,
which opened up its market for autos, it has been reported that "[y]oung, brand-blind buyers are willing to give
new Chinese models a chance even if they can't pronounce the name"xxv and they will be rewarded with lower
prices. Consumers have the power when we have undifferentiated products such as wheat or ball bearings, prices
will be driven down, but when firms have the power, when consumers think they are buying something different,
prices will not be driven down.xxvi Two sites I have used to shift the balance of power in my direction are
Amazon, where I can comparison shop for used books, and Edmunds where I can find information on car values.
I have not used it but there is also Lendingtree where you can do comparison-shopping for financial services. For
those interested in real estate, we have Zillow that dramatically increases the information available to those
interested in buying or selling real estate, while for those interested in air travel, there is a web site that helps you
choose the right time to lock in a seat on a flight. Farecast, by analyzing the past behavior of airlines, will predict
if and when prices will fall on particular flights. Buyers also stand to gain from recommendation software such
as that at Amazon and Netflix.
But don't start spending the windfall from the savings you get from the additional information because firms also
have access to IT, and they too can use it to their advantage. Massive investments in information and
telecommunications technology (ITT) have pushed firms into the arena of "scientific pricing" and away from the
ad hoc methods of the past.xxvii For those interested in some very interesting examples of how firms, and
governments, use the massive data sets that are being accumulated, check out Ian Ayers' book, Supercrunchers.
Firms’ massive investments in ITT are important for three reasons.xxviii
First, IT investment allows firms to "know" far more about their customers that has created a. movement from a
"make and sell" to "sense and respond" model of business. In the not-so-distant past companies would focus
their efforts on reducing production and distribution costs - a more sophisticated version of Henry Ford's
approach to auto production: you can have any color Model T, as long as it is black. Today, IT investment in the
production process allows firms to better cater to the individual needs and desires of potential demanders whether it be a computer with exactly your specifications or a pair of jeans cut to your exact specifications."xxix
Here are a few examples of how companies’ use of IT improved the bottom line.
1.
2.
3.
4.
5.
Capital One has developed a profile of each cardholder so that when the cardholder calls in and types in the
account number, the IT looks at the account and directs you where it thinks you are going. If you tend to call
for balance information each month, you will get balance information. If you call to cancel, it looks at your
past record and this determines what offers you get to induce you to stay.
Google's search software produces different results for different people. If Bill Gates and Martha Stewart
typed in Blackberry, they would get very different results based on past searches.
Harrah's looks for a “pain-point”- how much you can lose before they lose you as a customer.
Best Buy knows the odds you will make a claim on an extended warranty.
Cingular knows the odds of you going over your minutes
Second, IT investments give sellers the ability to better understand their customers and the ability to conduct
experimentsxxx similar to those lengthy and expensive medical tests where one group of patients gets the placebo,
one gets the real drug, and the researchers look for the differences. Capital One, in 2006, conducted 28,000
experiments on new products and new contract terms. Continental airlines identified people with a
“transportation event” and divided them into three groups that were given different options. One group got an
apology, the second received a trial membership in the President’s Club, and the third group got nothing. The
group receiving letters spent 8% more in the year, and of those who were given trial membership, about a third
signed up which generated more revenues.xxxi Closer to home, some colleges assign roommates randomly which
means that it is now possible to identify the impact a roommate has on grade performance – and it matters quite a
bit.
Oligopoly
So far we have talked about business choices without taking into consideration the behavior of other firms,
which makes sense because perfect competitors are too small and monopolists are too big to worry about this.
The same is not true when there are a few big players - a market structure called oligopoly. This is the world of
Big Business and massive advertising campaigns. The difficulty with oligopoly is that there is no 'ONE' model of
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oligopolistic behavior because the mutual interdependence of the individual firms can take on many forms, each
of which has a different implication for behavior. One oligopolistic industry may be dominated by a firm that
sets prices that others follow, while in another industry all competitors may follow price increases, but not price
decreases. For this reason we will not attempt to survey the many and varied models of oligopolistic behavior,
but rather to focus on a few important concepts.
We begin with Game Theory, a model of strategy that got some big PR in 2001-2002 with release of the movie A
Beautiful Mind, a loosely written biography of John Nash who won the Nobel Prize in Economics for his
pioneering work in game theory. Game theory's key insight is that decision makers must make choices and
develop strategies to improve their position based on the strategies of others. In the movie, Nash and his friends
see some women walk into a bar - four brunettes and a blonde - and all prefer the blonde. So what should they
do? If they were simply doing what we have said to date, maximizing their outcome, they would have all gone
for the blonde, angered the brunettes, and gone home without dates. By considering the others, however, the
better strategy was for all to pick the brunettes.
THE classic example of game theory is the Prisoners' Dilemma game,xxxii but here we will examine a business
decision using this model. Lowe's and Home depot are the major players in the home improvement business and
both conduct costly advertising campaigns. They do this knowing that it does not create any more industry
demand; it just alters the distribution of demand so if they could agree to not advertise then they would be better
off. The choice is then to advertise or not to advertise, and the payoff matrix containing estimates of company
profits appears below. Reverse engineering the payoff matrix you get the following words: If both companies
advertise then their profits are $400 million each, while if they both decide not to advertise their profits are $600
million each. If one decides to advertise and one does not, the firm that advertises earns $300 million, while the
non-advertising firm earns $800 million.
The Advertising Decision
Home Depot
Advertise
Not advertise
Advertise
L +$400 million
HD +$400 million
L +$800 million
HD +$300 million
Not advertise
L +$300 million
HD +$800 million
L +$600 million
HD+$600 million
Lowe's
We start with the search for a dominant strategy. Is there a strategy for Lowe's that will always be best regardless
of what Home Depot does? In this example, Lowe's best strategy when Home Depot advertises is to advertise,
and its best strategy when Home Depot does not advertise is to advertise. The same would be true for Home
Depot, so the dominant strategy, or the Nash equilibrium, would be for both firms to advertise.
There is another possible strategy for the game, what is called a maximin strategy in which a player makes a
choice where the minimum payoff is maximized - or where losses are minimized. In the situation above, the
worst case for Lowe's if it advertises is $400 million, while the worst it does if it does not advertise would be
$300 million. If Lowe's were pursuing a maximin strategy, it would advertise.
Game theory also sheds some light on the arms race between the US and USSR in the Cold War. The choices for
the US and USSR were to build massive arsenals of intercontinental missiles (ICBMs) at considerable cost, or
limited arsenals at substantial cost savings. The "best" strategy would be for the two countries to agree to cut
military spending, but because it would be a very costly mistake for one country to unilaterally choose to disarm
while the other spent $s on an arms buildup, the "equilibrium" solution was an arms buildup in a world with no
cooperation.xxxiii
If you look closely at the payoff matrix above, however, you see a "better" solution, one where the joint revenue
gains would be larger. The "best" strategy would be for both not to advertise, which would produce joint revenue
of $1,200 million. The problem is this is also the riskiest strategy if there is no cooperation, so this outcome is
only likely to emerge when there is cooperation. When oligopolists collude and coordinate their output and
11
pricing actions so as to act as a monopolist, we have a cartel – and the best example of a cartel would be the
Organization of Petroleum Exporting Countries (OPEC).xxxiv Formed in the 1960s, OPEC gained international
recognition in the 1970s when it’s supply restrictions nearly quadruple the price of oil and generated a HUGE
transfer of wealth to the oil producing countries in the 1970s.xxxv
So why do we have so few cartels if they are so profitable? The answer can be found in the conditions necessary
for a successful cartel.
First, for an effective cartel there must be a low elasticity of demand, which was good for OPEC, at least in the
short run, but for De Beers it was a different story. "It is not merely gems that De Beers is selling, but symbols,
myths, magic. As a worldwide dealer in enchanting illusions, Disney has nothing on de Beers: for the
preciousness of the diamond is not a fact but a triumph of modern marketing."xxxvi Because of this low elasticity
of requirement you are more likely to find cartels in markets where the product is a commodity - oil, paper, bulk
chemicals - where there is not much value to branding.
Second, a cartel is more likely to be formed where there is a low elasticity of supply of non-cartel members. In
simple terms this means that a cartel will work better when there are not non-cartel members willing to increase
production when prices rise. If non cartel suppliers do not respond to the price increase with expanded output
(low elasticity of supply for non-cartel members) then this would enhance the ability of the cartel members to
raise their price since new, non-cartel output would not enter the market. In the case of oil, if non-OPEC
members substantially increased their supply of oil as the price rose, then OPEC would not be too successful at
raising the price.
Third, firms have a small incentive to cheat when MC is high because any increase in output by the cheater
would raise costs sharply and thus the profit from expanding output would be limited. They do, however, have
an incentive to cheat when fixed costs are high. High fixed costs give firms a real incentive to raise output since
marginal cost is small and the additional revenue could help cover the substantial fixed costs. Oil production
would certainly be an industry where fixed costs (oil rigs) are large compared to the costs of pumping the oil,
and this has been a real problem for the cartel. It is easy and potentially profitable for an oil producer to cheat,
which is what they tend to do when demand falls. This is what happened in the early 1980s as the world
economy slipped into a recession demand for oil fell. Each individual seller was frantic to keep revenue from
falling and it cost them little to expand output - so they did expand and this drove down the price of oil when all
of the supply hit the market.
Fourth, success of a cartel requires there to be a high expectation of punishment for cheating on the cartel, which
is certainly not the case in the US where cartels are illegal. In the US it is illegal to sign contracts specifying
collusive behavior, which increases the chance there will be cheating because there is no "taking the cheater to
court" option.
Fifth, avoiding cheating will be easier when there are low organizational costs, which we are likely to see when
the industry is dominated by a few firms selling undifferentiated products, and when active trade associations
exist. This was the situation in the insurance industry that New York Attorney General Spitzer went after it in
2004 for bid-rigging. You would not expect collusion to be difficult in this industry since one family dominated
the industry. The CEO of the biggest insurance broker, Marsh&McLennan, was Jeffrey Greenberg, while his
brother and father ran two of the bigger insurance companies - ACE and AIG. You can only imagine how those
holiday get-togethers must have gone.
Fortunately these conditions are not often satisfied. In practice it is difficult to organize cartels and even more
difficult to control them as OPEC and De Beers have found out. The 'structural' flaw in the cartel is a divergence
between the optimal decision for the individual seller and the entire cartel. If you were the only seller in a
market, you would want to restrict output, which would drive up the price. As one of many sellers, however, you
would want to raise your output because the increase would not affect the market price. The problem is everyone
looks at it the same way and thus the cartel is likely to collapse as the members pursue their own optimal
strategy, and there is no way to punish the cheaters.xxxvii
This does not suggest, though, that consumers are freed from worries about collusion on the part of sellers. What
it means is that in the US, where explicit collusion is illegal, we see tacit collusion where sellers arrive at an
12
implicit "deal" to limit their competitive behavior, especially price cuts. One form of this behavior would be
price leadership (price fixing) where the players in an industry decide to allow one firm to set prices and they
follow suit. An example would be the airline industry's decision to cut the commissions paid to travel agents.
After Delta announced the cut, the largest airlines matched it, and the price cut held. If there were no advance
agreement on the part of the airlines, then this behavior is perfectly legal.
There is certainly no shortage of examples of collusive behavior based on the records of the antitrust cases in the
US. In fact, Adam Smith, writing in the 1700s, noted that, "People of the same trade seldom meet together, even
for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance
to raise price." Joseph Stiglitz, in his introductory textbook, describes a blatant attempt at price fixing by one of
URI's illustrious alumni - Robert Crandall, who in the early 1980s was president of American Airlines. A taped
conversation between Crandall and Howard Putman, the president of Braniff Airlines, a competitor of American,
vividly captures the essence of price fixing, and also the difficulty of proving the existence of this type of
behavior. Without the tape, it would have been extremely difficult to prove any illegal behavior.
Crandall: I think it's dumb as hell ... to sit here and pound the (deleted) out of each other and neither one
of us making a (deleted) dime. ... We can both live here [Dallas] and there ain't no room for Delta. But
there's, ah, no reason that I can see, all right, to put both companies out of business.
Putnam: Do you have a suggestion for me?
Crandall: yes, I have a suggestion for you. Raise your goddamn fares twenty percent. I'll raise mine the
next morning. ... You'll make more money, and I will too.
Putnam: We can't talk about pricing.
Crandall: Oh (deleted), Howard. We can talk about any goddamn thing we want to talk about.
It turns out the airline industry, probably because of the high fixed and low marginal cost structure, is prone to
collusion and in the early 1990s was again the target of antitrust action - this time for attempting to fix prices
using the industry's reservation system.xxxviii In 1999 some of the world's largest drug companies agreed to a
multi-billion dollar fine for "rigging" the world's vitamin market, and in 2004 we saw one of the more successful
cartels "caught" price-fixing when DeBeers pleaded guilty to price fixing in industrial diamonds. In one of the
more indefensible statements caught on tape, the former president of Archer-Daniels Midland, a major food and
grain producer, stated "Our competitors are our friends and our customers are our enemies."
A more recent example of collusion was in California where the “Justice Department complained in 2010 that
senior executives at Apple, Google, Intel, Pixar, and two other corporations had ‘formed and actively managed’
an agreement that ‘deprived’ the engineers and scientists who work for them of ‘access to better job
opportunities.’”xxxix In essence they had formed a cartel and agreed to not poach each other’s workers, and by
doing this they virtually eliminated any power these workers had in negotiations and tipped the balance of power
away from the workers and toward the corporations. It does not matter much if sellers get together and
manipulate supply or buyers get together and manipulate demand – in both cases the market power shifts to
those who collude and cooperate.
Price-fixing is not the only restrictive practice that can be employed to reduce competitive pressure in the
marketplace. Another strategy would be an agreement among the firms to divide up the market and establish
market shares - something done in the market for Italian bread in New York City and in the worldwide market
for lysine. Restrictive practices are generally classified as either vertical restrictions aimed at firms in other
levels of the supply chain or horizontal restrictions aimed at competitors at the same level of the supply chain.
An example of vertical restraints would be exclusive territories in which wholesalers and retailers are given the
exclusive rights to sell a producer's product in a given market area. In RI, for example, the Coca Cola you buy in
the supermarkets all come from the same bottler, and the same is true of the Miller beer you buy at the state's
liquor stores. Because the stores have no ability to purchase from other bottlers, you can expect the price of these
beverages to be higher than they would be without this restrictive practice. Another vertical restriction would be
the producer's requirement that any firm selling its product not sell its competitor's products - what would be
called an exclusive dealing. Tie-ins, or tying contracts, are another restriction, one that gained notoriety in the
Microsoft antitrust suit. Microsoft was accused of telling computer manufacturers that if they wanted their
Windows operating system, then they would also have to take its Internet Explorer browser.xl
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It is now very obvious that profit acts as a magnate for resources and there are some very real benefits to gaining
market power. In the antitrust and regulation unit we will look at how the government has gotten into the action
through the direct regulation of industry and its antitrust laws.
Market power and government policy
Market power means BIG money for those with the power, which is why businesses are always looking for ways
to gain market power and why we are always debating government’s proper role in maintaining competitive
balance. Conservatives believe business is the goose that laid the golden egg and government strangles that
goose, while liberals tend to see businesses as those psychopaths that society must be protected from, and US
policies reflect the dominant economic ideology at the time. In this section we will look briefly at the evolution
of two dimensions of government policy toward competition in the US - antitrust and regulation.
We pick up the story in the late 19th century, a time that turns out to have many parallels with the late 20th
century. Then the US was in the midst of an industrial revolution, now it is in an information revolution, and in
revolutionary times the existing order is swept aside and new centers of power emerge.xli For example, in the oil
refining business in the mid 1860s, Rockefeller created Standard Oil Company that eventually controlled about
90 percent of the nation's oil refining capacity and all of its pipelines, while in the 1990s Microsoft took control
of the word processing, spreadsheet, and operating systems markets, which made Bill Gates one of the world’s
wealthiest individuals.
The rising concentration of economic power in the hands of a few in the 19th century meant that life was very
good for the wealthiest with the power, but not so good for those without the power, and labor worked long
hours, for miserly wages, often times under terrible conditions. This was an era where the world's sweatshops
were not in Asia or South America, but in US cities, and to counteract the growing power of the nation's biggest
corporations, laborers and farmers began to consolidate their power into labor unions and granges and violence
erupted across the nation. The ideological balance of power, however, favored the conservatives as it had since
the nation’s earliest days.
The balance eventually began to swing toward labor with the rise of a Populist movement energized by a press
that wrote of the excesses of the industry titans, the abuses of power, political corruption, and the miserable
working conditions. Eventually the US government stepped into the fray with the passage of legislation that
established a two-pronged approach to "protecting" people from excessive market power. With passage of the
Interstate Commerce Act in 1887, "pushed" primarily by western farmers seeking protection from monopolistic
practices of railroads, the US government got into the regulation of industry by setting standards of behavior.
Three years later, in 1890, the US adopted its first antitrust laws with passage of the Sherman Act that limited
the concentration of power in any industry.
Antitrust
Federal antitrust legislation is designed to promote competition and outlaw certain anti competitive behaviors,
and the Sherman Antitrust Act of 1890 was where it began. Below are the two key sections of law:
Section 1 "every contract, combination in the form of trust or otherwise, or conspiracy in restraint of
trade or commerce among the several states, or with foreign nations, is declared to be illegal"
Section 2 "every person who shall monopolize, or attempt to monopolize with any other person or
persons, to monopolize any part of the trade or commerce among the several States, or with foreign
nations, shall be deemed guilty of a misdemeanor, and, on conviction thereof, shall be punished by a
fine not exceeding five thousand dollars, or by imprisonment not exceeding one year, or by both said
punishments, at the discretion of the court"
If you read it carefully you can see a problem that has plagued antitrust actions by the government since the
beginning – ambiguity – that raises the importance of ideology. For example, the legislation identified
monopolistic structure in Section 1 as illegal. The competitiveness of the market is to be judged by the structure
of the industry - how many sellers were in the market and how much of the market they controlled - which
would be reflected in concentration ratios that measure the percent of market sales controlled by the largest four
or eight firms. Section 2 of the legislation outlawed certain conduct a firm could use to gain market power. Here
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the competitiveness of markets would be judged by the behaviors of the sellers. Those in charge of enforcement
had to determine whether to focus on conduct or structure, and then determine the indicators of structure or
conduct to use in assessment, and these decisions were heavily influenced by the ideological balance of power.
At the time of enactment conservatives had the ideological high ground and you can see this in the fact bad
behavior was only a misdemeanor, the fine was relatively small, and it was open to the discretion of the court.xlii
The conservatives control can also be seen in the fact that it took nearly a quarter century for the first antitrust
"successes" when antitrust cases were brought before the Supreme Court against Standard Oil and American
Tobacco. These corporations controlled up to 90 percent of the oil and tobacco markets and they used predatory
pricing and preferential treatment from the railroad to drive out competitors. In 1911 the Court agreed that the
companies had a monopoly, but they determined this did not violate the Sherman Act. The Court did, however,
rule on the companies’ conduct and charged them with unfair business practices and ordered that Standard Oil
should be broken up into 34 independent companies and American Tobacco should be broken into 7 separate
companies.
The hand of the government was strengthened and clarified in 1914 with passage of the Clayton Act and the
Federal Trade Commission Act. The Clayton Act was designed to remove judiciary discretion in antitrust cases
by specifically outlawing certain behavior. The illegal practices were:
price discrimination: Firms could not charge different prices to different buyers. It was targeted at the
"deal" the railroads gave Rockefeller.
tying and exclusive contracts: Firms could not force a buyer to buy other products sold by the seller. It
also outlawed the practice whereby a seller would force a company not to sell a competitor's product if
it wanted to sell its product.
interlocking directorates. Competitors are prohibited from having the same people on their corporate
boards.
acquisitions of competing companies: Firms were restricted in their ability to buy up other companies
when it reduced competition.
The Federal Trade Commission Act, meanwhile, established the Federal Trade Commission (FTC) to investigate
"the organization, business conduct, practices, and management" of companies."xliii The commission could
identify certain practices as "per se" illegal, which meant these practices were simply wrong, and one behavior
declared illegal in 1926 by the Supreme Court was price-fixing, which is an agreement among participants in the
same market to buy or sell at the same price. The advantages of such a policy are obvious, so it should be no
surprise there have been numerous price fixing cases. Some of the more widely publicized price-fixing cases
were those brought against ADM in the mid 1990s in the market for Lysine that had all of the drama we expect
in movies – “secret rendezvous in hotel rooms, allegations of prostitutes hired to do corporate espionage, an FBI
dragnet, and a double-crossing mole;”xliv NASDAQ in the late 1990s for its dealers’ “tacitly colluding to keep the
gap between the price they paid for a share and the price at which they sold it wider than it would have been in a
truly competitive market;”xlv and Sotheby's & Christies in the early 2000s in the art auction market where they
had a 90% market share and they “conspired to raise commission rates, with their two chief executives,
Christopher Davidge (of Christie's) and Diana Brooks (of Sotheby's) holding lengthy secretive meetings.”xlvi
More recently three companies were convicted of price-fixing in the liquid crystal display market in 2007, Apple
and five major publishers were convicted of fixing e-book prices in 2013, the same year we heard story where
“at least three – and perhaps as many as 16 – of the name-brand too-big-to-fail banks have been manipulating
global interest rates, in the process messing around with the prices of upward of $500 trillion (that's trillion, with
a "t") worth of financial instruments.”xlvii
Antitrust law in the US changed directions in 1945 when structure was recognized as an adequate indicator of
monopoly in the judgment against Alcoa. The company that controlled the aluminum industry had not been
found to employ any unfair practices, but it was found guilty of being a monopolist based simply on its market
share. The basis for this decision was that a rule based on performance meant every case would be different and
it would be difficult to know in advance what behavior was acceptable. For example, if a company selling
computer operating systems made consumers buy its Internet browser, was this the firm using its power in the
systems market to gain power in the browser market, or was it a firm concerned about the users' best interest?
That's a tough call, but one it would have to make in the Microsoft antitrust case, so if we went with a simple
market share as an indicator of monopoly power, discretion would be taken out of the problem. Of course, you
15
know by now that this was not the end of the story because each solution creates a new problem, and this one is
with the definition of the market. In the Alcoa case, Alcoa had pushed the courts to consider other metals copper and steel - as being in the same market, and if this were done then Alcoa's market share would have been
relatively small.xlviii
In recent years, the three biggest antitrust cases were IBMxlix, AT&Tl, and Microsoft, and here we will just look
briefly at the high/low points of the Microsoft case. Microsoft which was accused of possessing monopoly power
in the PC operating systems, of tying other products such and the Explorer browser to it, and entering into
agreements with computer manufacturers that stopped them from offering competing software. Others saw
Microsoft's practice of bundling software, coupled with predatory pricing, as abuses of its monopoly power. By
bundling the software, Microsoft essentially could drive the price to zero on its new software and drive out
competition, and pay for it from the monopoly profits from its other product lines. Microsoft's strategies seemed
to have worked because it had successfully driven out the leading word processing software (WordPerfect), the
leading spreadsheet program (Lotus), and the leading Internet browser (Netscape).li Eventually Microsoft was
found guilty in 1999 and ordered to be broken into two companies - similar to how AT&T had been broken up
into the Baby Bells. The breakup of Microsoft was eventually overturned and by late 2002 the case had finally
been settled. Things did not end here, however, since Microsoft was found guilty by the European Union of two
anticompetitive actions - tying its Windows Media Player to its operating system and designing new server
software that favored its software.
In addition to breaking up existing monopolies, antitrust legislation is also the basis for discouraging the creation
of monopolies through mergers and acquisitions. The mergers that are most likely to get the attention of the
government are horizontal mergers, the combination of two companies in the same industry. In 2008 this was an
issue as Microsoft, Yahoo, and Google discussed different mergers. Basically what we had was a situation where
mergers are fought based on market shares - being turned down when the merging firms share of the market
exceeds guidelines. A more recent example of this was the Justice Department’s blocking of a proposed merger
between AT&T and T-Mobile – the second and fourth largest wireless phone carriers – on the grounds that it
would reduce competition and lead to higher prices and less innovation.
Regulation
The move toward regulation of industry emerged from a belief that economic and social problems created by a
conflict between private interests and public goals could not always be solved by unrestrained competition. In
much of the world the solution to this problem was nationalization, or public ownership, where the monopolist
was a government run operation. In the US there are a few examples of public ownership - Amtrak and the Post
Office - but the preferred approach was the regulation of private industry that can be roughly divided into two
categories - economic regulation and social regulation.
Social regulation tends to be product specific, cuts across industry lines, and focuses on specific attributes of the
product or production process. The justification for this type of government activity is most often the existence
of externalities or imperfect information. The regulation's goal is generally an improved quality of life - less
pollution, better working conditions, and safer products. These regulations are likely to raise the cost of
production - at least the explicit cost of production, which is why these regulations are so often the target of
industry campaigns designed to soften the regulations as a means of increasing the competitiveness of American
companies. As we will see in the unit on externalities, the private costs of the company do not include the social
costs of more pollution and more dangerous workplaces, and thus we must be careful to do a full accounting of
costs and benefits when evaluating regulations.
The earliest piece of social regulation came in 1906 with establishment of the Food and Drug Administration
(FDA) at a time when the delivery of food industry was undergoing exceptional change; not all of it "pretty" as
Americans saw in Upton Sinclair's depiction of the meatpacking industry in The Jungle (1906). The book's
impact was quick, with passage in the following year of the Animal & Plant Health Inspection Service that
covered meat and poultry packing plants. In 1934, in the midst of the Great Depression that many saw as the
result of abuses in the financial markets, the Securities and Exchange Commission (SEC) was established to
regulate the securities industry. It was not until the activist 1960s, however, that we saw the big push behind
social legislation. Buoyed by their success with macroeconomic "planning" in the 1960s, and confident that
government could right the wrongs of the market system, economists and policy officials turned their attention
16
elsewhere. The Equal Employment Opportunity Commission (EEOC) was established in 1964 to investigate
claims of discrimination; in 1970 the Occupational Safety and Health Administration (OSHA) was charged with
the task of providing safety in the labor market; and in 1972 the Consumer Product Safety Commission (CPSC)
was established to protect individuals in the output markets. In the following year the government took on the
safety issue in one of the nation's most dangerous workplaces, mines, with the creation of the Mine Enforcement
Safety Administration. There were also the problems of the environment, popularized in Rachel Carson's book
The Silent Spring that ultimately led to Earth Day and the formation in 1972 of the Environmental Protection
Agency (EPA).
Economic regulation tends to be industry specific and focuses on government control of economic decisions.lii
The first argument for restricting competition and regulating industry is that there are some natural monopolies,
industries where average cost falls as output increases. If average cost declines with higher production, then from
society's perspective we should have one BIG seller, but their behavior would need to be regulated to ensure it
does not "rip off" buyers. In the US the classic examples of natural monopolies has been utilities - electric, gas
and telephone. The rationale was simple - it made no sense having many companies string their own lines on
poles cluttering our streets and raising costs when one set of lines and poles was all that was needed. For those of
you who have cable, this is another example of a regulated industry. After 1972 cable began moving into the
nation's major metropolitan areas, but it made no sense to allow more than one company to lay the cable, so local
governments regulated prices. In 1984 the price regulation was eliminated, and prices promptly rose, which
prompted new legislation reinstating local governmental regulation of prices.
Another example of government regulation of a natural monopoly would be the Block Island Ferry that many of
you may end up taking to the island during the summer. This ferry service was regulated by the state because of
the belief the island was best served by a single provider of ferry services, although this was challenged in 1999.
The rationale was that the high fixed cost of the ferry means the average cost of providing service declines with
more travelers. For example, if the boat costs $10 million and it must be paid by the customers, the cost will be
lower if there was one boat with 50,000 travelers than if there were two boats with 25,000 travelers each.liii
A second problem addressed by regulators is universal access. Again the idea is simple, and the phone or postal
systems offer good examples of the concept. Let's say that for equity, or national security reasons, the
government wants all residents of the US to have access to phone and mail service. The problem is that a phone
company, or the post office, would love to provide service to large metropolitan areas such as Boston where one
line or one mail carrier could service many calls or letters, but they would look at a customer in a remote area
such as northern Maine as being too costly to provide service. The private market system will "require" a link
between price and cost, and it is just too costly to run the services to remote Maine. To provide an incentive for
universal access the government would contract out with a firm to provide service to everyone and set a pricing
structure that allows the company to make a profit on the low-cost metro areas and use that profit to cover losses
on the high cost, remote areas. This behavior is called cross-subsidization of prices.
If this pricing scheme is to be adopted, however, there needs to also be a restriction of entry and exit. The
restriction is necessary because a potential competitor could be expected to appear who would provide service
for the high profit activities - a process called cream-skimming - because prices on this service are high enough
on these services to justify entry into the market. This is clearly the situation with the Block Island ferry service,
and the problem should be apparent to anyone who has been to Block Island. It is a wonderful place to be in the
summer, but you could get very lonely there in the winter. As for the ferry service, potential suppliers would
most likely be interested in the summer business when the tourist flow to the island is heaviest and not in the
long winter months when the seas are heavy and the passengers few. If it was your ferry service and you had
your choice, you would likely shut down the operation in the winter or move it South following the people and
the sun. The problem from the state's point of view with this "rational" profit maximizing behavior is that it
would deny permanent island residents year-round access. The same was true in the phone business where it
would be much cheaper to supply service to an individual living in downtown Providence calling someone in
New York City than to someone on Block Island calling a friend in Presque Isle, Maine.
As for the future, the ideological battle will continue as we could see in the debate over regulation of the finance
industry. In the 1932 in the depths of the Great Depression triggered by risking investments by banks, Congress
passed the Glass-Steagall Act that established certain regulations for banks – one of which was a limit on the
assets in which they could invest – and by the early 1970s the regulation of industries had spread widely.
17
By the 1970s, the ideological pendulum was beginning to shift, a reaction to the Great Stagflation of the 70s that
raised serious doubts about the ability of American firms to compete internationally. The US was experiencing
unacceptably high levels of inflation and unemployment, and the regulation of industry was often mentioned as
the culprit since it raised the costs of industry and lowered the rate of productivity advances. Two other factors
that pushed the deregulation movement forward were changes in technology and an ideological shift to the right
that was accompanied by the growing power of US industry. "Through lobbying, political contributions, and
sophisticated public relations campaigns, they [corporations] and their leaders have turned the political system
and much public opinion against regulation" is how the situation is described in The Corporation. In fact, if you
read the book you will see the deregulation movement in the 1970s as the first big payoff for a concerted, wellfinanced effort by BIG BUSINESS to defeat the BIG GOVERNMENT policies launched by Roosevelt to
regulate industry during the Great Depression. It is also true that regulation is more difficult than it sounds.
Where do you get the people to pour over the company books needed if they are to be regulated? Too often it is
from the industries themselves, creating a problem known as "regulatory capture," that can be traced to the fact
that the same individuals move from the industry to regulatory bodies - and then back again - so there is little
reason to be too hard on the industry because you will be back there soon.
You can get a sense of what was happening in the various industries by looking at the airlines industry. The
regulation began in 1938 with establishment of the Civil Aeronautics Board (CAB) that was given the task of
establishing travel routes and fares for air travel. When jet travel arrived with the Boeing 707 in the late 1950s,
the stage was set for an explosion in air travel in the US, and the government regulated all of it. At this time the
CAB determined what companies would fly what routes, and what they could charge - a power that was evident
in the movies, The Aviator and Catch Me if You Can. What we saw in the Aviator was the competition for
routes, while in Catch Me If You Can we saw the airlines use of "accessories" like pretty stewardesses to gain
competitive advantage since you could not use prices that were set by the CAB. This ended in 1978 when
legislation was passed that allowed entry of new airlines into the market and allowed all firms to set routes and
fees. Initially the deregulation produced many new entrants, and increased competition, but over time we saw a
reconsolidation of the industry with only a few firms surviving - a pattern we also saw in other deregulated
industries. In the oil, phone, and tobacco industries where the giants were broken into numerous smaller
companies, a wave of mergers has left the industries with a few large players with considerable market power
that they have used to reduce unionization and lower wages.
The banking business was not immune to the rightward shift in the nation’s ideology and in the 1980s
regulations on the Savings and Loan industry were relaxed, which led to some speculative lending that
eventually produced the Savings and Loan crisis in which nearly 25 percent of the nation’s S&Ls closed and
Americans had to pony-up nearly $90 billion. Back in Rhode Island the collapse was so severe that in 1990 the
new governor’s first act was a closing of the state’s credit unions. This did not slow the rise of the right and their
belief in markets, and in 1999 under Bill Clinton the Glass-Steagall Act was repealed and banks once again
could do as they pleased with money that had been deposited there. What they did was a much bigger version of
what we saw in the S&L industry in the 1990s, and the consequences were also bigger – the Great Recession
triggered by the subprime mortgage crisis. As you would expect, the crisis has generated calls for a re-regulation
of banks, but as of 2012 the banks have been able to fend off new regulations.
Before we leave our discussion of regulation, some mention must be made of the energy deregulation that
precipitated the rolling blackouts in California in 2001, and probably was an important factor in the recall
election in 2003 in which Arnold Schwarzenegger was elected governor of California. In recent years the battle
has intensified in the area of environmental legislation, which we can see in the 2014 Supreme Court decision to
allow the Obama administration to regulate the greenhouse emissions of power plants. Going forward we can
expect to see a continuation of the battle over the correct boundary between the market and the government
continues. Now its time to look at two other battleground areas – inequality and the environment.
18
Imperfect Competition
i
You can get a sense of what market power can mean, as well as some of the jargon of imperfect competition, from the
1. "Retailers released documents yesterday that they say show that Visa and MasterCard colluded to monopolize the
market for debit cards." ("Retailers' Suit Says 2 Issuers of Credit Cards Acted Illegally," New York Times,
November 14, 2002)
2. "The Federal Trade Commission, in reviewing the merger of Exxon Corp. and Mobil Corp. last year, noted that big
oil companies often set their prices based on competitor' prices rather than their own costs. It called the practice 'an
earmark of oligopolistic behavior." (Alexi Barrionuevo, Secret Formulas Set the Prices for Gasoline," Wall Street
Journal, March 20, 2000).
3. "Hope springs eternal, at least at OPEC. Just three years ago, oil prices had collapsed to $10 a barrel, and the cartel
was in complete disarray. Yet today, the group confidently aims to micromanage the price of oil." ("Trouble
ahead," The Economist, July 28, 2001)
4. "He [Cecil Rhodes] observed that, uncontrolled, the industry dug out too many diamonds, flooded the market and
prompted a collapse in prices. ... The answer was to support prices artificially by seizing control of all mines."
"Glass with attitude," The Economist, December 20, 1997"
5. "...banks exercise market power in pricing money market deposits and CDs in their local markets. First, banks pay
lower deposit interest rates in markets that are more concentrated. Second, deposit interest rates are lower following
a bank's participation in a merger... The finding that mergers have an adverse effect on consumer deposit pricing
raises questions about whether antitrust enforcement has been sufficiently vigorous" (Katerina Simons and Joanna
Stavins, "Has Antitrust Policy in Banking Become Obsolete," New England Economic Review, Boston Federal
Reserve Bank, March/ April 1998)
6. "..economists from the Department of Justice concluded that the price of Interstate's sliced white breads strongly
affected sales of Continental's Wonder Bread, and vice versa, but made little difference on to sales of other white
breads or other varieties, such as rye. Having shown that each company's brands were the main restraint on the
other's prices, the authorities moved to block the merger." ("The trustbusters new tool," The Economist, May 2,
1998)
ii
Justin Fox, “The web’s new monopolists,” The Atlantic, J/F 2013
iii
Shelly Branch, "Maybe sex doesn't sell, A&F Discovering," WSJ December, 2003
iv
We'll look at RIU so see what profit maximization looks like in tables and graphs.
RIU: The tables
We return to the books of RIU, but this time where we allow our university to be the sole supplier of education in the market.
In this situation we find that the university faces a traditional downward sloping market demand curve so tuition and
enrollments are negatively related. If the university raises its price then the number of students enrolling at the institution will
decline. Once again we use the decision rule (MR=MC) and continue to expand the level of output as long as MR > MC.
A review of the table reveals that the main difference between the books when RIU is acting as a competitor and when it is
acting as a monopolist is in the MR column. When RIU was a perfect competitor, MR = P, but here we see that MR is less
than price since a decision to raise enrollment is also a decision to lower tuition. The optimal size of the university is
determined by looking at the Marginal profit column, the Profit columns, or by comparing the Marginal Revenue and the
Marginal Cost columns. Marginal profit turns negative at 10,125 students so we would not want to get this big, precisely
what we see in the profit column with profit reaching a maximum at 9,800 students. Finally, you see that at 9,800 students
MR > MC so it paid to get this big, and maybe even a little bigger, but at 10,125 MR<MC so you would not want to get that
big. Based on these numbers you would want to have a university of at least 9,800 students that would be making a profit of
at least $38,020,000.
Financials for RIU
Students
Tuition
Total Revenue
Marginal Revenue
Total Cost
Marginal Cost Total Profit Marginal Profit
6700
$10.3
$69,010
0
$45,000
0
$24,010
0
7300
$10.2
$74,460
$9.08
$48,500
$5.83
$25,960
$5.6
8000
$10.0
$80,800
$9.08
$52,000
$5.00
$28,000
$8.1
8775
$9.9
$87,750
$8.97
$55,500
$4.52
$32,250
$9.9
9800
$9.8
$97,020
$9.04
$59,000
$3.41
$38,020
$1.65
10125
$9.7
$99,225
$6.78
$62,500
$10.77
$36,725
($3.7)
10400
$9.6
$100,880
$6.02
$66,000
$12.73
$34,880
($5.3)
10625
$9.5
$102,000
$4.98
$69,500
$15.56
$32,500
($6.8)
10800
$9.4
$102,600
$3.43
$73,000
$20.00
$29,600
($8.3)
RIU: The graphs
The graphical representation of the data in the table appear in the two graphs below. Following the optimal choice logic we
look for the level of output where MR=MC. In the graph this appears where the MR and MC curves intersect - just under
19
10,000 students. Once we have established the number of students by drawing a line down to the x-axis, we then follow that
line up until we find the demand (AR) curve. If we draw a line over to the y-axis we can see what tuition rate to charge to
achieve the specified enrollment level. In this example it would be approximately $10 (in 1,000s).
Here we look at the graphical representation of a generic monopolist maximizing profit. The profit maximizing firm will
operate where MR = MC, so all we need to do is find where on the graph MR = MC. [There is one added stipulation - that
MC must be rising]. In the graph you see this happens at the output level of q*. If the firm produces this much then it will
charge a price of P* since the demand curve - the same as the AR curve - gives us the price that can be charged to sell P*
amount of output. You will also recall that the profit earned is the rectangle A.
v
Edward Jay Epstein, “Have you ever tried to sell a diamond?” The Atlantic Monthly, February, 1982. This is a good history
of De Beers and its efforts to “manipulate” the diamond market from both the supply and demand sides of the market
vi
For another example, think about all of those electric poles and lines you see on the streets. It costs virtually nothing to send
the electricity through the lines, but it costs a good deal to put them in the ground and install the wires. As a result of this cost
structure, a firm would want as many customers as possible because the installation costs could be distributed across more
customers. If a competitor arrived then each firm would have fewer customers and this would raise the average cost, so there
is no real incentive for firms to enter into a market where firms have this cost structure.
vii
In 2005 we saw another example of this when word began to circulate that Google was making it difficult for high tech
start ups to get venture capital funding and good high tech workers. The rapid expansion of Google was accompanied by a
surging demand for workers that raised the price of these workers and effectively shut off the supply to smaller companies. It
also prompted venture capitalists, who well remember the meteoric rise and catastrophic collapse of Netscape, to make it
more difficult for the small start ups to raise money because the start ups were continually asked; why can't Google do what
you are doing?
viii
Business strategy by firms can also generate market power, and thus earn economic profits. Two examples are Southwest
Airlines and Zara. Southwest Airlines has been a remarkably successful company on its success at identifying a market niche
- short distance, non-business travel. This is a market that is likely to be price sensitive, so it developed a strategy that
allowed it to lower costs below those of the major airlines. There were no first-class or business class seats on its planes and
they avoided major metropolitan area airports, which reduced the turnaround time enough to allow them to have fewer planes
per passenger mile. Southwest also reduced costs by eliminating meals, assigned seating and check-through luggage because
it believed this niche did not value the services enough to justify the costs. And it cut costs even more by buying only one
plane - the Boeing 737. By choosing its niche and focusing on just that sub market, it was able to lower its costs substantially
below that of its competitors, which was the source of its profit.
Zara, meanwhile, developed a successful strategy that has made it very profitable in the apparel industry, an industry that
suffers from large, and unanticipated, changes in people's tastes. It is just very hard to know what style will be hot, which is a
20
problem for most companies since they outsource much of their production to low wage countries such as China and thus
have long production runs to keep production costs low. The result is too often the companies have a surplus of what is not
selling and do not have adequate supplies of what is hot, which lowers their revenues, and they have to "eat" too much of
what is not hot, which raises their costs. Zara has developed a system based on information technology and a centralized
production and distribution center in Spain. This allows them to have small production runs that reduce the number of unsold
products, which lowers average costs. In addition, their information system identifies hot items and quickly and sends orders
to the company's factories which begin producing it and other related products. This gets product to the market within weeks
rather than the months for most companies, and this raises revenues.
ix
An interesting example of the barriers to entry created by strategic behaviors is the decision to locate the movie industry in
southern California. It turns out the movie business in its earliest days at the beginning of the 20th century, was located in
New York City, close to Thomas Edison who was not only a major innovator in the industry, but also a driving force behind
creation of the Movie Trust. This trust was established to keep out competitors by establishing an agreement with Eastman
Kodak that it would sell film only to a Trust member and by refusing to lease the necessary equipment to certain producers. It
turns out that some of these new producers decided that the only way around the Trust was to relocate, and that is what the
independent filmmakers did - they moved to Hollywood and in 1912 Universal Studios opened in Hollywood.
x
There were three early peaks in M&A activity: 1887-1904, 1918-1929, and 1950-1969. The first of these has been described
as a period of "merger for monopoly" and if you are looking for a symbol of the wealth associated with the emergence of
these American giants, take a trip to view the Newport summer homes of the "captains' of industry. The second period was
characterized as "merger for oligopoly" as the second-tier producers joined to take on the industry leaders. The third period
was characterized by conglomerate mergers where firms attempted to diversify their operations just as investors diversify
their portfolio. By the mid 1970s, however, this movement was being reversed as conglomerates began to sell off operations
that were not central to their operation. The birth of the mega-corporation in these merger eras can be seen in the number of
the nation's largest firms that were "born" in these years. Of the 500 largest firms in the US in 1994, 240 could be traced to
the decades spanning these three periods. Looked at a little differently, in these six decades out of a total of twenty-one,
nearly 50 percent of the nation's largest firms were born. The merger wave of the 1990s, meanwhile, was in many respects
similar to the merger movements of the late 19th century. In both cases advances in communications and transportation
technology allowed for the expansion of market areas. In the 19th century it was the emergence of national markets that in
large part could be traced to the completion of the transcontinental railroad and the telegraph, while in the 20th century it has
been the Internet and falling prices of international phone service that has contributed to the emergence of an international
market.
It is fairly easy to measure a firm's size - sales, profit, market capitalization - but more difficult to measure market power.
One of the primary measures of competition and potential market power is the concentration ratio, which is the percentage of
an industry's output produced by its four largest firms. As you can see from the table below, concentration ratios vary
substantially across industries and across time. Concentration is lowest in ready mix cement, which can be explained by the
low value to weight ratio. A $s worth of cement is VERY heavy and is unlikely that it will be transported over long distances
so you are likely to have a few independent sellers in each market, which will keep concentration rates low. Concentration
rates are also low in the apparel sectors, while in the cigarette and breakfast cereal markets concentration is quite high. At the
aggregate level, concentration rates in manufacturing stood at about the same level in 1992 as 1970 and below what they
were in 1954. By early 2000s you had 4-firm concentration ratios of 99% in cigarettes, 90% in batteries and brewing, 89% in
light bulbs, and 83% in breakfast cereals.
Four Firm Concentration Ratios
1963
1992
Meat Packing
31
50
Cereal breakfast foods
86
85
Cigarettes
80
93
Men's and boy's suits and coats
14
39
Women's dresses
6
11
Ready mix concrete
4
6
Pulp mills
48
48
Blast furnaces and steel mills
48
37
Metal cans
74
56
xi
According to James Twitchell, the key insight that has shaped modern advertising came to cigarette manufacturers in the
1930s. In the course of market research, they discovered that smokers who taste-tested various cigarette brands without
knowledge of the brands could not tell them apart. If the manufacturer wanted to sell more of his particular brand, he was
going to have to make it distinctive or make consumers think it was distinctive, which was considerably easier.xi This was
also the approach taken by De Beers, the diamond monopolist that essentially “created” the market for diamond engagement
rings with a massive advertising campaign to “educate” the American – and then Japanese women – of the value of those
rings. Edward Jay Epstein, “Have you ever tried to sell a diamond?” The Atlantic Monthly, February, 1982.
xii
The Colvin Interview, "Information Worth Billions" Fortune, July 21, 2008
21
xiii
Juliet Schor, Born to Buy.
Another example of this would be the work done by companies such as Zilliant that supplies software to companies to
determine the impact of price changes on sales. In 2001 DHL began offering cold callers different prices, while the software
tracked the effects. DHL learned much about the effect of prices, which translated into higher revenues.
xv
It's definitely a hot topic and at the TUM Research Center Mass Customization & Customer Integration you will find a
pointer to The Second World Congress on Mass Customization and Personalization with the following description.
xvi
Hal Varian, “Versioning Information Goods,” 1997
xvii
Bob Tedeschi, "Where is Wal-Mart's Fancy Stuff? Try Online," NYT 11/21/2005
xviii
Robert Frank, “How do they charge that? (And other questions), NYT May 13, 2013
xix
In June 2005 Fast Company was devoted to the power of design as a tool to create loyalty. The design chief of Whirlpool
was commenting on how there was a lack of "brand loyalty" and that design would "alter buyer behavior and drive sales" and
help the company escape from the downward price spiral. It also may be true that Amazon was able to keep customers who
were familiar with their web site and felt the additional cost was not worth learning about a new site.
xx
The reason bundling is more important in the information industry is because the marginal cost of another spreadsheet or
word processing diskette is negligible, so bundling adds substantially to the profit. For some background on the "Rules" of
the information economy, you will read Carl Shapiro and Hal Varian's Locked In, Not Locked Out, "Versioning: The smart
way to sell information," and Varian's Market Structure in the Network Age and "Miles And Miles Of Flexible Track." If you
are really energetic you will want to read Kevin Kelly's, New Rules for the New Economy (1999) and Carl Shapiro & Hal
Varian's, Information Rules: A Strategic Guide to a Network Economy.
xxi
The Colvin Interview, "Information Worth Billions" Fortune, July 21, 2008
xxii
Varian makes the distinction between "direct" and "indirect" network effects. The direct would be the fax machine
example - as the market increases in size the value to the individual user increases. An example of indirect effects would be
XBOX or DVDs. DVDs are valuable if there is content that can be seen on them, just as the value of Microsoft's entry into
the game market will depend upon the number of games that are produced.
xxiii
Adam Penenbeg, "Ning's Infinite Ambition," Fast Company, May 2008
xxiv
Stephanie Clifford, “Knowing Cost, the Customer Sets the Price,” NYT March 27, 2012
xxv
Alex Taylor III, "The New Motor City," Fortune, October 27, 2008
xiv
xxvi
The web site BF2005.com is one example of the potential shift in favor of buyers. This web site released all
of the information on store flyers promoting sales on Black Friday, the day after Thanksgiving. Without the web site, a
dedicated consumer would need to spend hours comparing prices in flyers to see where the best prices were, but with sites
like BF2005, the Internet would reduce substantially the cost ofxxvi the comparisons and consumers would win. There are also
sites on which consumers share info on good deals such as RetailMeNot.com, FatWallet.com and the Budget Fashionista.
Michael Barbaro, "Shop-till-you-drop specials, revealed here first," New York Times
xxvii
You can certainly see that in advertising. John Wanamaker, the father of modern advertising, once described the problem
with advertising: "[h]alf the money I spend on advertising is wasted, and the trouble is I don't know which half." It turns out
that IT helps firms to be more productive with their advertising. We have come from full page ads in the newspapers and
magazine to ads on Internet search engines tailored to your search and now maybe, to viral loops such as those on Facebook
and Ning that a former ad exec describes as " the most advanced direct marketing strategy being developed in the world right
now." Adam Penenbeg, "Ning's Infinite Ambition," Fast Company, May 2008
xxviii
Larry Warnock of Zilliant, who is mentioned by Fishman, describes what he believes are the three dominant ad hoc
pricing strategies - cost plus, because my competitor did it, out of thin air, and suggests that the ITT investments can allow
firms to move toward optimizing prices. Once we enter the world of imperfect competition, therefore, we enter the world of
strategies, and we are going to focus on pricing strategies. This is the world that provided a good six-figure salary to a friend
of mine many years ago when those salaries were rare. All he needed to do was simply help a company determine the correct
price for their products. Charles Fishman, in his 2003 Fast Company article "Which price is right?" describes the difficulties
he encountered when trying to find decision makers willing to talk on the record about their pricing strategies and how he
was escorted out of a Professional Pricing Society Conference.
In "The price is right, the differentiation is described as follows:
That's good news for companies fretting that pricing pressure brought on by everything from the Internet
to Wal-Mart to globalization has locked them into a corner with low margins and no flexibility. "The idea
that it's impossible to raise prices anymore is totally false," says Silverstein. "New-luxury competitors
have proved the opposite."
It's a huge opportunity for companies that understand consumers' lust for quality goods that forge an
emotional connection. It also represents a huge risk for companies that offer neither low prices nor
premium products. "When a new-luxury competitor enters the category, polarization can happen so fast
that it becomes difficult to escape death in the middle,"
xxix
Software also allows sellers such as Zara to monitor sales on a regular basis - to sense consumer demand - and quickly
respond with production changes. It also allows companies to target their advertising because in the "new phase of
Webonomics, its not just the eyeballs, stupid, as it was before the dotcom crash. It's the kind of eyeballs you collect and how
you can slice, dice, and model them,” Adam Penenbeg, "Ning's Infinite Ambition," Fast Company, May 2008
xxx
For example, you should look more closely at those grocery stores that keep track of your purchases through the barcoded card, or the trail of web sites you have visited. As Hal Varian, a leading figure among the New Economy economists,
22
sees it, "information technology allows for fine-grained observation and analysis of consumer behavior." The Department of
Justice efforts in an antitrust case in 1995 offers a good example of the potential. When Interstate Bakeries proposed to buy
Continental Baking, the Justice Department examined scanner data to determine the nature of the relationship between prices
and sales volumes. Ultimately they estimated cross-price elasticities between the two breads and used these findings to stop
the merger because hey found Interstate’s prices were lower when Continental was competing.
xxxi
Credit Indemnity of South Africa ran electronic ads for a financial product and found out that a girl on an ad was worth
4.5 percentage points in interest rates, while Capital One, a leader in its use of these random sample tests, in 2006 conducted
28,000 experiments on new products. In fact alternative titles were tested electronically before the book became
Supercrunchers.
xxxii
The prisoner’s dilemma is described as follows. Two suspects, Mary and Bill, are arrested by the police. The police have
insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal. If one
testifies ("defects") for the prosecution against the other and the other remains silent, the betrayer who testifies goes free and
the silent accomplice receives the full 10-year sentence. If both remain silent, both prisoners are sentenced to only six months
in jail for a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must choose to betray
the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the
investigation. How should the prisoners act? (Wikipedia)
Below you will see this description of the problem translated into a payoff matrix, and you should make sure you understand
the translation. If you were Mary, what would you do - and how would you approach this decision? We can begin by looking
at the possible outcomes of Mary's choices based on Bill's decision. If Bill testifies and fingers Mary, then Mary's best choice
would be to testify because she would get a lighter sentence - 5 years instead of the 10 if she was silent. If Bill remains
silent, then Mary's best choice would be to testify since she would get off free. The optimal choice here should be obvious regardless of what Bill chooses, the best choice for Mary is to testify. In technical terms we would call this a dominant
strategy because there is one strategy that is best regardless of what a competitor does. This optimal choice, what is called a
Nash equilibrium, would put both of them in prison.
The Prisoners’ Dilemma
Mary
testifies
Bill 5 years
testifies
Mary 5 years
Bill
Bill - 10 years
silent
Mary free
silent
Bill - free
Mary - 10
years
Bill 6
months
Mary 6
months
There is another possible strategy for the game, what is called a maximin strategy in which a player makes a choice where the
minimum payoff is maximized - or one where losses are minimized. In the situation above, if Mary testifies then the worst
that could happen to her was a 5 year sentence, but if she remained silent then the worst-case scenario would be 10 years. In
this case, if Mary was adopting this maximin strategy, she would testify.
You will note there was a better solution than was chosen. To get to that solution, however, the players would need to
cooperate. In the prisoner's dilemma game, if Mary and Bill could have gotten together and decided to cooperate and agree on
a story, then they could have reduced the sentences, which is why in all those movies the prisoners are kept in separate
rooms.
Another example of this problem, one of my personal favorites, involves two students who missed an exam and phoned their
professor and described how the car got a flat tire so they could not get to the exam. The professor called the two students in
to his office one at a time and asked only one question: "What tire was it that blew out." This is a good example of where
cooperation would have helped since it is unlikely they will choose the same tire and then they are likely to feel the wrath of
the professor.
xxxiii
One limitation of this model is its static nature, but it could be modified to allow the "game" to be played many times
which allows the players to learn from each other and take chances. They could adopt a "tit-for-tat" strategy, which in this
case might involve Lowe's lowering its advertising and waiting to see what Home Depot does. If Home Depot does not lower
its advertising then an advertising war is on, and if they do lower their ad budgets, then we may have the beginnings of a
profitable deal for the companies - and a bad deal for consumers. A real world example of this occurred in 2002 when
American Airlines altered its pricing strategy, raising the minimum number of days needed for discount tickets with advance
reservations from 3 to 7 days. This raised the price for business travelers who did not have a 7-day lead-time, and quickly
Continental followed. Other airlines did not follow the move, however, because they expected to earn extra revenue by
attracting new fliers who switched airlines. American quickly came out with a new lower fare on flights in cities serviced by
the other carriers, but not on cities served by Continental.
23
For those who have used eBay, you can find the influence of game theory in its auction method. In traditional sealed-bid
auctions, people put their best bid in a sealed envelope and the winner is highest bid. For example, consider an auction for a
camera. If you value it at $200, how much would you bid? You probably would not bid $200. You would bid something
lower than $200, but above what you thought others might bid. In this situation the auction would be won by someone
bidding less than its true value. Nobel Prize recipient William Vickery, had a solution for this problem, the Vickery auction.
In this sealed-bid auction the highest bidder would win the auction and the price would be set at the second highest bid. This
would be the dominant strategy in this game. There is no incentive to bid less than $200 because you would be disappointed
if it sold for less, and you would never bid above $200 because this was more than it was worth to you. The best bid would be
the bid that equaled the value you attached to it, which is why eBay uses the second-price auction model.
xxxiv
And the gains can be huge, which you can see by doing the math - if prices quadruple and output (demand) remains little
changed, then the suppliers of oil will see their revenue nearly quadruple - good if you are an oil supplier and bad if you are a
user. But consumers in the US were insulated from the oil price increases because President Nixon had imposed price
controls that kept gas prices from rising - at least that was the theory. In practice the rationing of the decreased oil supply,
which normally occurs with higher prices, in this case was accomplished with looooong gas lines similar to those depicted in
the picture. The crisis was so severe that it prompted President Nixon to propose an extension of Daylight Savings Time, a
ban on Sunday sales of gas, and the construction of a pipeline in Alaska. And the cartel was not done yet, and at the end of
the decade the price of oil once again almost quadrupled - this time the trigger being the fall of the shah in Iran and the onset
of the Iran-Iraq war.
The extent of the gains earned by a cartel acting as a monopolist can be seen in the cost of crude oil imports diagram below.
In 1960s five major oil producing countries established the OPEC) and by the 1970s the cartel was ready to flex its economic
muscle. In October 17, 1973 the OPEC oil cartel announced an embargo of oil to the US as "punishment" for support of
Israel in the 1973 war and raised the price to US's allies from $3 to $5 a gallon, and in the following year it was raised again
to $11.65 a gallon.
xxxv
When discussing cartels, you might want to think about the mafia as it was depicted in movies such as The Untouchables,
Scarface and The Godfather. Let's flash back to the 1920s at a time when the US government outlawed booze. I suspect we
all know the story - demand did not disappear, but legal supply did, so into the market stepped some illegal suppliers who
saw demand increase substantially. But what should the mafia do - drive each other from the market, compete with each
other, or cooperate and act like a cartel. There was little incentive to knock off a competing mafia family and eliminate the
competition because any family that took that route would immediately become the common enemy for all other families.
Competing was not much better because it is likely you would have seen disastrous price wars that lowered everyone's profit,
so what you often ended up with was a classic cartel-like agreement to divide up the market - either by product or by
geography.
xxxvi
"Glass with attitude," The Economist, December 20, 1997 p 113
xxxvii
The weakness of cartels can be shown with the following simple game involving Saudi Arabia, the world's largest
producer of oil, and Iraq, another producer of oil. he difference between the two is that Saudi Arabia (SA) produces enough
so its production will affect price, while Iraq (I) will not be able to affect the world price of oil. In the payoff matrix you see
that total profit will be greatest from selling oil if both countries agree to restrict output, which is precisely what OPEC has
attempted to do. They will earn $100 million, instead of $60 million if they both increase output. The problem is that Iraq has
an incentive to cheat because if Iraq raises output unilaterally, this will have minimal impact on the price of oil so Iraq's
profits will increase to $15 million because it sells the additional output at the same price. If many of the OPEC countries
face similar situations, which they do, then they will all cheat and this will drive down the price of oil and break the cartel.
Oil price payoff matrix
Iraq
24
low output
Saudi Arabia
low output
SA earns $90 million
I earns $8 million
high output
SA earns $60 million
I earns $15 million
SA earns $75 million SA earns $50 million
I earns $6 million
I earns $4 million
Saudi Arabia, however, because of its size might be able to enforce discipline on the other members. Because Saudi Arabia is
such a large producer it could raise production and drive down the price to "punish" other cartel members who had cheated.
In this example, Saudi Arabia's decision to raise output would have dropped profits in Iraq regardless of its output decision,
so it was in Iraq's best interest to fall in line with Saudi Arabia's lead and lower output.
xxxviii
According to the settlement, described in the New York Times on October 12, 1994, the airline industry had resorted to
price-fixing in the midst of a recession that had produced losses of $10+ billion in 1990-92. Using the reservation system, an
airline would announce "price changes in advance through the reservations systems. If competitors did not go along with the
price change, it would be rescinded before it was to take effect." "Suit Settled by Airlines," The New York Times, October 12,
1994, p D8.
xxxix
Barry Lynn, “Killing the competition,” Harpers, February, 2012
xl
Sellers could also use most-favored-nation clauses, where all buyers are guaranteed the lowest prices, to reduce the
incentive to lower prices. This is a feature of NASDAQ stock market where every dealer is allowed to match the quotes of
rivals without losing sales. There are also meeting-the-competition clauses in which each seller agrees to match the buyers’
best price. The problem with both of these strategies designed to reduce price competition is that the public often does not
recognize these schemes for what they can do to prices. For example, consider the situation in which Target and Wal-Mart
are competing to sell you - and me - a TV. Wal-Mart charges $600 for the TV, and now Target must decide on its strategy.
One possibility would be to lower the price to $500 with the expectation that consumers would respond to the price and
demand for Target's TVs would rise. In this case, the consumer benefits from the competition.
But what if Wal-Mart offers to meet any lower prices, so if Target offers the TV for $500, Wal-Mart will meet that price and
sell it to you for $500. It sounds like a good deal for consumers, but it is not quite what it sounds like. In this situation Target
has no incentive to charge $500 since it knows Wal-Mart will match it. This would alter Target's strategy and reduce its
incentive to lower the price since any price reduction would be matched by similar price cuts by other sellers. The end result
would be no increase in demand as a result of the lower price - plus there would be the lost revenue on all of the existing
buyers. Both stores would settle at a price of $500 and the consumers lose again.
xli
It was a period of monumental technological change. On May 24, 1844 the first magnetic telegraph line was opened as
Samuel Morse sat in Washington, DC when he sent the message "What hath God wrought," to Baltimore. The system spread
like wildfire, although not everyone was supportive. Farmers are said to have destroyed lines in South Kentucky in 1849
because of a belief that the wire would remove the electricity from the air so it would not rain and there would be crop
failures. This did not stop the industry's growth and in 1856 Western Union was formed and the first transcontinental
telegraph system was completed in 1861, the same year the Pony Express made its last run cross-country. In addition to
reducing substantially the time and money needed to transport a message over long distances, the telegraph also played a key
role in the growth of the railroad. Without the telegraph, it is very likely that the cost of an intercontinental system would
have been substantially higher since without the telegraph's ability to pass on information about the trains, there would have
been a need to two rail lines to allow traffic in both directions.
Alexander Graham Bell, a teacher for the deaf, patented his phone on March of 1876 and within a few days had made the
initial call in which he uttered the words "Mr. Watson, come here. I want you!" By the summer Bell had taken his primitive
phone to the Centennial in Philadelphia where it received a Certificate of Award. Western Union, in one of the classic
blunders, failed to accept Bell's offer to sell them the phone's patent for $100,000. In their 1877 memo they note: "This
'telephone' has too many shortcomings to be seriously considered as a means of communication. The device is inherently of
no value to us." Bell, who had confidence in his machine, set up his own telephone company, Bell Telephone Company, in
1878 and in the following year the first commercial exchange, and telephone directory appeared, as did competition in the
form of Western Union who tried to get into the phone market. In 1879 phone numbers first appeared, as did the National
Bell Telephone Company, and in the following year the first pay phones, with attendants not coins, opened in New York
City. In 1881 the first commercially successful long distance line, running between Boston and Providence, opened and in the
following year American Bell (formerly National Bell Telephone Company) specified Western Electric as the sole suppliers
of Bell telephones and telephone equipment. AT&T, a BIG name in telephone, came into existence in 1885, and seven years
later the automation of switching became a reality. Real competition arrived in the following year when Bell's patent expired,
but the Bell system continued to dominate the market - an early example of the power of network effects. By early 1915
AT&T had established the first transcontinental telephone line linking San Francisco and New York and by the end of the
year trials on a transatlantic line had begun.
Next came the wireless. By the year 1900 Guglielmo Marconi had already successfully experimented with wireless
telegraphy, sending a message across the English Channel, and in 1901 the first transatlantic signal was sent. It was a hit and
the "U.S. Navy was so impressed that it replaced a flock of carrier pigeons with the "wireless" for ship-to-shore
communications." The move from transmission of messages consisting of Marconi's dots and dashes to the continuous waves
needed for radio was made by Ernst Alexanderson, an engineer for General Electric. In 1906 an alternator was installed and
high output
25
used to transmit voice and a violin solo. By 1910 the first songs were being sent over the airwaves in the US, and the vacuum
tube was invented, which expanded the possibilities for wireless radio transmissions.
There were other lesser inventions that also played an important role in the urbanization and industrialization of the US. This
was the era of the iron-and-steel frame construction process that allowed for a substantial increase in the height of buildings.
This would have been an uninteresting architectural development had it not been for Elisha Otis's elevator, which he
introduced at the Crystal Palace Exposition in New York City in 1853. This innovation allowed buildings to be built higher,
increasing sharply the potential employment in the city by increasing the potential floor space on any plot of land. [You
might want to revisit the discussion of land to see what this would do to the level of rents in the center of cities]. The first
modern 'skyscraper' appeared on the scene in 1885, a ten story building erected in Chicago for the Home Insurance Company
of Chicago.
What little manufacturing done, was done primarily to clothe and feed the people so they could exploit the resources, and it
was done primarily in the cities in the Northeast. The wealth and size of the cities was dependent upon the value of the
resources in its hinterland, which in turn depended upon the transportation network (ex. New York City and Erie Canal). This
changed in the next sixty years. It should not be surprising that between 1860 and 1920 the share of our exports that were
manufactures increased from 11.4% to 39.7%, while manufactured goods' share of imports declined from 50% to 17%. By
1920 we were exporting cotton manufactures, automobiles, iron and steel, and machinery. An additional indicator of the
meteoric growth of the manufacturing sector was the changing composition of the labor force. In the period 1860-1920, the
share of employment in agriculture fell from 53% to 26%, while the main gains were in the manufacturing sector that
increased its share of total employment from less than 14 percent to more than 27 percent. In addition to moving from the
farms to the factories, the factories were also getting much larger, and it was only in the major cities where these firms were
likely to find the workers for their factories. At the aggregate level, in 1870 the US ranked second behind the UK with 23
percent of the world's manufacturing output. In little more than a decade the US had surpassed the UK and by 1913 the US
accounted for 42 percent of the manufacturing output of the world. There was also a definite pattern of specialization among
the major industrial cities. For example, at the end of this period Chicago had become the center for agricultural implements,
Pittsburgh was the center of the iron and steel industry, and Detroit was the auto making capital of the country.
The inflow of immigrants during this period was a result of both push and pull factors. The immigrants were "pushed" out of
a Europe that was experiencing population pressures due to declining mortality rates that more than doubled the continent's
population in the 19th century. It was also pulled by the prospect of jobs in the rapidly expanding and industrializing US. In
addition to rising in volume, the pattern of immigration changed markedly after the 1880s as is evident in the right-side
diagram. Before the 1890s, the majority of America's immigrants originated in Ireland, Germany, and the UK (IUG) averaging about 55 percent in the 1820s and 1880s. By the 1890s, the pattern had shifted with the majority of immigrants
arriving from Italy, Austria-Hungary, and Russia (IAS), and in the first decade of the 20th century two-thirds of the
immigrants came from these three countries.
xlii
What muddied the water even more was the economics profession's inability to agree on the impact the trusts. Some
suggested that the massive scale of production was due to economies of scale and technological change, and thus size by
itself was not necessarily a bad thing, while other saw competition as threatened by the rise of the trusts that could act as
monopolists restricting output and raising prices.
xliii
The mission statement of the FTC's available on its web site appears below.
Mission Statement
The FTC's antitrust arm, the Bureau of Competition, seeks to prevent business practices that restrain competition. As a
result, purchasers benefit from lower prices and greater availability of products and services.
The Bureau carries out this mission by investigating alleged law violations and, when appropriate, recommending that the
Commission take formal enforcement action. If the Commission does decide to take action, the Bureau will help to
implement that decision through litigation in federal court or before administrative law judges.
The Bureau also serves as a research and policy resource on competition issues. It prepares reports and testimony for
Congress, and may present comments on specific competition issues pending before other agencies.
The Bureau of Competition has developed expertise in a number of industries important to consumers, such as health care,
other professional services, food, and energy.
The antitrust laws are enforced by both the FTC's Bureau of Competition and the Antitrust Division of the Department of
Justice. In order to prevent duplication of effort, the two agencies consult before opening any case.
The Commission's antitrust authority comes primarily from the Federal Trade Commission Act and the Clayton Act both
passed by Congress in 1914.
The language of the FTC Act was altered to add deceptive to unfair with the Wheeler-lea Act of 1938. This gave the FTC the
ability to tackle the problems of deceptive advertising.
xliv
Erika Kinetz, At Archer Daniels, a bitter taste lingers,” NYT, March 22, 2002
xlv
“Collusion in the stockmarkt,” The Economist, January 15, 1998
xlvi
“What an art,” The Economist, August 5, 2004
xlvii
Matt Taibbi, “Everything is rigged: The biggest price-fixing scandal ever,” Rolling Stone, April 25, 2013
xlviii
Market definitions were also important in a case against DuPont's monopoly of the cellophane market. It was deemed
that no monopoly existed because aluminum foil and wax paper were considered to be within the same market as cellophane,
even though DuPont was the only producer of cellophane. In 1993, the merger of Gillette and Parker pens was opposed
because it would give the firm control of 40% of the premium fountain pen market, but the merger was allowed because the
26
market was more broadly defined to include rollerballs and ballpoint pens. The geographical scope of the market also
matters, as happened in the proposed merger of Pabst and Blatz. These firms accounted for under 5% of the national market,
but because these regional brewers controlled nearly a quarter of the Wisconsin market, the merger was stopped.
xlix
IBM: In 1967 IBM was sued for antitrust violations. IBM's share of the computer market was approaching 75%, which it
had gotten as a result of unfair practices including bundling. if you wanted an IBM computer you needed to run IBM
software and buy IBM services. And because IBM kept updating their machines regularly it was determined that others were
put at a competitive disadvantage. This case never settled, and in 1982 the government withdrew its case. IBM may have
won, but many believe the company was so distracted by the case that it missed the move from mainframe computers to
desktop computers. Others say that IBM, when they were building their new PCs, passed on the chance to buy Bill Gates'
DOS operating system because it was afraid it would raise antitrust flags - and we know the history of Gates and Microsoft
l
AT&T: In the mid 1970s, an investigation was opened of AT&T, which was THE telecommunications company in the US at
that time, controlling the local phone networks, the long distance lines linking the local networks, the manufacturing of
equipment (Western Electric), and the research and development (Bell Labs). It had been determined earlier that the
telephone industry was a natural monopolist and thus it was legitimate to have only one company. Why would you ever allow
companies to put in two sets of telephone poles? It would make no sense, so there was only one, albeit heavily regulated,
phone company. Some economists accepted this and believed that the US had the best phone system, while others believed
AT&T was operating as a lazy monopolist and we could do better, especially because of technological changes that were
occurring in the 1970s.
The biggest change was the communications satellite that allowed for alternatives in long-distance communications. The
problem was that the new technology allowed for a cheaper way of supplying long-distance calls, but the last mile of the call,
the connection to the houses and businesses was controlled by AT&T. Furthermore, the regulators had set long-distance rates
high to cover some of the losses for low local rates high, so when the new competitors came in with lower prices AT&T
responded by restricting access to their local lines. The case ended in 1982 when it was determined that AT&T was to be
dismantled, and in the Modification of Final Judgment (MFJ) AT&T was allowed to keep its long-distance operations and
forced it to spin off Bell Labs and Western Union and divest itself of seven Regional Bell Operating Companies. These seven
'baby bells' [Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis, Southwestern Bell, and U.S. West] were given
control over all local calls and toll calls originating and ending in their market areas, but were restricted from carrying calls
market areas.
li
The real concern among those looking to throw the book at Microsoft was that Microsoft was using illegal actions to squash
the competition, and once the competition was eliminated, would then take it out on consumers through higher prices. One of
the difficulties with the case was proof that Microsoft did use its monopoly power to raise prices since at this time the prices
of nearly all software was falling - just as the time of the Standard Oil case was a time of falling kerosene prices. Part of the
proof offered by the plaintiffs was the fact that between 1985 and 1995, the price of products in markets where Microsoft had
no competitors dropped 15%, while in the markets where Microsoft had competitors the drop was 65%. Looks like
competition matters, and that monopoly power translates into control of prices.
lii
This desire on the part of government to protect natural monopolies or otherwise limit competition is not a phenomenon
peculiar to the US. In Europe and Japan, the control of natural monopolies was often accomplished through public ownership
brought about by the nationalization of an industry, while in the US control was accomplished through regulation of industry.
liii
Another possible source of monopoly power that might require regulation would be "bottleneck" facilities. A good
example of a bottleneck that most of you can probably relate to is your Windows operating system. Windows controls your
computer and is the interface between you and all of your software, so to access your software you need to utilize Windows.
If you want to get onto the web, you will get there through Netscape or Explorer, but you get to these through the operating
system. You could see why this was an issue in the Microsoft antitrust case since Microsoft could use the bottleneck to show
"favoritism" to its software, and this would likely alter the competitive playing field in Microsoft's favor. It is also a common
problem with utilities that own phone lines, power lines, or pipelines. Imagine you are one of the "Baby Bells" that "owns"
those phone lines coming into homes in your area, but you have to give access long-distance carriers to reach these
customers. You might also be a power company that generates your own power plus you own power lines that other power
companies would need to use if they were going to supply customers in your area. In both cases the amount of competition
would depend upon the price charged for the bottleneck, which is why it is an important issue faced by regulators.
27