Prof. Bryan Caplan

Econ 370


HW#2 (please type; diagrams may be drawn by hand)


I.                     Explain how superior efficiency allows a firm to price above AC. What limits the final price charged? Discuss one form of superior efficiency that has been subject to antitrust prosecution.


A firm of superior efficiency is, by definition, able to produce a given quantity at a lower cost than other firms. This means, in turn, that the superior firm can charge a price ABOVE its own MC, but BELOW any rivals' MC. One form of superior efficiency that has been attacked by antitrust has been economies of scale the lower costs of scale production. For example, in the case of the Proctor and Gamble/Clorox merger, Bork explains that one objection raised under the antitrust laws was: "Clorox would share in volume discounts on advertising rates supposedly granted Proctor by television networks and magazines."


II.                   Most historical discussions of collusion and predation overlook the many difficulties associated with successfully pursuing these strategies. Find one discussion of collusion or predation in a source of your choosing. Summarize the charges. What economic checks on collusion/predation does your source ignore?


Langer et al, Western Civilization: The Struggle for Empire to Europe in the Modern World tells us that:


In the course of the second half of the nineteenth century, Krupp [a German armaments producer] and a few score other titans came to wield enormous power... [B]lessed with government support or at least non-interference, they manipulated the levers of industrial capitalism to gain power, fame, and fortune... Through such devices as the joint-stock merger (Britain), trusts and holding companies (United States) and cartels (Germany), they divided the market and eliminated competition.


This makes collusion sound very easy, with or without government help. It says nothing about how such efforts routinely attract new entry. It also fails to mention hold-out problems, cheating, and so on.


III.                  Draw a graph of a naturally monopolistic industry (you will need to show both the AC curve and the demand curve). Show where the unregulated firm would price if equally efficient potential competitors exist.


They would produce at the intersection of D and AC. If these curves intersect more than once, potential competition would force the natural monopolist to produce at the lowest-price/highest-quantity intersection.


IV.               A natural monopoly has AC of $5, and charges $25 per unit. The government imposes rate-of-return regulation on the firm, forbidding it to charge more than 10% above AC. Explain both of the strategies the firm could use to deal with this regulation.


One is to cut the price down to $5.50. But it would be equally within the law to let costs rise until they reached $22.72 (=$25.00/1.1).


V.                 If firms use collusion and/or predation on the free market to gain monopoly positions, what sign would the correlation between concentration and profit have (positive, negative, or zero)? If firms gain monopoly positions through superior efficiency, what sign would the correlation between market share and profit have?


Assuming that collusion and predation work better is more concentrated industries, there would be a positive correlation between concentration and profit.


On the other hand, monopoly through superior efficiency would not lead to high profits in concentrated industries, but only high profits for market LEADERS. In other words, there would be a positive correlation between profits and market share.


VI.               Label the following as horizontal, vertical, or conglomerate mergers.

A.                 Boeing merges with McDonnell-Douglas.


Horizontal both make planes.


B.                 Microsoft buys Quicken.


Horizontal Microsoft produces the competing programs of MS Excel and MS Money.


C.                The Olive Garden buys Prego spaghetti sauce.


Vertical merger, assuming the Olive Gardens plans to start serving Prego sauce in its restaurants.


D.                McDonald's buys the Olive Garden.


Conglomerate merger they are both restaurants, but they are extremely different kinds of restaurants.


E.                 Microsoft buys Intel.


Conglomerate merger both supply inputs to computer manufacturers, but the inputs (software and chips) are not substitutes.


What implicit assumptions about market definitions did you have to make in each case? What would lawyers for the government probably argue if they were contesting a merger? What would the lawyers for the companies involved argue?


Lawyers for the government would try to argue that the conglomerate mergers are really horizontal. For example, they might say that Microsoft and Intel are both in the "computer inputs" market. On the other hand, Boeing and McDonnell-Douglas might claim that their planes are really quite different, so it is actually a conglomerate merger.


VII.              Which of the following are per se illegal? Which are subject to a "rule of reason"? Which are for practical purposes legally safe?

A.                  Vertical mergers.


Rule of reason.


B.                 Research joint ventures


Rule of reason.


C.                Setting low prices.


Rule of reason.


D.                Setting high prices.




E.                 Setting the same price as your competitor.


Rule of reason.


F.                 Calling up your competitor to discuss prices.


Per se illegal.


VIII.            Dairy Queen is debating whether to run its restaurants itself, or to use franchises. DQ can run them itself for $100,000 per restaurant per year. Franchisees can run them for $80,000 per restaurant per year (since the franchisee's owner-manager has an incentive to run the them more efficiently than an employee-manager). Each restaurant can expect to sell 100,000 ice cream comes per year; because they face competition, they must be produced in the lowest-cost way and priced at average cost.

A.                 If franchisees are unable to sue Dairy Queen, how will cones be produced (by DQ directly, or by franchises)? What will the price of ice cream cones be?


They will be produced by franchises, and cones will be sold for $.80 each ($80,000/100,000).


B.                 Suppose that franchisees have the right to sue DQ. 10% of franchisees sue, costing an average of $100,000 in damages and legal expenses. Now what will the price of ice cream cones be?


They will still be produced by franchises, and cones will be sold for $.90 each ($80,000+.1*$100,000)/100,000).


C.                Suppose the legal system becomes more sympathetic to franchisees, so now 20% sue and cost an average of $250,000 in damages and legal expenses. How will DQ ice cream produced, and at what price?


DQ will run the restaurants directly, and cones will be sold for $1.00 each ($100,000/100,000). Franchises could only be profitable if they charged $1.05 per cone.


IX.               Suppose that an industry has 3 firms, with market shares of 50%, 40%, and 10%. A deconcentration bill is passed, setting the maximum market share at 9%. What would be one legal way to re-organize the industry? How would your answer be affected if this ruling bankrupted the firm that originally had a 10% market share?


You could split the 50% firm into 6 firms of 8% and 1 firm with 2%, the 40% firm into 5 firms of 8%, and the last into one firm of 8% and another of 2%. If this bankrupted the smallest firm, the market shares of the first two firms would rise to 56% and 44%, so they would have to be split up even further.