Business Economics

Chapter 4

INDUSTRIAL STRUCTURE,
GOVERNMENT REGULATION
AND BUSINESS DECISION
By Tran Thi Kieu Minh, VJCC
Contents
1. Analysis of Industrial Structure

2. Business Decision in Competitive,

Monopoly and Oligopoly environment

3. Market failure, Government intervention

and business decision

Reading: Michael Baye, Chapter 7, 8, 9, 14

Chapter 8
2
4.1 Analysis of Industrial Structure
 Market Structure
◦ Number and size of firms.
◦ Industry concentration.
◦ Technological and cost conditions.
◦ Demand conditions.
◦ Ease of entry and exit.
 Conduct
◦ Pricing.
◦ Advertising.
◦ R&D.
◦ Merger activity.
 Performance
◦ Profitability.
◦ Social welfare.

Reading: Michael Baye, Chapter 7

Chapter 8
3
 Approaches to Studying Industry
• The Structure-Conduct-Performance
(SCP) Paradigm: Causal View
Market
Conduct Performance
Structure

 The Feedback Critique

◦ No one-way causal link.
◦ Conduct can affect market structure.
◦ Market performance can affect conduct as
well as market structure.
 The Five Forces to the SCP Paradigm and the
Feedback Critique (figure 7-1)
Entry Costs Entry Network Effects
Speed of Adjustment Reputation
Sunk Costs Switching Costs
Economies of Scale Government
Restraints

Power of Power of
Input Suppliers Buyers
Supplier Level, Growth, Buyer Concentration
Concentration
Price/Productivity of and Sustainability Price/Value of
Substitute Products or
Alternative Inputs Of Industry Profits Services
Relationship-Specific Relationship-Specific
Investments Investments
Supplier Switching Customer Switching
Costs Costs
Government Government
Restraints Restraints

Industry Rivalry Substitutes & Complements

Concentration Switching Costs Price/Value of Network
Price, Quantity, Timing of Surrogate Products or Effects
Quality, Decisions Services Governmen
or Service Information Price/Value of t Restraints
Competition Government Complementary Products
Degree of Restraints or Services
Industry Concentration
 Four-Firm Concentration Ratio
◦ The sum of the market shares of the top four firms in the defined
industry. Letting Si denote sales for firm i and ST denote total industry
sales
Si
C4  w1  w2  w3  w4 , where w1 
ST
 Herfindahl-Hirschman Index (HHI)
◦ The sum of the squared market shares of firms in a given industry,
multiplied by 10,000: HHI = 10,000  S wi2, where wi = Si/ST.
 7-7

Example
 There are five banks competing in a local market.
Each of the five banks have a 20 percent market
share.
 What is the four-firm concentration ratio?

C 4  0 . 2  0 .2  0 .2  0 .2  0 . 8
 What is the HHI?

HHI  10,000 .2  .2  .2  .2  .2  2,000
2 2 2 2 2

 7-8

Limitation of Concentration Measures

 Market Definition: National, regional, or local?

 Global Market: Foreign producers excluded.
 Industry definition and product classes.
 7-9

Technology
 Industries differ regarding the technology
used to produce goods and services.
◦ Some industries are labor intensive;
◦ Some industries are capital intensive;
◦ Other industries use a combination of labor
and capital.
 7-10

Measuring Demand and Market Conditions

 The Rothschild Index (R) measures the elasticity

of industry demand for a product relative to that
of an individual firm:
R = ET / EF .
◦ ET = elasticity of demand for the total market.
◦ EF = elasticity of demand for the product of an individual firm.
◦ The Rothschild Index is a value between 0 (perfect competition) and 1
(monopoly).
 When an industry is composed of many firms,
each producing similar products, the Rothschild
index will be close to zero.
 7-11

Own-Price Elasticities of Demand and

Rothschild Indices
Elasticity Elasticity
Industry of Market of Firm’s Rothschild
Demand Demand Index
Food -1.0 -3.8 0.26
Tobacco -1.3 -1.3 1.00
Textiles -1.5 -4.7 0.32
Apparel -1.1 -4.1 0.27
Paper -1.5 -1.7 0.88
Chemicals -1.5 -1.5 1.00
Rubber -1.8 -2.3 0.78
 7-12

Market Entry and Exit Conditions

 Barriers to entry
◦ Capital requirements.
◦ Patents and copyrights.
◦ Economies of scale.
◦ Economies of scope.
 7-13

Conduct: Pricing Behavior

 The Lerner Index
L = (P - MC) / P
◦ A measure of the difference between
price and marginal cost as a fraction
of the product’s price.
◦ The index ranges from 0 to 1.
 When P = MC, the Lerner Index is
zero; the firm has no market
power.
 A Lerner Index closer to 1
indicates relatively weak price
competition; the firm has market
power.
 7-14

Markup Factor
 From the Lerner Index, the firm can determine the
factor by which it should over MC. Rearranging the
Lerner Index
 1 
P  MC
1 L 
 The markup factor is 1/(1-L).
◦ When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC.
◦ When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the
firm charges a price that is 1.25 times marginal cost.
 7-15

Lerner Indices & Markup Factors

Industry Lerner Index Markup Factor
Food 0.26 1.35
Tobacco 0.76 4.17
Textiles 0.21 1.27
Apparel 0.24 1.32
Paper 0.58 2.38
Chemicals 0.67 3.03
Petroleum 0.59 2.44
 7-16

Integration and Merger Activity

 Vertical Integration
◦ Where various stages in the production of a
single product are carried out by one firm.
 Horizontal Integration
◦ The merging of the production of similar
products into a single firm.
 Conglomerate Mergers
◦ The integration of different product lines into a
single firm.
 7-17
DOJ/FTC Horizontal Merger Guidelines
 Based on HHI = 10,000 S wi2, where
wi = Si /ST.
 Merger may be challenged if
 HHI exceeds 1800, or would be after merger, and
 Merger increases the HHI by more than 100.
 But...
◦ Recognizes efficiencies: “The primary benefit of
mergers to the economy is their efficiency
potential...which can result in lower prices to
consumers...In the majority of cases the Guidelines
will allow firms to achieve efficiencies through
 7-18

Performance
 Performance refers to the profits and social
welfare that result in a given industry.
 Social Welfare = CS + PS
◦ Dansby-Willig Performance Index measure by
how much social welfare would improve if firms
in an industry expanded output in a socially
efficient manner.
 7-19

Dansby-Willig
Performance Index
Industry Dansby-Willig Index
Food 0.51
Textiles 0.38
Apparel 0.47
Paper 0.63
Chemicals 0.67
Petroleum 0.63
Rubber 0.49
 7-20

Preview of Coming Attractions

 Discussion of optimal managerial decisions
under various market structures, including:
◦ Perfect competition
◦ Monopoly
◦ Monopolistic competition
◦ Oligopoly
 7-21

Conclusion
 Modern approach to studying industries involves examining
the interrelationship between structure, conduct, and
performance.
 Industries dramatically vary with respect to concentration
levels.
◦ The four-firm concentration ratio and Herfindahl-Hirschman index measure
industry concentration.
 The Lerner index measures the degree to which firms can
markup price above marginal cost; it is a measure of a firm’s
market power.
 Industry performance is measured by industry profitability
and social welfare.
4.2 Managing in Competitive,
Monopolistic, and Monopolistically
Competitive Markets
4.2.1 Perfect Competition
◦ Characteristics and profit outlook.
◦ Effect of new entrants.
4.2.2 Monopolies
◦ Sources of monopoly power.
◦ Maximizing monopoly profits.
◦ Pros and cons.
4.2.3 Monopolistic Competition
◦ Profit maximization.
◦ Long run equilibrium.
4.2.4 Oligopolies
◦ Profit maximization.
◦ Long run equilibrium.
 Reading: Michael Baye, Chapter 8
 8-23

4.2.1 Perfect Competition Environment

 Many buyers and sellers.
 Homogeneous (identical) product.
 Perfect information on both sides of
market.
 No transaction costs.
 Free entry and exit.
 8-24

Key Implications
 Firms are “price takers” (P = MR).
 In the short-run, firms may earn profits or
losses.
 Entry and exit forces long-run profits to
zero.
 8-25

Unrealistic? Why Learn?

 Many small businesses are “price-takers,” and decision
rules for such firms are similar to those of perfectly
competitive firms.
 It is a useful benchmark.
 Explains why governments oppose monopolies.
 Illuminates the “danger” to managers of competitive
environments.
◦ Importance of product differentiation.
◦ Sustainable advantage.
 8-26

Managing a Perfectly Competitive

Firm (or Price-Taking Business)
 8-27

Setting Price

$ $
S

Pe Df

QM Qf
Market Firm
 8-28

Profit-Maximizing Output Decision

 MR = MC.
 Since, MR = P,
 Set P = MC to maximize profits.
 8-29

Profit = (Pe - ATC)  Qf*

MC
$
ATC
AVC
Pe Pe = Df = MR

ATC

Qf* Qf
 8-30
Should this Firm Sustain Short Run Losses or
Shut Down?
Profit = (Pe - ATC)  Qf*
<0 MC ATC
$

AVC

ATC
Loss
P Pe = Df =
e MR

Qf* Qf
 8-31

Shutdown Decision Rule

 A profit-maximizing firm should continue to
operate (sustain short-run losses) if its
operating loss is less than its fixed costs.
◦ Operating results in a smaller loss than ceasing
operations.
 Decision rule:
◦ A firm should shutdown when P < min AVC.
◦ Continue operating as long as P ≥ min AVC.
Firm’s Short-Run Supply Curve: MC
8-32

Above Min AVC

MC ATC
$

AVC

P min
AVC

Qf* Qf
 8-33

Short-Run Market Supply Curve

 The market supply curve is the summation of
each individual firm’s supply at each price.

P Firm 1 Firm 2 Market

P P

S1 S2
SM
15

10 18 Q 20 25 Q 30 43Q
 8-34

Long Run Adjustments?

 If firms are price takers but there are
barriers to entry, profits will persist.
 If the industry is perfectly competitive,
firms are not only price takers but there
is free entry.
◦ Other “greedy capitalists” enter the market.
 8-35

Effect of Entry on Price?

$ $
S

Entry S*

Pe Df

Pe* Df*

QM Qf
Market Firm
 8-36

Effect of Entry on the Firm’s Output and Profits?

MC
$
AC

Pe Df

Pe* Df*

QL Qf* Q
 8-37

Summary of Logic
 Short run profits leads to entry.
 Entry increases market supply, drives down
the market price, increases the market
quantity.
 Demand for individual firm’s product shifts
down.
 Firm reduces output to maximize profit.
 Long run profits are zero.
 8-38

Features of Long Run Competitive

Equilibrium
 P = MC
◦ Socially efficient output.
 P = minimum LAC
◦ Efficient plant size.
◦ Zero profits
 Firms are earning just enough to offset their
opportunity cost.
 8-39

4.2.2 Monopoly Environment

 Single firm serves the “relevant market.”
 Most monopolies are “local” monopolies.
 The demand for the firm’s product is the
market demand curve.
 Firm has control over price.
◦ But the price charged affects the quantity
demanded of the monopolist’s product.
 8-40

“Natural” Sources of
Monopoly Power
 Economies of scale
 Economies of scope
 Cost complementarities
 8-41

“Created” Sources of
Monopoly Power
 Patents and other legal barriers (like
licenses)
 Tying contracts
 Exclusive contracts Contract...

 Collusion I.
II.

III.
 8-42

Managing a Monopoly
 Market power permits
you to price above MC
 Is the sky the limit?
 No. How much you sell
depends on the price
you set!
 8-43

A Monopolist’s Marginal Revenue

P
TR Unit elastic
100
Elastic
Unit elastic
60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
MR
Elastic Inelastic
 8-44
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that
corresponds to that quantity.
MC
$
Profit ATC

PM
ATC

QM Q
MR
 8-45

Alternative Profit Computation

  Total Revenue - Total Cost
  P  Q  Total Cost
 P  Q  Total Cost

Q Q
 Total Cost
 P
Q Q

 P  ATC
Q
  P  ATC Q
 8-46

Useful Formulae
 What’s the MR if a firm faces a linear demand curve
for its product?
P  a  bQ
MR  a  2bQ, where b  0.
 Alternatively,
1  E 
MR  P  
 E 
 8-47

Long Run Adjustments?

 None, unless the
source of
monopoly power is
eliminated.
Why Government Dislikes Monopoly? 8-48

 P > MC
◦ Too little output, at too high a price.
 Deadweight loss of monopoly.

MC
$
ATC
DWL

PM

D
MC

QM MR Q
 8-49

Arguments for Monopoly

 The beneficial effects of economies of
scale, economies of scope, and cost
complementarities on price and output
may outweigh the negative effects of
market power.
 Encourages innovation.
 8-50

Monopoly Multi-Plant Decisions

 Consider a monopoly that produces identical
output at two production facilities (think of a firm
that generates and distributes electricity from
two facilities).
◦ Let C1(Q2) be the production cost at facility 1.
◦ Let C2(Q2) be the production cost at facility 2.
 Decision Rule: Produce output where
MR(Q) = MC1(Q1) and MR(Q) = MC2(Q2)
◦ Set price equal to P(Q), where Q = Q1 + Q2.
 8-51
4.2.3 Monopolistic Competition:
Environment and Implications
 Numerous buyers and sellers
 Differentiated products
◦ Implication: Since products are differentiated,
each firm faces a downward sloping demand
curve.
 Consumers view differentiated products as close
substitutes: there exists some willingness to substitute.
 Free entry and exit
◦ Implication: Firms will earn zero profits in the
long run.
 8-52
Managing a Monopolistically
Competitive Firm
 Like a monopoly, monopolistically competitive
firms
◦ have market power that permits pricing above marginal cost.
◦ level of sales depends on the price it sets.
 But …
◦ The presence of other brands in the market makes the demand for
your brand more elastic than if you were a monopolist.
◦ Free entry and exit impacts profitability.
 Therefore, monopolistically competitive firms
have limited market power.
 8-53

Marginal Revenue Like a Monopolist

P
TR Unit elastic
100
Elastic
Unit elastic
60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
MR
Elastic Inelastic
 8-54
Short-Run Monopolistic Competition
MC
$
ATC
Profit

PM
ATC

QM Quantity of
MR
Brand X
 Maximize profits like a monopolist
◦ Produce output where MR = MC.
◦ Charge the price on the demand curve that corresponds to that quantity.
 8-55

Long Run Adjustments?

 If the industry is truly monopolistically
competitive, there is free entry.
◦ In this case other “greedy capitalists” enter,
and their new brands steal market share.
◦ This reduces the demand for your product
until profits are ultimately zero.
 8-56

Long-Run Monopolistic Competition

Long Run Equilibrium
(P = AC, so zero profits) MC
$
AC

P*

P1

Entr D
y
M D1
R
Q1 Q Quantity of
* MR1 Brand X
 8-57

Monopolistic Competition
The Good (To Consumers)
◦ Product Variety
The Bad (To Society)
◦ P > MC
◦ Excess capacity
 Unexploited economies of scale
The Ugly (To Managers)
◦ P = ATC > minimum of average
costs.
 Zero Profits (in the long run)!
 8-58

Optimal Advertising Decisions

 Advertising is one way for firms with market power to
differentiate their products.
 But, how much should a firm spend on advertising?
◦ Advertise to the point where the additional revenue generated from
advertising equals the additional cost of advertising.
◦ Equivalently, the profit-maximizing level of advertising occurs where
the advertising-to-sales ratio equals the ratio of the advertising
elasticity of demand to the own-price elasticity of demand.
A EQ , A

R  EQ , P
 8-59

Maximizing Profits: A Synthesizing

Example
 C(Q) = 125 + 4Q2
 Determine the profit-maximizing output and
price, and discuss its implications, if
◦ You are a price taker and other firms charge $40
per unit;
◦ You are a monopolist and the inverse demand for
your product is P = 100 - Q;
◦ You are a monopolistically competitive firm and the
inverse demand for your brand is P = 100 – Q.
 8-60

Conclusion
 Firms operating in a perfectly competitive market
take the market price as given.
◦ Produce output where P = MC.
◦ Firms may earn profits or losses in the short run.
◦ … but, in the long run, entry or exit forces profits to zero.
 A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power is
not eliminated.
 A monopolistically competitive firm can earn profits
in the short run, but entry by competing brands will
erode these profits over time.
 9-61

4.2.3 Oligopoly Environment

 Relatively few firms, usually less than 10.
◦ Duopoly - two firms
◦ Triopoly - three firms
 The products firms offer can be either
differentiated or homogeneous.
 Firms’decisions impact one another.
 Many different strategic variables are modeled:
◦ No single oligopoly model.
 9-62

Role of Strategic Interaction

 Your actions affect
the profits of your
rivals.
 Your rivals’
actions affect your
profits.
 How will rivals
respond to your
actions?
 9-63

An Example
 You and another firm sell differentiated
products.
 How does the quantity demanded for
your product change when you change
your price?
 9-64

P D2 (Rival matches your price

change)

PH

P0

PL

D1 (Rival holds its

price constant)

Q
QH1 QH2Q0 QL2 QL1
 9-65

P D2 (Rival matches your price change)

Demand if Rivals Match Price

Reductions but not Price Increases

P0

D1
(Rival holds its
price constant)
D
Q0 Q
 9-66

Key Insight
 The effect of a price reduction on the quantity demanded
of your product depends upon whether your rivals
respond by cutting their prices too!
 The effect of a price increase on the quantity demanded of
your product depends upon whether your rivals respond
by raising their prices too!
 Strategic interdependence:You aren’t in complete
control of your own destiny!
Sweezy (Kinked-Demand) Model
9-67

Environment
 Few firms in the market serving many consumers.
 Firms produce differentiated products.
 Barriers to entry.
 Each firm believes rivals will match (or follow) price
reductions, but won’t match (or follow) price
increases.
 Key feature of Sweezy Model
◦ Price-Rigidity.
 9-68

Sweezy Demand and Marginal Revenue

P
D2 (Rival matches your price change)

DS: Sweezy Demand

P0

D1
(Rival holds its
price constant)
MR1
MR2
Q0 Q
MRS: Sweezy MR
 9-69

Sweezy Profit-Maximizing Decision

P
D2 (Rival matches your price change)

MC1
MC2
P0 MC3

D1 (Rival holds price

constant)

DS: Sweezy Demand

MRS
Q0 Q
 9-70

Sweezy Oligopoly Summary

 Firms believe rivals match price cuts, but not
price increases.
 Firms operating in a Sweezy oligopoly
maximize profit by producing where
MRS = MC.
◦ The kinked-shaped marginal revenue curve implies
that there exists a range over which changes in MC
will not impact the profit-maximizing level of
output.
◦ Therefore, the firm may have no incentive to
change price provided that marginal cost remains
in a given range.
 9-71

Cournot Model Environment

 A few firms produce goods that are either perfect
substitutes (homogeneous) or imperfect
substitutes (differentiated).
 Firms’ control variable is output in contrast to
price.
 Each firm believes their rivals will hold output
constant if it changes its own output (The output
of rivals is viewed as given or “fixed”).
 Barriers to entry exist.
 9-72

Inverse Demand in a Cournot Duopoly

 Market demand in a homogeneous-product

Cournot duopoly is
P  a  bQ1  Q2 
 Thus, each firm’s marginal revenue depends on
the output produced by the other firm. More
formally,
MR1  a  bQ2  2bQ1

MR2  a  bQ1  2bQ2

 9-73

Best-Response Function
 Since a firm’s marginal revenue in a homogeneous
Cournot oligopoly depends on both its output and its
rivals, each firm needs a way to “respond” to rival’s
output decisions.
 Firm 1’s best-response (or reaction) function is a
schedule summarizing the amount of Q1 firm 1 should
produce in order to maximize its profits for each
quantity of Q2 produced by firm 2.
 Since the products are substitutes, an increase in firm
2’s output leads to a decrease in the profit-maximizing
amount of firm 1’s product.
 9-74

Best-Response Function for a Cournot

Duopoly
 To find a firm’s best-response function, equate its
marginal revenue to marginal cost and solve for its
output as a function of its rival’s output.
 Firm 1’s best-response function is (c1 is firm 1’s
MC)
a  c1 1
Q1  r1 Q2    Q2
2b 2
 Firm 2’s best-response function is (c2 is firm 2’s
MC)
a  c2 1
Q2  r2 Q1    Q1
2b 2
 9-75
Graph of Firm 1’s Best-Response
Function
Q2
(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2

Q2

r1 (Firm 1’s Reaction Function)

Q1 Q1M Q1
 9-76

Cournot Equilibrium

 Situation where each firm produces the

output that maximizes its profits, given the the
output of rival firms.
 No firm can gain by unilaterally changing its
own output to improve its profit.
◦ A point where the two firm’s best-response
functions intersect.
 9-77

Graph of Cournot Equilibrium

Q2
(a-c1)/b
r1
Cournot Equilibrium
Q2 M

Q2*

r
2
Q1* Q1M (a-c2)/b
Q1
 9-78

Summary of Cournot Equilibrium

 The output Q1* maximizes firm 1’s profits,

given that firm 2 produces Q2*.
 The output Q2* maximizes firm 2’s profits,
given that firm 1 produces Q1*.
 Neither firm has an incentive to change its
output, given the output of the rival.
 Beliefs are consistent:
◦ In equilibrium, each firm “thinks” rivals will
stick to their current output – and they do!
 9-79

Stackelberg Model Environment

 Few firms serving many consumers.
 Firms produce differentiated or homogeneous
products.
 Barriers to entry.
 Firm one is the leader.
◦ The leader commits to an output before all
other firms.
 Remaining firms are followers.
◦ They choose their outputs so as to maximize
profits, given the leader’s output.
 9-80

The Algebra of the Stackelberg Model

 Since the follower reacts to the leader’s output,

the follower’s output is determined by its
reaction function
a  c2
Q2  r2 Q1    0.5Q1
2b
 The Stackelberg leader uses this reaction function
to determine its profit maximizing output level,
which simplifies to
a  c2  2c1
Q1 
2b
 9-81

Stackelberg Summary
 Stackelberg model illustrates how
commitment can enhance profits in
strategic environments.
 Leader produces more than the Cournot
equilibrium output.
◦ Larger market share, higher profits.
◦ First-mover advantage.
 Follower produces less than the Cournot
equilibrium output.
◦ Smaller market share, lower profits.
 9-82

Bertrand Model Environment

 Few firms that sell to many consumers.
 Firms produce identical products at constant
marginal cost.
 Each firm independently sets its price in order to
maximize profits (price is each firms’ control
variable).
 Barriers to entry exist.
 Consumers enjoy
◦ Perfect information.
◦ Zero transaction costs.
 9-83

Bertrand Equilibrium
 Firms set P1 = P2 = MC! Why?
 Suppose MC < P1 < P2.
 Firm 1 earns (P1 - MC) on each unit sold, while firm
2 earns nothing.
 Firm 2 has an incentive to slightly undercut firm
1’s price to capture the entire market.
 Firm 1 then has an incentive to undercut firm 2’s
price. This undercutting continues...
 Equilibrium: Each firm charges P1 = P2 = MC.
 9-84

Conclusion
 Different oligopoly scenarios give rise to
different optimal strategies and different
outcomes.
 Your optimal price and output depends on …
◦ Beliefs about the reactions of rivals.
◦ Your choice variable (P or Q) and the nature of
the product market (differentiated or
homogeneous products).
◦ Your ability to credibly commit prior to your
rivals.
4.3 Market failure, Government
intervention and business decision
4.3.1 Market Failure
◦ Market Power
◦ Externalities
◦ Public Goods
◦ Incomplete Information
4.3.2 Government Policy and International
Markets
◦ Quotas
◦ Tariffs
◦ Regulations
85
 14-
86

Market Power
 Market power is the ability
of a firm to set P > MC. P
Deadweight
 Firms with market power Loss
produce socially inefficient MC
output levels. PM
◦ Too little output
PC
◦ Price exceeds MC
◦ Deadweight loss MC
 Dollar value of society’s welfare
loss D

QC Q
QM MR
 14-
87

Antitrust Policies
 Goals:
◦ To eliminate deadweight loss of monopoly and
promote social welfare.
◦ Make it illegal for managers to pursue strategies
that foster monopoly power.
 14-
88

Sherman Act (1890)

 Sections 1 and 2 prohibits price-
fixing, market sharing and other
collusive practices designed to
“monopolize, or attempt to monopolize”
a market.
 14-

United States v. Standard Oil of New 89

Jersey (1911)
 Charged with attempting to fix prices of petroleum
products. Methods used to enhance market power:
◦ Physical threats to shippers and other producers.
◦ Setting up artificial companies.
◦ Espionage and bribing tactics.
◦ Engaging in restraint of trade.
◦ Attempting to monopolize the oil industry.
 Result 1: Standard Oil dissolved into 33 subsidiaries.
 Result 2: New Supreme Court Ruling the rule of reason.
◦ Stipulates that not all trade restraints are illegal, only those that are
unreasonable are prohibited.
 Based on the Sherman Act and the rule of reason, how
do firms know a priori whether a particular pricing
strategy is illegal?
 14-
90

Clayton Act (1914)

 Makes hidden kickbacks (brokerage
fees) and hidden rebates illegal.
 Section 3 Prohibits exclusive dealing
and tying arrangements where the
effect may be to “substantially lessen
competition.”
 14-
91

Cellar-Kefauver Act (1950)

 Amends Section 7 of Clayton Act.
 Strengthens merger and acquisition policies.
 Horizontal Merger Guidelines
◦ Market Concentration
 Herfindahl-Hirschman Index: HHI = 10,000 S wi2
 Industries in which the HHI exceed 1800 are
generally deemed “highly concentrated”.
 The DOJ or FTC may, in this case, attempt to block
a merger if it would increase the HHI by more than
100.
 14-
92
Regulating Monopolies: Marginal-Cost
Pricing

MC

PM

PC
Effective Demand

MR
QM QC Q
 14-93

Problem 1 with Marginal-Cost Pricing:

Possibility of ATC > PC

MC

PM
ATC ATC
PC

MR
QM QC Q
 14-94

Problem 2 with Marginal-Cost Pricing:

Requires Knowledge of MC

Deadweight loss
after regulationMC

PM
Deadweight loss
prior to regulation

PReg
Effective Demand
MR
QRegQM Q* Q

Shortage
 14-95

Externalities
 A negative externality is a cost borne by
people who neither produce nor consume
the good.
 Example: Pollution
◦ Caused by the absence of well-defined property
rights.
 Government regulations may induce the
socially efficient level of output by forcing
firms to internalize pollution costs
◦ The Clean Air Act of 1970
 14-96
Socially Efficient Equilibrium: Internal and
External Costs
P
Socially efficient equilibrium
MC external + internal

PSE MC internal

PC
MC external

Competitive
D
equilibrium

QSE QC Q
 14-97

Public Goods
 A good that is nonrival and nonexclusionary in
consumption.
◦ Nonrival: A good which when consumed by
one person does not preclude other people
from also consuming the good.
 Example: Radio signals, national defense
◦ Nonexclusionary: No one is excluded from
consuming the good once it is provided.
 Example: Clean air
 “Free Rider” Problem
◦ Individuals have little incentive to buy a public
good because of their nonrival &
 14-98

Public Goods
$
Total demand for
9
0 streetlights

5 MC of
4 streetlights
Individ
ual 3
Consum 0
er 1 Individual
8 demand for
Surplus
streetlights
0 1 3 Streetlight
2 0 s
 14-99

Incomplete Information

 Participants in a market that have

incomplete information about prices,
quality, technology, or risks may be
inefficient.
 The Government serves as a provider of
information to combat the inefficiencies
caused by incomplete and/or asymmetric
information.
 14-100

Government Policies Designed to

Mitigate Incomplete Information
 OSHA
 SEC
 Certification
 Truth in lending
 Truth in advertising
 Contract enforcement
 14-101

Rent Seeking
 Government policies will generally benefit
some parties at the expense of others.
 Lobbyists spend large sums of money in an
attempt to affect these policies.
 This process is known as rent-seeking.
 An Example: Seeking Monopoly 14-102

Rights
 Firm’s monetary incentive to
lobby for monopoly rights: A Consume
P r Surplus
 Consumers’ monetary A = Monopoly
incentive to lobby against Profits
monopoly: A+B. B = Deadweight Loss
PM
 Firm’s incentive is smaller
than consumers’ incentives. A B MC
 But, consumers’ incentives PC
are spread among many
different individuals. D
 As a result, firms often MR
succeed in their lobbying QM QC Q
efforts.
 14-103

Quotas and Tariffs

Quota
◦ Limit on the number of units of a product that a
foreign competitor can bring into the country.
 Reduces competition, thus resulting in higher prices, lower consumer
surplus, and higher profits for domestic firms.
Tariffs
◦ Lump sum tariff: a fixed fee paid by foreign firms
to enter the domestic market.
◦ Excise tariff: a per unit fee on each imported
product.
 Causes a shift in the MC curve by the amount of the tariff
which in turn decreases the supply of all foreign firms.
 14-104

Conclusion
 Market power, externalities, public goods,
and incomplete information create a
potential role for government in the
marketplace.
 Government’s presence creates rent-
seeking incentives, which may undermine
its ability to improve matters.