Questions: Can govt regulation improve competition?  Are regulations effective?  Are regulations costly, cost-effective, and who bears the cost?

STRUCTURE OF THE U.S. ECONOMY

Economy is very diverse - 87% of all companies have less than 20 employees, and these firms employ 25% of all workers.  Only 1/1000 firms has more than 1000 empolyees (999/1000 firms have < 1000 workers), and these firms employ 13% of the workforce.  Also, the structure of the economy has changed over time, see page 289.  (One result of structural change?  Structural unemployment.)

Since 1900: 1) Agriculture, mining and manufacturing have declined.
2) Construction and Transportation have remained constant.
3) Retail, Finance and Services have grown dramatically, Govt less so.

Point: Productivity has risen significantly in mfg, so that output has NOT fallen as much as employment.

COMPETITIVENESS IN THE U.S. ECONOMY

In general, monopoly is the least competitive, followed by oligopoly.  One general broad indicator of competitiveness is the Concentration Ratio:

   TOTAL SALES OF THE FOUR LARGEST FIRMS
   TOTAL SALES OF THE INDUSTRY

The ratio can range from close to zero (wheat farms) to 100% (US car industry, ignoring imports).  The closer to 100% the more like likely there is collusive behavior by oligopolistic firms.

Problems with the Concentration Ratio:
1) ignores foreign firms, which can represent a substantial competitive threat to domestic firms
2) doesnt really measure the barriers to entry.  Oligopolistic markets can be competitive if the market is contestable, barriers to entry are low.
3) doesnt measure elasticity of demand, and availability of substitutes, which affect the competitiveness of the market.  Example: major commercial airlines may have an oligopoly, close to 100% concentration ratio, but the demand for air travel is elastic due to availability of substitutes: bus, car, train, conference calls, fax, email, etc.

Concentration ratios, although crude and simplistic, can be useful when supplemented with other info.  See page 291 for a study of US competitiveness over time.  Between 1939 and 1980, US economy is much more competitive.

Why??
1. Antitrust policy enforcement
2. Increased import competition
3. Deregulation

MERGERS - affect the structure and competitiveness of the U.S. economy.  Three types:

1. Horizontal - two rivals, or firms in the same industry, merge into one firm.   Examples: DaimlerChrysler, TV station buys a radio station, Office Depot and Staples.  Potential problem with merger?

2. Vertical merger - combining two firms, both in the same general industry, in different stages of the production process.  Example: Lumber company buys a furniture store or vice-versa.  GM buys a steel company, or vice-versa.  Meijer buys a wholesale baking company.  Paper company buys a book publishing firm or Borders.  Potential problem?  Film companies used to own movie theaters.

3. Conglomerate merger - two firms in unrelated industries merge.  Example, Montgomery Wards (retail) merges with Mobil Oil (oil).
 

ANTITRUST LEGISLATION (LAW AND ECONOMICS)

Quote page 291.  In the late 1800s there was a wave of horizontal mergers as the economy made significant advances in industrial technology - US Steel, Std Oil, General Elec, General Mills, etc.  Some of the merged companies organized legally as TRUSTS, where the assets of two or more merged firms are placed in a trust, which is managed by a Board of Trustees for the owners.

Advantages?  Economies of scale.  Traditional industry growth pattern.  In the beginning, there are lots of small firms competing, then economies of scale lead to mergers, several or one dominant firm.  Disadvantages? Possible collusion, oliogopoly, cartel power, i.e. economic and political power of the trusts could be anti-competitive.  Led to Antitrust legislation:

Sherman Act (1890) - Made illegal any "attempt to monopolize" or any "conspiracy in restraint of trade."  Antitrust legislation has been criticized for being too vague.  What exactly is the "conspiracy to monopolize?"  Govt did use the Sherman Act to break up Std Oil (had 90% of market) and American Tobacco (75% of mkt).

Clayton Act (1914) - Passed to clarify antitrust, by preventing specific actions like
1. Price discrimination - at the wholesale level.  GM has to offer the same wholesale prices to dealers all over the country.  Designed to eliminate predatory pricing - dominant firm lowers price, suffers losses (P < ATC), with the intent to drive smaller rivals out of business, then it can raise prices with no existing competition.  Problem with that strategy?
2. Tying contracts - seller requires to the buyer to buy X if they want Y.
3. Exclusive dealings - manufacturer will only sell products to a store if they refuse to handle a competitor's products.  If you sell X in your store, you cannot sell Y.  Examples: If you want to be an AVEDA concept salon, you cannot sell other hair products.  If you want to be the Steinway piano dealer in Detroit, you cannot sell Baldwin or Bosendorfer pianos.
4. Interlocking stockholding - one firm owning the stock of a competing firm.  GM cannot own FMC stock.
5. Interlocking directorates - individuals cannot serve on the board of competing firms.  GM board member cannot be on Ford's board.

FTC (1914) - established as a federal agency to investigate and prevent "unfair business competition."  The courts, Dept of Justice, have ultimate authority, but FTC does investigations, especially of mergers.

Specifically, FTC is supposed to:
1) enforce consumer protection legislation,
2) prohibit deceptive advertising, and
3) prevent collusion (approve mergers).  FTC responds to complaints, investigates, then attempts to settle by negotiating with the parties.  Example: GM files a complaint that Ford makes unfair comparisons of Ford vs GM, engages in deceptive advertising.  FTC investigates, negotiates a settlement.

Robinson-Patnam Act (1936) - prohibits "unreasonably low prices", aimed at chain stores and mass distributors.  Economists have been critical of this act - makes low prices illegal - what is the alterative?  This law has reduced price competition and protects inefficient producers.  Who would favor the law?

Celler-Kefauver Act (1950) - Prevents mergers if they substantially reduce competition.  Proposed mergers are scrutinized by the FTC or DOJ.
 

CURRENT ANTITRUST POLICY

Depends on administration.  Regan administration took a "hands-off" policy, did not vigorously prosecute antitrust.  Clinton administration has been more aggressive - Mircrosoft.  Starting with antitrust policy under Regan, the trend has been to concentrate on consumer welfare, which is the proper focus/concern of antitrust.  Mergers have been allowed, even when the merged firm controls a large market share, if merger is viewed as pro-competitive, leading to lower prices.  Only mergers expected to result in higher prices are challenged.

New DOJ guidelines emphasize the Herfindahl Index, a more sophisticated, precise measure of concentration in an industry.  Ranges from 0 (wheat farms) to 10,000 (monopoly - Post Office).

Herfindahl Index (H)  = S₁² +  S₂² +  S₃² +  S₄²....S_n² , where S is the market share for individual firms with S1 being the biggest firm S2 is the second largest firm, and n is the number of firms in the industry.
 
Example 1: Four firms make up the entire market, each with 25% mkt share.

 H =  25²  +  25² + 25² + 25²   = 2500

Example 2: Four firms make up entire mkt, 70%, 10%, 10%, 10%.

 H = 70²  + 10² + 10² + 10²   = 5200

H index gives stronger weight to the larger firm with 70% mkt share.  The simple concentration ratio would be 100 for both examples, when the second case is much more concentrated, as the H Index shows.

Current guidelines for mergers using H Index:
a) Merger results in H < 1000, OK.
b) If H > 1000 after the merger, and the merger adds 100 points or more to H, merger will be challenged.
c) If H > 1800 after the merger and the merger adds 50 points to H, challenge.

Other issues that make a merger challenge less likely:
a) Foreign competition is significant
b) One of the firms will go out of business without the merger.
c) Firms in industry do NOT produce a homogeneous product.
d) Barriers to entry are low, and firms will enter the industry if the merger results in higher prices.

Mergers are only challenged if they are determined to be harmful to consumers.
 

LIMITING ANTICOMPETITIVE PRACTICES

Problem with antitrust policy: Hard to tell whether business practices are anti or pro competitive, may not be obvious if a practice is harmful to consumers or not.

Examples: 1) Predatory pricing.  Hard to prove that P < ATC.  Even if P < ATC, it may not be harmful to consumers, may not be a predatory attempt to reduce competition and restrain trade.  Why might predatory pricing be a sensible, competitive business practice?  Who complains about predatory pricing?  Many investigations and court cases, but has almost never been proven.

2. Exclusive contracts/dealerships.  May actually be pro-competitive.  Only prosecuted when it lessens competition or creates a monopoly.  Example: AVEDA requires "full AVEDA concept salons" to only sell AVEDA products.  Reason: AVEDA spends lots of money on advertising, want AVEDA salons to offer its products exclusively.  If customers are attracted to AVEDA salons by the advertising and the high quality of its products, and then have a choice between high priced AVEDA and lower priced substitutes, the lower priced products will be "free-riding" on AVEDA products.  The higher prices support more advertising.

Example: Steinway piano dealers are not able to also offer Bosendorfer pianos, both high end pianos for the professional end of the market.

Example: Fast food chain makes exclusive agreement for soft drinks, either Coke or Pepsi.

Problem: Exclusive contracts are not necessarily anti-competitive, hard to identify those cases where they are harmful to consumers.
 

ANTITRUST POLICY - DISSENTING VIEWS

Economists (and businesses) have generally been critical of antitrust.  Laws are too vague - hard to know ahead of time what is illegal?  Some economists have advocated repealing antitrust completely.  Different views:

1. Strengthen Antitrust.  Increase antitrust enforcement to increase competition.  Non-economist, anti-business view of those who have more faith in bureaucrats, bureaucracy, and govt. than entrepreneurs and the market.

2.  Antitrust is unnecessary and harmful.  Belief that innovation and competition in dynamic markets provide sufficient discipline for firms, making vigorous antitrust enforcement unnecessary.  Many (most) mergers are pro-competitive, resulting in economies of scale and lower prices, preventing mergers results in higher prices less competition.  Concentration does not necessarily equal inefficiency, it can mean an extremely efficient market - ALCOA, Microsoft.

90-95% of antitrust action involves one firm filing a complaint against a rival firm in the same industry.  Inefficient firms complaining to the DOJ about more successful, efficient firms.

In today's global economy, foreign competition is intense, and provides strong disciple to domestic firms, making antitrust enforcement unnecessary.   Example: Ford, GM and Chrysler have an oligopoly but face intense foreign competition.

3. Government is OFTEN the source of a coercive monopoly.  Government licensing restricts competition and provides significant barriers to entry.  When govt itself is the source of monopoly, antitrust policy is unlikely to restore competition, since the DOJ would have to prosecute another govt agency, e.g. break up the Post Office.  See application on page 298 regarding taxi industry.
 

REGULATION

See page 300.  There has been a general trend toward more regulations, in terms of money spent and number of employees, except during the Regan administration and in some industries - e.g. airlines and trucking.

Economic regulation - regulations on prices or industry structure in a specific industry, often resulting in higher prices, barriers to entry and inefficiency.  Solution: deregulation.  Example: airlines.  CAB set prices, limited competition.  Result: high prices, limited competition, barriers to entry.  Deregulation resulted in substantial cost savings for consumers, billions of dollars.

Health and Safety Regulations - Legislation to improve the health, safety and environmental conditions.  Examples: mandatory seat belt laws, mandatory air bags, CAFE (fuel economy standards), FDA (regulates new drugs, medicine), handicap accessability laws, etc.  Economic result of regulations: Higher prices, lower production.  See page 303.  Because prices rise, REGULATIONS = HIGHER TAXES.

Optimal amount of regulation requires balancing the COSTS of regulation with the BENEFITS of regulation, which is very hard sometimes.  Excessive regulation of the economy can result in the COSTS > BENEFITS.  For example, FDA approval process for new drugs requires millions of dollars and 7 years waiting period.  Costs of FDA regulations: 1) some people will die waiting for the approval process and 2) some beneficial drugs will never be developed by pharmaceutical companies because the cost is prohibitive.  Incentive will to develop drugs with the greatest marketability, widest market.  Drugs with limited markets, rare diseases, will not be developed.

Perverse consequence of excessive regulation: "If you make the world safe for idiots, you create a world full of idiots."  If regulators make all decisions about safety, there is no incentive for individuals to learn about the tradeoffs, risks vs safety, costs/benefits, issues, etc.

Distortions of regulations - see page 304-305.  Oil prices skyrocketed in 1973.  Govt response: Price controls + CAFE standards to reduce dependence on foreign oil, conserve energy.  We would have been better off if we would have just let prices rise, would have forced conservation, fuel efficiency, etc. without the regulations.  Higher oil prices would have been more effective than regulations.

Secondary effect of CAFE: smaller cars, more traffic fatalities.

CAFE standards have NOT reduced oil consumption over time.  Reason: regulations are distortionary, like taxes, BECAUSE THEY CAN BE AVOIDED.

1. As a result of CAFE, new large cars are more expensive since companies produced fewer.  People with old large cars who wanted a large car, would keep their cars longer, drive them longer, use more gas, pollute more.

2. More small cars were produced, prices were cheaper, resulting in more cars being purchased, increasing the total number of cars.  More smaller cars led to more gas consumption, not less.

3. Car companies shifted to SUVs (classified as trucks, not cars) as a way to circumvent CAFE, resulting in more, larger fuel-inefficient vehicles, MORE gas consumption, not LESS.
 

POLITICAL ECONOMY OF REGULATION.
 
Public Choice analysis of regulation:

1. Well-organized special interest groups, including firms and bureaucrats, often seek regulation for their self-interest, in violation of economic efficiency.  "Iron triangle" - special interest groups, bureaucrats and politicians - leading to the "tyranny of the status quo."  Sellers can gain from regulation by a) reducing competition or b) raising costs for rival firms and potential rivals.  Regulations can create a high barrier to entry.

Example: AMA as a govt enforced cartel, restricting entry, raising prices, restricting supply, reducing competition, etc.

Example: Dept of Agriculture administers farm price support programs.  Suppliers (farmers) and bureaucrats have an interest in regulation.

Once again, the well-organized concentrated special interest groups dominate the political process when regulation is considered, at the expense of the disorganized, dispersed consumer/taxpayer.  AMA dominates the political process of considering medical regulations, consumers are not represented.

2. Over time, the regulators will adopt the views of the regulated business interests, and may not serve the regulated special interest groups, NOT the public interest.  Individual consumers/taxpayers don't have incentive to monitor the regulated industry and proposed changes in regulation, the regulated industries do.  The regulated industry will invest economic and political resources to influence the political process in their favor, and can offer organized, concentrated political support for politicians.  Politicians will be very responsive to the regulated special interest group, and will have an incentive to support the special interest group by appointing people to the regulatory agency who are favorable to the interests of the regulated group.

Example: when airlines were heavily regulated, they could use their political power to influence those appointed to the CAB (Civil Aeronautics Board), hopefully those who are favorable to the airline industry.

Capture theory - regulators are "captured" by the special interest group being regulated.

3. Regulation is inflexible, static, rigid, and fails to adjust to changing market conditions.  By establishing a rigid set of rules, laws and regulations, the regulatory process is usually very rigid and inflexible and does not easily respond to dynamic changes in the economy.  "Tyranny of the status quo."  Innovation and regulation are incompatible.  By impeding/preventing innovation, regulation raises costs.

Example: Building codes regulate the construction industry, putting standards in place for building materials that are appropriate when adopted. These building codes become obsolete when new, cheaper, more efficient materials are introduced.  In many cases, the outdated building codes prevent the introduction of new methods and materials, even when superior.

Example: Water pipes in houses used to be galvanized steel, required specialized pipefitters.  When copper pipe was introduced, steel pipefitters resisted, even though copper pipe was better, cheaper and easier to install.  Now plastic pipe is being used.  Sheetrock replaced lath and plaster.

4. When regulators have to approve new products, there will be a bias against innovation, even when those products will save lives.  Example: FDA approval of new drugs, medicine, medical procedures.  Consider the thinking of a bureaucrat at FDA: "If I reject a new drug that might save lots of lives, and keep it off the market, the pharmaceutical company might not like it, but it will look to my boss like I am doing a really conscientious job.  On the other hand, if I approve a new drug that causes problems and maybe kills people, I will look bad and may lose my job. Given that choice, I will be super conservative and hardly approve anything, or I willl require an incredible high level of evidence and make drug companies wait for 7 years."  Bias toward too much safety, raising the cost of new products, preventing some new products from reaching the market.
 

FUTURE OF REGULATION

Like many issues, economic theory can help us analyze and determine the optimal amount of regulation, weighing the costs and benefits of various programs.  Is it possible to have too much or too little regulation?  How to decide?  Compare the costs vs benefits.

Some of the costs (both hidden and invisible, SR and LR) of regulations are: 1) the costs of administering the regulations, 2) wasteful rent seeking by special interest groups, 3) inefficiency resulting from barriers to entry caused by regulations, 4) costs of outdated, rigid regulations preventing innovation, etc.

See page 308 for a cost comparison of various regulatory agencies.

Regulatory trend is somewhat toward deregulation, subjecting regulations to cost- benfit analysis.  Other possible solution: expiration dates on regulation.

Total Cost of Government Day. Americans for Tax Reform.  Tax Spending Freedom Day in 1998 was May 6.  Total Cost of Govt Day was June 25.  The fifty days between May 6 - June 25 was the cost of govt regulations.