Prof. Bryan Caplan

Econ 370


Week 3:  Market Monopoly?

I.                     Market Monopoly?

A.                 So far we've looked at firms facing competitive free market conditions, and contrasted them with firms legally shielded from competitive market conditions by the government.

1.                  Firms on the free market either driven to MC or at least AC by competition.

2.                  Legally shielded monopolies able to permanently earn monopoly profits in excess of both MC and AC.

B.                 Many people are concerned with a third situation: a firm faces free market conditions, but still manages to earn more than AC without the help of the government.

C.                Is this possible, and, if so, likely?

II.                   Monopoly Through Superior Efficiency

A.                 Suppose that one firm is more efficient (i.e., has lower MC and AC) than all of its competitors.

B.                 As discussed earlier, it could then safely charge just under the MC (or AC) of the 2nd most efficient firm.  (This is sometimes called "limit pricing.")

C.                This does result in some allocative inefficiency, but probably not much. 

D.                Also, the monopoly profits the firm earns provide an incentive to firms to reduce costs.  If you can improve your efficiency, then you can take over as the market leader.

E.                 Is there any feasible regulation to eliminate the allocative inefficiency?

F.                 Most alleged examples of (non-legal) "barriers to entry" boil down to superior efficiency.  Examples:

1.                  Economies of scale

2.                  Product differentiation

3.                  Advertising

4.                  Capital requirements

G.                There is probably a lot of "monopoly" on the free market created by superior efficiency, although it seems mostly beneficial.

III.                  Collusion

A.                 Do firms actually compete with each other?  Maybe they conspire with each other to keep prices high and output low.  Business conspiracies of this sort are usually called "collusion."

B.                 Open collusion: Firms sign a contract or make a gentleman's agreement with each other to raise prices and slash production.  This has been illegal in the U.S. for over a century, but can still be seen on the international level (e.g. OPEC).

C.                Tacit collusion: Without communicating, firms watch each other's pricing and output decisions.  If the other firms raise their prices, you show that you're "in" by doing the same.  Big Three automakers a standard example.

D.                In either case: Firms take advantage of repeated interaction.  If you cooperate, I'll cooperate too.  If you don't cooperate, I won't cooperate either.  "Tit-for-tat."

IV.               Problems with Collusion

A.                 Problem #1: One dissident (the "hold-out") can ruin the collusion of everyone else.  The more competitors there are, the harder it is to reach an understanding with all producers. 

B.                 Problem #2: "Cheating" - due to imperfect information about competitor's pricing and output. Secret discounts, "kickbacks," and quota violation.

C.                Problem #3: Division of the spoils.  Who has to cut back their production, and by how much?

D.                Problem #4: New entrants.  The monopoly profits attract new entrants, eager for their "fair share." 

1.                  If you let new entrant into the cartel, you just encourage them and reduce everyone's share of the monopoly profits. 

2.                  If you don't let them in, they will greatly expand their production to take advantage of the high price.  They become the industry "dissident."

3.                  If you buy them out, you encourage people to build new firms just to "blackmail" you.

E.                 Problem #5: Quality competition.  Even if you keep the agreement to set the same price, you can still win extra customers by improving your quality, service, advertising, etc.  This can reduce or eliminate the monopoly profit generated by collusion.

F.                 Possible Exceptions

1.                  Collusion in industries that are already losing money.

2.                  Non-reproducible products.

V.                 Predation

A.                 Suppose that an aspiring monopolist makes the following announcement: "I'm going to price at 10 times AC.  But, if anyone dares to enter my market, I will give my product away for free until my competition goes bankrupt.  Once they leave, prices go back up." 

B.                 This is usually called predation, or predatory pricing (it's also been illegal for about a century).  In international trade, it's called dumping.

C.                The key is that the predator makes pricing decisions conditional upon the behavior of competitors. 

1.                  Drive competitors out of business by selling below cost.

2.                  Once all competition is gone, charge monopoly price way above cost.

VI.               Problems with Predation

A.                 Problem #1: The predator loses as much as the prey, and probably more.  If the predator is the market leader, then they must sell a much larger quantity at the same per-unit loss as the competition.

B.                 Problem #2: The predator has to increase production to meet demand.  With increasing AC, this can get expensive.

C.                Problem #3:  The prey can temporarily shut down, and/or build up inventories until the predator gives up.

D.                Problem #4:  Large-scale entry.  A big firm might bankrupt Mom&Pop stores, but could a big firm credibly threaten to bankrupt another big firm that decided to enter the market?

E.                 Problem #5:  Banks and financial markets. In a modern economy, even the largest firm is small relative to total liquid capital.  If a firm is assured high profits if it only holds out, wouldn't it be a good loan or investment?

F.                 Interesting puzzle: Why don't we hear more about the predation of small firms against large firms?  Tylenol example.

VII.              Natural Monopolies

A.                 Just a case where given the AC curve and market demand, there is only "room" for one firm.

B.                 Lots of examples, some highly regulated, some unregulated.

1.                  Regulated: electricity, gas, cable TV, local phone service.

2.                  Unregulated: neighborhood grocery stores, pharmacies, movie theaters, etc.  The smaller your town is, the more of these there are.

C.                Has regulation helped consumers?  Important: Regulation caps prices, but also usually forbids new entry.  (Suspicious.)

D.                Many examples of entry when allowed.  MCI; DirecTV.

E.                 Even if regulation improves allocative efficiency, it hurts productive efficiency (especially in the long-term).

F.                 My pet theory: "natural monopoly" regulation has nothing to do with whether something is a natural monopoly as economists define it.  If you have to tear up the streets to enter, your industry is called a "natural monopoly."

VIII.            The Concentration-Profits Relationship

A.                 Industry concentration: An index quantifying the number and sizes of firms in a market.  Ex: CR4, Herfindahl index. 

B.                 Big problem: Defining a market (future lawyers and expert witnesses, take note!)

C.                Early studies: in the 1950's, Joe Bain of UC Berkeley claimed to find a POSITIVE correlation between concentration and profitability.  He argued that this showed that market monopoly was a serious problem.  This work influenced a generation of lawyers and regulators.

D.                Later studies:

1.                  Yale Brozen of Chicago got a much bigger data set.  The correlation went away. 

2.                  F.M. Scherer of Harvard, once appointed FTC head, ordered firms to (anonymously) supply a lot more data.  Still no correlation.

E.                 Interesting study: Harold Demsetz of UCLA suggested controlling for market share.  What he found is that the market leaders in each industry tend to have above-average profits, but concentrated industries overall have average profits.

F.                 Conclusion: While Demsetz provides some evidence for market monopoly based on superior efficiency, there's very little evidence that any other kind of monopoly exists on the market.

G.                Question:  But is antitrust and other regulation responsible for the non-existence of market monopoly?  To answer this, we must first investigate what antitrust law purports to do, and what it actually does.


Prof. Bryan Caplan

Econ 370


Week 4: Antitrust

I.                     Antitrust Law

A.                 Sherman Act (1890)

1.                  "Restraint of trade"

2.                  "Monopolization" and "attempted monopolization"

B.                 Clayton Act (1914)

1.                  Singles out business practices "where the effect may be to substantially lessen competition or tend to create a monopoly"

2.                  Suspect practices include: price discrimination, exclusive dealing, corporate stock acquisitions

3.                  Private treble damage suits

C.                Robinson-Patnam Act (1936)

1.                  Tightens rule against price discrimination

D.                Amendment to Clayton Act (1950)

1.                  Tightens rules against corporate mergers

II.                   Antitrust Violations

A.                 Laws are extremely vague so there is enormous discretion for both judges (how to "interpret the law") and regulators (which cases to pursue).

B.                 Price-fixing: per se illegal (Addyston Pipe & Steel).  Most other practices subject to "rule of reason"(?)

C.                Monopoly by internal growth (Alcoa)

D.                Horizontal mergers (Brown Shoe)

E.                 Vertical mergers (Ford Motor spark plug case)

F.                 Simply setting high prices almost never constitutes an antitrust violation.

G.                Government-created collusion largely immune to prosecution (farm cartels, licensing, taxi medallions, auto import quotas, tariffs, etc.)

III.                  Antitrust Enforcement, I: Private Antitrust Suits

A.                 Private suits outnumber government suits by a factor of 20:1.  Treble damages makes suing very attractive.

B.                 What kinds of suits do antitrust plaintiffs bring?

C.                Most common: You get sued by your own dealers or franchisees.  (N.B.  Contract law  give 1x damages; antitrust gives 3x damages!)

D.                2nd most common: Competitors sue you for predation or other "anti-competitive practices."  Sure way to avoid these suits: always price high!

IV.               Antitrust Enforcement, II: Government Antitrust Suits

A.                 Enforced break-ups rare, especially since 1950.

B.                 Government often extracts a "consent decree" whereby a firm agrees to give up a disapproved business practice.

C.                Mergers - especially horizontal mergers, need prior approval in "concentrated" industries.  (Exception: Impending bankruptcy).

D.                Bork's "Paradox": Conflicting motives behind government's antitrust enforcement:

1.                  Consumer welfare

2.                  Small business protectionism

E.                 "Trust-busting" as abuse of economic theory: The effort to impose perfect competition on industries with a big minimum efficient scale.

F.                 Deconcentration proposals.

V.                 Price Discrimination

A.                 Robinson-Patnam Act forbids price discrimination where the effect "may be to substantially lessen competition."

B.                 The theory of price discrimination: Given a monopoly, price discrimination is GOOD!  Price discrimination can completely eliminate all allocative inefficiency from monopoly.

C.                Superficially, there seems to be a lot of price discrimination.  Can this be explained away somehow as a cost difference?

D.                Take Landsburg's challenge: Why does popcorn cost more at movies?

VI.               The Negative Effects of Antitrust

A.                 Even when used to promote (allocative) efficiency, antitrust often promotes both productive and allocative inefficiency.

B.                 Ban on price-fixing and collusion

1.                  Impedes research joint ventures, joint use of patents, etc.

2.                  Encourages inefficient mergers, since setting prices within a firm is legal (merger waves at turn of the century)

C.                Regulation of mergers

1.                  Regulation of Horizontal Mergers: often reduces productive efficiency

2.                  Regulation of Vertical and Conglomerate Mergers: definitely reduces productive efficiency, with no gain to allocative efficiency

D.                Ban on predation

1.                  Discourages firms from cutting prices

2.                  Gives market leaders an incentive to "pull their punches" to avoid bankrupting competitors

E.                 (Semi-) Ban on price discrimination

1.                  Remember: price discrimination reduces or eliminates losses to allocative efficiency, so this ban is inefficient on its face

2.                  Discourages (cost-based) price differences along with price discrimination.

F.                 Private and public antitrust suits have huge deadweight costs (lawyers for both sides + court time).  (standard payment for plaintiff's council: 1/3 of judgment)

G.                Using political means to "increase competition" leads business to shift their resources from production to lobbying and suing.

VII.              Is Antitrust Responsible for the Non-existence of Market Monopoly?

A.                 Antitrust cases don't generally target monopoly in the economist's sense of the term.  At most, they target a few symptoms of monopoly.

B.                 Laws are vague enough that almost any firm is arguably guilty.

1.                  Charge high price - monopoly

2.                  Charge low price - predation

3.                  Charge same price as competitors - collusion

C.                Antitrust decisions are basically random (especially for private suits), so they have little deterrent effect.  (Why?) 

D.                Antitrust is more like a random tax (a "negative lottery") on legally vulnerable activities (like franchising).

E.                 Market checks on collusion and predation work much better than antitrust without the negative side effects discussed above.

F.                 Conclusion: Observed non-existence of monopoly (from Brozen, Scherer, and Demsetz studies) has little or nothing to do with antitrust law.

VIII.            What is to Be Done?

A.                 Abolish government grants of monopoly privilege.

B.                 Abolish antitrust.

C.                Concluding thought: "American opinion has been traditionally 'antimonopoly.'  Yet it is clearly not only pointless but deeply ironic to call upon government to 'pursue a positive antimonopoly policy.'  Evidently, all that is necessary to abolish monopoly is that the government abolish its own creations." (Rothbard, Power and Market)