Long-run Monopolistically Competitive Equilibrium

Is society better off or worse off under monopoly as compared with perfect competition? Referring again to Figure 8.11,the reader will verify that under perfect competition the net benefits to society are given by the sum of consumer and producer surplus, P*AE + BP*E = BAE.Under monopoly,however,the net benefits to society are given by the sum of consumer and producer surplus PmAC + BPmCF = BACF.Since BACF < BAE, then society has been made worse off as a result of monopolization of the industry.The lost consumer and producer surplus is given by the area GCE + FGE = FCE.The area FCE is referred to as total deadweight loss.The area GCE is referred to as the consumers’ deadweight loss,which represents the reduction in consumer surplus that is not captured by the monopolist.The area FGE is referred to as producers’ deadweight loss.Since the monopolist is not producing at minimum per unit cost,producer deadweight loss represents the loss to society from the inefficient allocation of productive resources.

Definition:Total deadweight loss is the loss of consumption and production efficiency arising from monopolistic market structures.It is the loss of consumer and producer surplus when a monopolist charges a price that is greater than the marginal cost of production.

Governments can attempt to reduce or eliminate total deadweight loss by making it illegal for a firm or group of firms to exercise or acquire market power. Antitrust legislation represents an attempt by government to move industries closer to the “ideal”price and output conditions that would prevail under a perfectly competitive market structure.

Definition:Antitrust legislation represents government intervention in the marketplace,such as making it illegal for firms in an industry to engage in collusive pricing and output practices,to prevent industry abuse of market power.

LANDMARK U.S. ANTITRUST LEGISLATION

As we have already seen,a perfectly competitive market structure provides a model for evaluating economic efficiency.As we have seen in Chapter 8 and elsewhere,perfectly competition is defined by a number of important requirements,including a large number of buyers and sellers, homogeneous goods and services,perfect information,easy entry into and exit from the industry by approximately identical firms,and the absence economies of scale.Also characteristic of perfectly competitive markets is the principle of laissez-faire,or nonintervention by government in the marketplace.

The conditions that define perfectly competitive market structures, however,are rarely satisfied in practice.The output of different firms,for example,are typically differentiated;buyers and sellers rarely have complete information about the goods and services being transacted;and entry

into and exit from the market by potential competitors are frequently inhibited.Moreover,many industries are dominated by large firms that have engaged in monopolistic pricing practices,stifled competition,and inhibited product innovation and new product development.This exercise of market power often causes the market to fail,which means in turn that free markets have failed to provide a socially optimal mix of goods and services.

Since 1890,the U.S.government has endeavored to prevent monopolistic pricing and output behavior to promote competition by promulgating a host of antitrust legislation.The most important of these pieces of antitrust legislation are the Sherman Act (1890),the Clayton Act (1914),the Federal Trade Commission Act (1914),the Willis–Graham Act (1921), the Robinson–Patman Act (1936), the Wheeler–Lea Act (1938), the Celler–Kefauver Act (1950), and the Hart–Scott–Rodino Act (1980). The most significant elements of these antitrust laws are outlined next.

SHERMAN ACT (1890)

The Sherman Act,which was the first major piece of antitrust legislation passed by Congress,was designed to prevent the growth and exercise of monopoly power.The substance of the Sherman Act is contained in its first two sections:

Section1. 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 hereby declared illegal....

Section2. Every person who shall monopolize,or attempt to monopolize,or combine or conspire 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,in the discretion of the court.

The Sherman Act had a number of shortcomings.To begin with,while it declared monopolistic structures and certain kinds of monopolistic behavior as illegal,the acts that constituted a “restraint of trade”were not clearly specified.Moreover,there was no specific agency designated to enforce the provisions of the Sherman Act.This shortcoming was rectified in 1903 with the creation of the Antitrust Division of the U.S.Department of Justice.

In 1911,two major antitrust cases were brought before the Supreme Court.The plaintiffs were the Standard Oil Company,which controlled about 91% of the petroleum refining industry,and the American Tobacco Company,which controlled between 75 and 90% of the market for tobacco products except cigars.Both companies employed ruthless tactics to acquire competing firms or drive them out of business.The Supreme Court found both companies guilty of violating Sections 1 and 2 of the Sherman Act and ordered each one to divest itself of large holdings in other companies.In

its ruling,however,the court indicated that not all actions that seemed to restrain trade violated the Sherman Act.In enunciating its “rule of reason,” the court said that violations of the Sherman Act included only those actions that seemed “unreasonable.”Thus,it would be possible for a nearmonopoly to be in conformity with the Sherman Act as long as it had used reasonable tactics to obtain its market share.

In the subsequent decade,the Justice Department brought antitrust cases against Eastman Kodak, International Harvester, United Shoe Machinery,and United States Steel.While each of these companies controlled a significant share of its market,all four cases were dismissed on the grounds that there was no evidence of “unreasonable conduct.” Regrettably,the “rule of reason”did little to clarify the wording of the Sherman Act,a drawback that ultimately led to the drafting of another antitrust law.

CLAYTON ACT (1914)

Enacted by Congress to strengthen the Sherman Act and to clarify the rule of reason,the Clayton Act made a number of specific practices illegal if these practices substantially lessened competition or tended to create a monopoly.

The practices outlawed by the Clayton Act include price discrimination, exclusive contracts, tying contracts, intercorporate stockholdings,and interlocking directorates.As defined by the legislation,price discrimination is the practice of charging different customers different prices provided these differences were not the result of grade,quality,or quantity of the product sold,where lower prices resulted from cost differences,or where lower prices were offered to match competitors’ prices.

Definition:Exclusive contracts were used to force customers to purchase one product as a precondition for obtaining some other product.

Definition:A tying contract makes the purchase of one or more goods or services from one firm contingent on the customer’s refusal to purchase other goods and services from competing firms.

Definition:An intercorporate stockholding is the practice of one corporation acquiring shares in a competing corporation.

Definition:An interlocking directorate exists when the same individual sits on the board of directors of two or more competing corporations.

FEDERAL TRADE COMMISSION ACT (1914)

The Federal Trade Commission Act created the Federal Trade Commission (FTC).The FTC was established to investigate “the organization, business conduct,practices and management”of companies engaged in interstate commerce.Unfortunately,the Federal Trade Commission Act also contributed to uncertainty in antitrust legislation by declaring unlaw-

ful “unfair methods of competition in commerce.”The determination of what constituted unfair methods of competition was left to the FTC.The FTC was also given the authority to issue “cease-and-desist”orders in cases of violations of the Sherman and Clayton Acts.Thus,the Federal Trade Commission could proactively safeguard the public from unfair or misleading business practices.Under the Federal Trade Commission Act it was no longer necessary for the government to await private law suits before prosecuting firms engaged in unfair business practices.

WILLIS–GRAHAM ACT (1921)

The Willis–Graham Act exempted telephone mergers from antitrust review.The reason for this was that the government determined that the telephone industry,which was dominated by the American Telephone & Telegraph Company (AT&T),was a natural monopoly.The reader will recall from Chapter 8 that a natural monopoly may occur when a firm exhibits substantial economies of scale in production.In this case,a single firm may be able to supply the output for the entire market more efficiently than a number of smaller firms.Because AT&T was able to provide telephone service at lower per-unit cost than a large number of smaller utilities,it was believed to be in the public’s best interest to regulate,rather than to break up,the telephone industry.The issues involved in optimal price regulation will be discussed shortly.

ROBINSON–PATMAN ACT (1936)

The Robinson–Patman Act was enacted to protect to independent retailers and wholesalers from unfair discrimination by large sellers exercising purchasing power.Often referred to as the Chain Store Act,this legislation amended Section 2 of the Clayton Act dealing with price discrimination. The Robinson–Patman Act outlawed the following practices:

Charging different prices to different customers on identical sales

Selling at different prices in different parts of the country “for the purpose of destroying competition or eliminating a competitor”

Selling at “unreasonably low prices”to eliminate competition or a competitor

Price discrimination

Paying brokerage commissions to buyers,or to intermediaries under their control

Granting allowances,services,or other accommodations to sellers by buyers,regardless of whether the services are provided by the buyer or not,which are “not accorded to all purchasers on proportionally equal terms”

WHEELER–LEA ACT (1938)

The Wheeler–Lea Act extended the language of the Federal Trade Commission Act to protect consumers against “unfair and deceptive acts or practices”in interstate commerce.Wheeler–Lea gave the FTC authority to prosecute companies engaged in false and deceptive advertising.The act defines “false advertising”as “an advertisement other than labeling which is misleading in a material respect.”The Wheeler–Lea Act is significant because it gave consumers an equal footing with producers who may have been materially harmed as a result of unfair competition.

CELLER–KEFAUVER ACT (1950)

THE Celler–Kefauver Act extended Section 7 of the Clayton Act,which made it illegal for companies to acquire shareholdings in competing corporations.The Clayton Act outlawed only horizontal mergers (mergers of firms producing the same product).The Celler–Kefauver Act closed this loophole by giving the government the authority to prohibit vertical mergers (mergers of firms at various stages of the production process) and conglomerate mergers (mergers of firms producing unrelated products),provided it can be shown that such mergers substantially reduced competition or tended to result in monopolies.

Definition:A horizontal merger is a merger of firms producing the same product.

Definition:A vertical merger is a merger of firms at various stages of the production process.

Definition:A conglomerate merger is a merger of firms producing unrelated products.

The Celler–Kefauver Act was intended to maintain and promote competition.This legislation applied mainly to mergers among large firms,or mergers of large firms with small firms.The Celler–Kefauver Act was not intended to prevent mergers among small firms that tended to strengthen the competitive position in the market of the new company.

HART–SCOTT–RODINO ACT (1980)

Before the Hart–Scott–Rodino Act,antitrust legislation was directed toward the business practices of corporations.Many large companies,such as law and accounting firms,however,are not corporations but partnerships. The Hart–Scott–Rodino Act extended antitrust legislation to include proprietorships and partnerships.The act also required that proposed mergers between,and among,proprietorships and partnerships be reported to the Antitrust Division of the U.S.Department of Justice.

MERGER REGULATION

Although the Clayton Act (1914) and the Celler–Kefauver Act (1950) gave the federal government the authority to dissolve mergers that “substantially lessen competition,”it was not until 1968 that the Antitrust Division of the U.S.Department of Justice issued its first guidelines to reduce uncertainty about the kinds of merger it found unacceptable.These guidelines stated that if the largest four firms in an industry controlled 75% or more of the market,the merger of a firm with 15% or more market share with another firm controlling as little as 1% market share would be challenged in the courts.In 1982 the Justice Department issued a new set of more lenient guidelines.These guidelines were amended in 1984 and remain in effect today.The new guidelines were based on the Herfindahl–Hirschman Index (HHI), which was discussed in Chapter 10. The Herfindahl–Hirschman Index ranges in value from zero to 10,000.According to the guidelines,the Justice Department views any industry with an HHI of 1,000 or less as being “unconcentrated.”Mergers in unconcentrated industries will go unchallenged.If the index is between 1,000 and 1,800, however,then a proposed merger will be challenged if,as a result of the merger,the index rises by more than 100 points.Finally,if the HHI is greater than 1,800,proposed mergers will be challenged if the index increases by more than 50 points.

PRICE REGULATION

While antitrust laws attempt to prevent a firm or group of firms from exercising market power to the detriment of consumers,not all anticompetitive arrangements are necessarily undesirable.The production of some goods and services can generate substantial economies of scale.As mentioned in earlier and in Chapter 8,utility companies and other such firms are called natural monopolies,and the government may determine that it is in the public’s best interest to allow such monopolies to exist.In return for this privileged market position,however,government authorities often will reserve the right to regulate product prices at socially optimal levels. In principle,the objective of price regulation is to eliminate the deadweight loss associated with monopolistic market structures.This situation is illustrated in Figure 15.1.

Unregulated,profit-maximizing monopolists will produce at the output level at which marginal cost equals marginal revenue.In Figure 15.1,the profit-maximizing monopolist will produce Qm units of output at a price of Ppc.A perfectly competitive industry,on the other hand,will produce at the levels at which supply (marginal cost) equals demand.In Figure 15.1 this occurs at the output level Qpc at a price of Ppc.If the government believes

A

Pm Ppc E MC = S

Ppc

B

0 F

Qm Qpc MR D

Q

FIGURE 15.1 Regulating price at the perfectly competitive level to eliminate deadweight loss.

that it is in the best interest of society to allow a single firm to produce the industry’s output,but wishes to eliminate the deadweight loss associated with monopolistic market structures, then regulatory authorities will mandate that the firm charge a price that is no higher than Ppc.

When the price is regulated at Ppc,the monopolist’s effective demand curve in Figure 15.1 is given by the heavy-line segment PpcED.The firm’s new marginal revenue curve is given by the narrow line segments E(Ppc) and F(MR).A profit-maximizing monopolist will produce at the output level at which MC = MR,which occurs at the perfectly competitive output level, Qpc.At this output level the selling price of the good or service will be at the perfectly competitive price, Ppc.

By regulating the selling price of the product at Ppc,which is less than Pm,the government has effectively eliminated the deadweight loss associated with the monopolist’s market power.In the situation depicted Figure 15.1,the result of price regulation at the perfectly competitive level is to reduce monopoly profits but to increase the total societal benefits.The net benefit to society is positive because the loss of producer surplus resulting from regulating price at the perfectly competitive level is less than the increase in consumer surplus.

Our analysis suggests that price regulation is an effective method for inducing profit-maximizing monopolists to produce at socially optimal levels.Unfortunately,while this may be true in principle,reality is quite another matter.Assuming that regulators have the best interests of society as a whole in mind,which may not be the case,government efforts to increase the total societal benefits may be thwarted by an inability to accurately determine the market supply and demand conditions.In fact,the lack of complete or accurate information may set a price that is socially detrimental.To see this,consider the situation depicted in Figure 15.2.