Limiting Market Power: Regulation and Antitrust To protect the public interest when industries are monopolistic or oligopolistic,

many governments use two basic tools. Antitrust policy seeks to prevent acquisition of monopoly power and to ban certain monopolistic practices. All firms are subject to antitrust laws. In addition some industries are regulated by rules that constrain firms pricing and other decisions. Generally only firms suspected of having the power to act like monopolists are regulated in this way. The public interest is often threatened when firms posses monopoly power or market power. Market power is defined as the ability of firms to raise and keep their prices well above the level which would prevail in a competitive market. Market power prevents a firm from being punished by the market for having high prices. In a competitive industry, any firm which tries to charge high prices would lose customers to rivals with lower prices. Monopoly power is undesirable for several reasons including: High prices reduce the wealth of consumers. It causes a redistribution of wealth from consumers to firms which is usually deemed to be undesirable. High prices lead to resource misallocation. Economists usually view this undesirable effect as more serious than the one just mentioned. High prices tend to reduce the quantity of the commodity which consumers demand. This leads to a smaller quantity of labour, capital and raw materials used in the production of the high priced goods relative the amount which would have been used if pricing was done at the competitive level. This means less resources are flowing into this area than would best suit More of these inputs will be transferred to the products of

consumers needs.

competitive industries. The result will be underproduction of the products priced at monopoly levels and overproduction of the products of competitive industries. The economy therefore does not produce the mix of goods which best serve the public interest. Monopoly power may create obstacles to efficiency and innovation. A company which does not have to fear competition may not need to be constantly searching for efficient
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ways of production (i.e. to reduce waste) and innovation (i.e. developing new products and processes). These are usually costly exercises. Without the incentive to constantly be searching for better and cheaper ways of doing business, products and services offered might be relatively low quality compared to that offered in a competitive industry. The efficiency problem caused by monopoly power is among the main reason why governments want to intervene to control firms behaviour. The critical issue is the control of monopoly power and prevention of acts by firms that are designed either to harm or destroy rivals, or to curb the use of that power to exploit the public. While small firms do not have market power, it is not true that all large firms do have market power, although some do. It might be the case where a large firm is constrained in its pricing behaviour by another large firm. Coca-Cola and Pepsi are both large firms, but neither can act unilaterally without taking account of the reaction of the other. It is also possible for an industry to have only one firm, but that firm is unable to exercise monopoly power. If entry into the industry is easy, any attempt to make super-profits will attract potential firms into the industry. The incumbents firms behaviour is constrained not by other firms in the industry, but the threat of new entrants (such a market is known as a contestable market). For this reason government competition (or antitrust) agencies tend not to interfere with firms in an industry in which entry is relatively easy. Antitrust Law and Policies Antitrust policy refers to programmes that preclude the deliberate creation of monopoly and prevent powerful firms from engaging in related anticompetitive practices. In Jamaica the Fair Trading Commission is the agency charge with the responsibility of enforcing the Fair Competition Act. Private individuals or firms can however take action under the Fair Competition Act directly in the courts without going through the FTC.

It is generally agreed that a firm is not strong enough to violate the antitrust laws if it possess no monopoly power i.e. power to prevent entry of competitors and to raise prices substantially above the competitive level. Competition or antitrust agencies usually look at the concentration of an industry to see if it is possible for a firm to possess market power. A market or an industry is said to be highly concentrated if it contains only a few firms, most or all of which sell a large share of the industrys products. An industry with many small firms is said to unconcentrated. Concentration is measured in a number of ways. The most straight forward method is to calculate what share of the industrys output is sold by some selected number of the industrys firms. Most often a four-firm concentration ratio is used for this purpose. If the four largest firms in an industry account for, say 58 percent of the industrys sales, we say that the four-firm concentration ratio is 0.58. Another formula now widely used to measure concentration is the HerfindahlHirschman Index (HHI). This index is calculated by determining the market share of each of the firms in the industry, squaring each of these numbers, and adding them together. An industry which has three firms with market shares of 30%, 33% and 37% will have an HHI of 3358 (30 2 + 332 + 372). The HHI ranges from 10,000 (in the case of a pure monopoly) to a number approaching zero (in the case of near perfect competition). It is common for competition agencies to consider an industry to be unconcentrated if its HHI is less than 1,000, and highly concentrated if it exceeds 1,800. A crucial problem for antitrust enforcement is to differentiate between vigorous competition and anticompetitive behaviour. Vigorous competition can look very similar to acts which undermine competition. Vigorous competition might force a firm which is unable to offer lower prices out of business. Anticompetitive behaviour can also drive a firm out of business. In the first instance society is better off but in the latter it is made worst off. One anticompetitive practice which antitrust agencies usually have to deal with is predatory pricing. Predatory pricing occurs when a firm charges a very low price with the
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intent of driving rivals out of business. Low prices are however beneficial to consumers, so great care is taken in determining predatory pricing. Courts usually look to see if price is below marginal cost or average variable cost. The logic of this is that even under perfect competition, in the long-run, prices will not fall below this level and will in fact be equal to marginal cost. Even when price falls below marginal cost or average variable cost they are deemed to be predatory only under two conditions: If evidence show that the low prices would be profitable only if it succeeded in destroying a rival or in keeping it out of the market. When there is a real probability that the allegedly predatory firm could raise prices to monopoly levels after the rival was driven out, thereby profiting from its venture in crime. Regulation Regulation of industry refers to the activities of a number of government agencies that enforce rules about business conduct enacted by parliament or rules that the agencies themselves have adopted. When an industry is suspected of possessing monopoly power and, because of economies of scale or for other reasons, it is not considered feasible or desirable to bring effective competition into the market, the regulatory agency imposes rules upon the firms designed to curb their monopoly power. The agency may place limits on the price that firms can change and require firms to make application to it for change in prices. Before changes are made the agencies usually conduct public hearings or trials (which can be quite expensive) in which concerned parties may plead their cases. The Office Of Utilities Regulation is one such agency in Jamaica which regulates certain industries. Apart from economics of scale or scope, public policy might want to restrict competition in order to ensure universal service. It might be desirable that all citizens of a country have access to a good or service. It might however be costly to service some customers e.g. electricity to remote villages located in the mountains. A regulated firm might be able to service these customers at a loss if it is able to recoup this loss by charging other customers a

price above what it cost to provide them with their service. If firms are permitted to compete some firms would seek to compete only in the lucrative market segments driving those prices close to competitive levels. There would be no surplus from these areas to cross-subsidize the areas that are not economically viable. The practice of going only for the lucrative parts of the market is referred to as cream skimming. Regulators around the world face two key issues that are fundamental for economic policy. When governments regulate prices, they usually want to prevent those prices from being so high that they bring monopoly profits to the firm. At the same time governments want to set prices that are compensatory i.e. prices must be sufficiently high to enable the firms to cover their costs and consequently to survive financially. Prices intended to promote the public interest may cause financial problems for firms. The firms incentives and reward for the effort and expenditure needed to improve efficiency and to innovate is the higher profits that they expect to make if they succeed. But a frequent objective of regulators is to put a ceiling on profit to prevent monopoly earning. The issue is how to prevent monopoly profits without destroying incentives. Where it is feasible most economists favour setting price equal to marginal cost, because this is the pricing rule that best serves consumers wants most efficiently. However, such a pricing rule could force the regulated firm into bankruptcy. Many regulated firms are characterized by economies of scale i.e. the long-run average cost curve is falling. Because the average cost curve in falling, the marginal cost must be below average cost. Charging a price equal to marginal cost would therefore not allow the firm to meet its average cost. Regulators try to get around the problem by setting price equal to average cost. The problem is that average cost is very difficult to calculate. Most firms make many different products, average cost is defined as total cost divided by quantity. With many different products it is difficult to define quantity, since that would involve adding apples and oranges. People who oppose regulation do so on the grounds that it impairs efficiency: 1. One source of inefficiency is the endless paperwork and complex legal proceedings that prevent the firm from responding quickly to changing market conditions.
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2.

By forcing prices to differ from those that would prevail in a free, competitive market, regulations lead consumers to demand a quantity of the regulated product that does not maximize consumer benefits from the quantity of resources available to the economy.

3.

Regulators often are required to prevent the regulated firm from making excessive profits, while at the same time offering it financial incentives for maximum efficiency of operation and allowing it enough profit to attract capital it needs to expand. It would seem ideal if the regulator would allow the firm to cover its costs including the cost of capital. If the current rate of profit in competitive industries was 10%, the regulated firm should cover cost plus 10%. The problem with such a rule is that it removes all profit incentives for efficiency, responsiveness to consumer demand and innovation. It offers one rate of profit to competent and the incompetent alike. When firms are offered fixed returns no matter how well or how poorly they perform, gross inefficiencies often result. A regulatory innovation designed to prevent monopoly profits while offering

incentives for the firm to improve its efficiency is now in use in many countries. Under this programme, regulators assign ceilings (called price caps) for the prices (not the profits) of the regulated firms. The price caps (which are measured in real, power of money) are reduced each year at a rate based on the rate of cost reduction (productivity growth) previously achieved by the regulated firm. If the regulated firm is able to achieve saving greater than those received in the past it will be permitted to keep the increased profit as a reward. Of course if the regulated firm reduced its costs by 2% while in the past it reduced them by 3%, the price cap will also fall by 3% - the firm will therefore lose profits i.e. the firm is punished if its cost reduction does not keep pace with past performances.

TRADE THEROY Absolute Advantage Adam Smith while inquiring into the source of the wealth of nations formulated the first theory of trade. Smiths basis of trade is an absolute advan tage. According to him Country A will export an item to Country B only if Country A is able to produce that item cheaper than Country B. If Country A is able to produce everything cheaper than Country B, it will buy nothing from Country B and sell everything to Country B. Smith saw trade as a vent for surplus, a means of disposing of over production. A pre-condition for Smiths theory is that trade must be free i.e. there must be no forces except market forces which affect trade.

Comparative Advantage David Ricardo while examining the effects of trade on the rate of profit formulated his classic theory of trade. He disagreed with Smith that the basis for trade was an absolute advantage. Ricardo argued that in a two country, two commodity world, if Country A has an absolute advantage over Country B in the production of both Good X and Good Y, trade is still possible. Ricardo uses the labour theory of value. Exchange value and price are therefore determined by the socially necessary labour embodied in the various commodities. Trade patterns in a Ricardian world are determined by differences in labour productivity between countries. Let us examine the following example where Jamaica and Guyana produce both sugar and rice.

Guyana Rice Sugar

Cost in Man/Hours 15 10

Opportunity Cost 15/10 = 1.5 10/15 = 0.66

Jamaica Rice Sugar

Cost in Man/Hours 30 15

Opportunity Cost 30/15 = 2 15/30 = 0.5

From the above table it is clear that Guyana enjoys an absolute advantage over Jamaica in the production of both rice and sugar (it is able to produce both of these goods cheaper than Jamaica can). Guyana also enjoys a relative or comparative advantage in rice since before trade it will only have to sacrifice 1.5 units of sugar in order to obtain an additional unit of rice, as compared with Jamaica which would have to sacrifice before trade 2 units of sugar in order to obtain an additional unit of rice. Jamaica in spite of its absolute disadvantage, enjoys a relative advantage in the production of sugar since it is only required to give up 0.5 units of rice for an additional unit of sugar compared with Guyana which is required to sacrifice 0.66 units of rice in order to obtain an additional unit of sugar. According to the Ricardian scheme of Comparative Advantage the basis for trade exists. Guyana will produce rice and buy sugar from Jamaica (since it will be able to obtain sugar cheaper from Jamaica 0.5 units of rice than if it produces the sugar itself 0.66 units of rice). Jamaica will produce sugar and buy rice from Guyana (it can obtain rice cheaper from Guyana 1.5 units of sugar than if it produces it itself 2 units of sugar.

The actual exchange price of rice in terms of sugar will lie somewhere between 1.5 units of sugar and 2 units of sugar. Guyana will not be prepared to sell its rice for less than 1.5 units of sugar since that is the amount of sugar which Guyana must give up in order to produce one unit of rice. Jamaica will not be willing to pay to Guyana more than 2 units of sugar for one unit of rice since it is able to produce rice itself at a cost of 2 units of sugar for one unit of rice. If the exact price lies strictly between 1.5 and 2 then both countries will be better off, Guyana would be getting more than the 1.5 units of sugar which it cost to produce a unit of rice, and Jamaica would be getting rice at less than the 2 units of sugar which it would cost if it produced the rice itself. If the actual cost is 1.5 units of sugar, Guyana would be no worse off after trade than before while Jamaica would be better off. If the actual price is 2 units of sugar, Jamaica would be no worse off while Guyana would be better off. The exact terms of trade will be determined by the relative bargaining power of the two countries. Similarly, the price of sugar in terms of rice will lie somewhere between 0.5 units of rice and 0.66 units of rice. Since both countries will be concentrating on the production of the good which they make best it follows that the total amount of rice and sugar produced by Guyana and Jamaica respectively will be more than when both countries produced both goods themselves. Specialization and trade means that consumers in both countries will have more of both commodities available to them at prices that are at least not any higher than before trade and more likely at lower prices. For the Ricardian scheme of Comparative Advantage to work trade must be free i.e. there must be no forces except market forces which interfere in the trade process.

MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION IN PERFECTLY COMPETITIVE MARKETS

The market equilibrium wage rate will be determined by the market demand for and supply of labour. Since each firm is too small to affect the wage rate by changes in its labour input, the labour supply curve facing each producer is a perfectly elastic (horizontal line) at the level of the market wage rate. The value of the marginal product of a variable productive input is equal to its marginal product multiplied by the market price of the commodity in which it is used.

Dollars w1 C E SL = w2 F VMP

L1

L2

Labour

The value of the marginal product is given by the curve labeled VMP in the above diagram. The market wage rate is O , so that the supply of labour to the firm is the horizontal line SL. If the firm employed OL1 units of labour, the value of the marginal product is L 1C = 0w1. The wage rate is O , 0w1> O . An additional unit of labour will add more to total revenue than to total cost. The value of the marginal product will be added to total revenue and its unit wage rate will be added to cost. A profit-maximizing entrepreneur would therefore employ

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more units of labour. He would continue to add units of labour so long as the value of the marginal product exceeds the wage rate. If the firm employed OL2 units of labour, the value of the marginal product would be L2F = 0w2. This is less than the wage rate O . Each unit of labour adds more to total cost than to total revenue. A profit maximizing entrepreneur would not employ OL 2 units of labour, or any number for which the wage rate exceeds the value of the marginal product. A profitmaximizing entrepreneur will employ units of a variable input until the point is reached at which the value of the marginal product of the input is exactly equal to the input price. Although we have confined our discussion to labour as the only variable input, the argument presented holds for any variable input. If the wage rate was 0w1 the firm would employ 0L1 units (equating the value of the marginal product of labour with the wage rate). Similarly if the wage rate was 0w 2, the firm would employ 0L2 units of labour. It is clear therefore that the value of the marginal product curve for a single variable input is the individual demand curve for that input. The individual demand curve for a single variable input is given by the value of the marginal product curve of the input in question. When a production process involves more than one variable input, the value of the marginal product curve of an input in not its demand curve. The reason for this is that the various inputs are interdependent in the production process. A change in the price of one input leads to changes in the rates of utilization of the others, this in turn shifts the marginal product curve of the input whose price initially changed.

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Product Exhaustion Theorem In long-run competitive equilibrium, rewarding each input according to its marginal physical product precisely exhausts the total physical product. The amount of remuneration going to a factor of production is given by the value of the marginal product (i.e. price of that factor) times the amount of the factor used. The total physical product is divided up between the various factors of production. The share of each factor is given by the product of the value of the marginal product and the quantity of the input factor used. The value of the marginal product is given by the marginal physical product times the price of the output. Given that the price of the output is fixed, the entrepreneur is therefore deciding the remuneration of a factor of production upon the marginal physical product. Distributing the total physical product according to the marginal physical product therefore exhausts the total physical product. Given that the total product is exhausted some economists view the marginal productivity theory as an explanation of the distribution of the total social product between people in an economy. The marginal productivity theory dictates how much of the social product should go as remuneration to capital, how much to land, and how much to labour. It is of course the owners of land which receive the contribution attributed to land, and the owners of capital which receive the amount attributed to capital. The marginal productivity theory of distribution does not seek to explain how some people came to own land or capital in the first place, it merely stipulates how total output should be divided up between the owners of the factors of production given the prevailing distribution of the ownership patter of these factors of production.

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