Competitive firms sell at market prices, which maximizes both consumer surplus and total surplus. Consumer surplus is the additional benefit enjoyed by consumers over the price that they paid for the product. Monopolies, on the other hand, set prices to maximize their own profits, by decreasing supply, increasing their own producer surplus at the expense of both consumers and society. And because there is a deadweight loss from imperfect competition, the economy produces less because of the monopoly. Furthermore, allocative efficiency is reduced, not only because desired products are not produced in the quantity that could be produced considering the costs of production, but also because monopolies often don't produce a product that would be most desirable by society, because they do not have to worry about competition, so there will not be another company producing a better or more desirable product that could possibly take market share away from the monopoly. And the lack of competition makes the employees of the monopoly complacent. Indeed, innovation may be shunned because there are always risks with new ideas and the complacent employees do not want to upset the status quo. With competition, they must take those risks; otherwise, they would lose market share and may even become bankrupt eventually.
Monopolies always reduce the economic wealth of society in many ways. Hence, governments regulate monopolies with the objective of benefiting societies more than would be the case if the monopolies maximized their profits. There are 3 major methods to increase the benefits of monopolies to society:
- removing or lowering barriers to entry through antitrust laws so that other firms can enter the market to compete;
- regulating the prices that the monopoly can charge;
- operating the monopoly as a public enterprise.
Antitrust Laws
The main purpose of antitrust laws is to prevent business practices that either create or maintain a monopoly. Although this article discusses United States antitrust law, the basic principles will still apply worldwide, since monopolies operate much the same in most modern economies. Moreover, many of the legal remedies available in different countries will be similar, since they address similar situations.
In the United States, the 2 major antitrust laws are the Sherman Antitrust Act, passed in 1890, and the Clayton Antitrust Act, passed in 1914.
The Sherman Antitrust Act is the broadest of the antitrust laws, prohibiting practices whose main objective is to create or maintain a monopoly. The Sherman Act does not define monopoly, but it is well-established that it involves any firm that has a power to significantly affect prices and exclude competition in a particular market.
The United States Supreme Court defined monopolization as involving 2 components: the possession of monopoly power in the relevant market, and the willful acquisition or maintenance of the power that did not occur because of the growth or development of a superior product, superior business acumen, or historic accident. Even the attempt to monopolize is prohibited, but only if the attempt has a reasonable probability of success. In other words, the would-be monopolist must possess some degree of market power, where it has a reasonable chance to become a monopoly.
While it is not illegal to have a monopoly position in a market, the antitrust laws make it unlawful to maintain or attempt to create a monopoly through tactics that either unreasonably exclude firms from the market or significantly impair their ability to compete. Because some business operations have no legitimate business reason, while others may have legitimate business objectives, there are 2 different types of analysis applied in determining whether a practice violates antitrust laws under the Sherman Act.
Per se means in and of itself. A per se violation is considered inherently illegal, and has no legitimate justification for it.
Business practices that may have antitrust implications and legitimate business justifications are not illegal per se, so they must be examined under a rule of reason analysis, using principles and criteria developed by the courts and antitrust agencies. A practice is illegal if it restricts competition in some significant way without any overriding business justification. Thus, while a monopoly is not illegal per se, a rule of reason analysis may find that the methods used to achieve and maintain it had no other business objective other than monopolizing a market, and this is illegal.
The Clayton Antitrust Act was passed to address issues that the Sherman Act did not. However, any practice considered illegal under the Clayton Act is illegal only if it substantially reduces competition or tends to create monopoly power. The Clayton Act prohibits price discrimination, interlocking directorates, tying arrangements, and, if they restrain trade, mergers and acquisitions. The Clayton Act also allows private parties to sue for treble damages.
The Federal Trade Commission Act was also passed in 1914, creating the Federal Trade Commission [FTC] with the power to conduct investigations and to prohibit unfair practices in interstate commerce. Section 5 of the FTC Act covers all anticompetitive practices not covered under the other federal antitrust laws, generally prohibiting unfair, deceptive, or anticompetitive practices affecting commerce. Only the FTC is authorized to implement the Act's provisions.
The FTC also enforces the Clayton Act, but not the Sherman Act, and has the sole authority to enforce Section 5 violations of the FTC Act.
The main remedies of violating antitrust laws are divestiture, where the company is forced to give up 1 or more of its acquisitions or functions, injunctive relief, and dissolution. A private party can sue for treble damages and attorney's fees under Section 4 of the Clayton Act, if the party was injured as a result of any federal antitrust law violations except under Section 5 of the FTC Act.
Other countries have also enacted antitrust laws, including the European Union and Japan and several countries in Southeast Asia. Antitrust laws apply to foreign firms operating domestically, where the domestic operations have a significant effect on competition.
The main types of practices considered anticompetitive under antitrust laws include the following:
- Horizontal restraint is any agreement restraining competition between rival firms competing in the same market.
- Price-fixing is an agreement among business participants in a particular market to restrict supplies to maintain prices. Oligopolists are in the best position to fix prices.
- A group boycott is an agreement by several competitors to boycott or refuse to deal with a particular person or firm, to reduce competition.
- Horizontal market division occurs when several competitors divide up territories in which each agrees to sell in a particular territory, or to a specific group of buyers, such as institutional or government buyers, or retailers.
- Trade associations may also be instrumental in restraining competition, but they do have legitimate purposes: to exchange information, to represent members' interest before government bodies, to engage in advertising campaigns, and to set regulatory standards for the profession or industry. Since trade associations do have legitimate business applications, any antitrust analysis would be under a rule of reason analysis.
- Joint ventures may also be used for anticompetitive purposes and will also be subject to a rule of reason analysis.
- A vertical restraint is any restraint on trade created by agreement between firms at different levels of the manufacturing and distributing process for a product or service. A firm engaged in the manufacture and distribution of its own products is a vertically integrated firm. While firms at different levels of the manufacturing and distribution process are not direct competitors, any agreements among them can have a significant effect on competition.
- Territorial or customer restrictions may also be anticompetitive, but since they do also serve legitimate business purposes, they are subject to a rule of reason analysis. For instance, franchisors may limit the number of franchises in a particular geographic area or a manufacturer may restrict retailers of its product from selling at too low of a price.
- Resale price maintenance agreements are agreements between the manufacturer and distributors or retailers of the product where the manufacturer stipulates the minimum price that must be charged.
- Refusals to deal may also be considered anticompetitive if there is a probability that the firm refusing to deal will acquire monopoly power and that the refusal is likely to have an anticompetitive effect on its market. In vertical arrangements, a manufacturer can sometimes set retail prices by refusing to deal with retailers or dealers that sell at prices substantially lower than the manufacturer's suggested retail price.
- Predatory pricing is a strategy where a manufacturer will sell its products at substantially lower market prices to eliminate competitors. Once the competitors are eliminated, then the manufacturer is free to raise prices. Microsoft provides 1 of the best examples of predatory pricing. For years, Microsoft gave away Microsoft Office with new computer systems, thereby eliminating the competition, such as WordPerfect. Then, it eventually started charging for Microsoft Office, and now sells it as a subscription.
- Price discrimination is charging different prices to different buyers to substantially lessen competition, when the difference in price cannot be justified by differences in production costs, transportation costs or other cost differences.
- Exclusionary practices are forbidden, where sellers or lessors sell or lease goods based on any agreement that the purchaser or lessee cannot buy or deal in the goods of a competitor or competitors of
the seller. Exclusionary practices generally consist of 2 types of vertical agreements: exclusive-dealing contracts and tying arrangements.
- An exclusive-dealing contract is an agreement where the seller forbids a buyer to purchase products from the seller's competitors.
- Tying arrangements, where the buyer and seller enter into agreement in which the buyer of the product or service becomes obligated to purchase additional products or services from the seller, are prohibited.
- Mergers are also prohibited under the Section 7 of the Clayton Act, if the purpose of the merger is to lessen competition. A merger is any person or business organization that holds stock or assets in another entity. A horizontal merger occurs between 2 firms competing in the same marketplace, while a vertical merger is the acquisition of a company in a different level of the marketing chain for a product or service. The main considerations in
determining whether mergers are anticompetitive are the market share of the relevant firms and whether such mergers will make it more difficult for new businesses to enter the market.
- The main consideration for vertical mergers is foreclosure, which occurs when competitors of the merging firms can no longer sell or buy products from the merged entity. A vertical merger will be deemed illegal if it increases market concentration or increases barriers to entry into the market, and it was the apparent intent of the merging parties to thwart competition.
- A conglomerate merger may also be considered anticompetitive. A conglomerate merger is a merger between firms that do not compete with each other because they are in different markets. Most conglomerate mergers are legal, but whether they will be subject to Section 7 of the Clayton Act depends on whether the mergers were effected to reduce competition or whether it heightened the barriers to entry.
There are 3 types of conglomerate mergers: market extension, product extension, and diversification mergers.
- A market-extension merger occurs when the acquiring firm wants to sell a product in a new market by merging with the firm already selling in that market.
- A product-extension merger occurs when the acquiring firm wants to add a closely related product to its lineup.
- A diversification merger occurs when 2 or more firms merge who provided unrelated products or services.
- Interlocking directorates, where individuals serve as directors on the boards of 2 or more competing companies simultaneously, are prohibited, but only if either of the corporations has capital, surplus, or undivided profits aggregating more than a specific amount or competitive sales of a certain amount [2018: $34,395,000 and $3,439,500, respectively], both of which are adjusted for changes in the gross national product, and published each January by the Federal Trade Commission [FTC]. Any mergers or acquisitions exceeding a certain threshold, which in 2018, was $84.4 million, must be reported to the FTC under §7A of the Clayton Act.
Price Regulation
There are some products that can be provided at a lower cost by a natural monopoly than what could be provided by competing firms. The primary characteristic of a natural monopoly is that its average total cost declines continually over any quantity demanded by the market. If the industry has a large fixed cost, then a single firm can provide the product at a much lower cost than several or many firms, because the average total cost of each firm will be much higher than it will be for the natural monopoly. Hence, a natural monopoly can provide a product for a lower price if there is no competition. Some examples of a natural monopoly include the distribution of natural gas, electricity, and landline phone service.
What price should be set for the natural monopoly? For a competitive firm, profit is maximized when marginal cost [MC] = market price. However, since the average total cost of a natural monopoly continually declines, the marginal cost will always be less than the average total cost [ATC], since the average total cost is the average of all costs including the large fixed costs while the marginal cost is only the extra cost of producing an additional unit. Therefore, a natural monopoly will continually lose money if the price that they can charge is limited to its marginal cost.
A better regulated price would be one that allowed the monopoly to charge a price — sometimes called the fair-return price — equal to its average total cost, which in economics, also includes a normal profit. This would allow the natural monopoly to survive as a going concern, but it would not incentivize the owners to reduce costs. So this type the regulation can be enhanced by allowing the monopolist to keep some of the profits earned by reducing costs. Note that this price is less than the price charged by a profit-maximizing monopoly, which selects the price where marginal cost = marginal revenue [MR].
Government Ownership
Sometimes the government will regulate a monopoly by actually owning it. For instance, in the United States, the federal government owns the United States Postal Service, and in Europe, many governments own and operate utilities, such as water and electricity.
The main problem with government ownership is that these monopolies are operated by bureaucrats, and more often than not, they are unionized, so they have little incentive to operate the business efficiently or to provide good service to the taxpayer. Indeed, if technology were available that increased the efficiency of the monopoly, the bureaucrats would probably reject it to protect their jobs. Furthermore, the bureaucrats act as a special interest group who seeks to enrich themselves at taxpayers' expense. As a monopoly, they don't have to worry about competition. That bureaucrats, and especially unions, operate in their self-interest is well evidenced in the United States by their high salaries and lush pensions, even though most of their work is administrative and under ideal conditions. A primary reason that Greece is so far into debt is because a large part of the Greek economy consists of public workers, whose actual work is often nonessential or perfunctory, yet they have relatively large salaries and a nice pension, and they can retire quite young.
Exemptions from Antitrust Laws
There are several activities exempt from antitrust laws, including the following: labor unions, insurance, agricultural associations and fisheries, foreign trade, oil marketing, cooperative research and production, joint efforts by business people to obtain legislative or executive action, and professional baseball.
So, competing firms can jointly lobby Congress to enact special interest legislation. Other main exemptions of the antitrust laws include actions by governments, especially those that further the public interest or that further the defense of the nation. Also, many activities of regulated industries, such as communication and banking, are also exempt from antitrust laws, since other federal agencies have primary regulatory authority.
Why is baseball exempt from antitrust laws and not other private professional sports? Because the United States Supreme Court said so in 1922, and though it has been modified by the Curt Flood Act of 1998, baseball is still less restricted than other professional sports regarding antitrust concerns. The original Supreme Court decision was justified by arguing that baseball was a local activity [i.e., not interstate commerce], although today, professional baseball is hardly local.