We have seen that monopolies have the ability to raise prices and restrict quantities, putting them at the other end of the spectrum from the competitive market price-taker ideal. Thus, monopolies are price makers. Also, we have just seen that firms use their market power to price discriminate, attempting to achieve as much producer surplus as they can even if it comes by way of reducing consumer surplus. In an attempt to mitigate the maximum market power of monopolies, government has used two approaches: regulation and antitrust.

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As we saw when we discussed barriers to entry, there are some instances when natural monopolies occur. A natural monopoly exists when economies of scale are so large that the minimum efficient scale of operation is roughly equal to market demand. In this case, efficient production can only be accomplished if the industry lies in the hands of one firm—a monopolist. Public utilities and water departments are examples.

How can policymakers prevent natural monopolists from abusing their positions of market dominance? There are various approaches to dealing with natural monopolies: (1) They can be publicly owned, (2) they can be privately owned but subjected to price and quantity constraints, or (3) their right to operate could be auctioned to the firm agreeing to the most competitive price and quantity conditions.

A market representing a natural monopoly is shown in Figure 10. Notice that the average cost and marginal cost curves decline continually because of large economies of scale.

If the monopolist were a purely private firm, it would produce only output Q_M and sell this for price P_M (point a). Accordingly, the monopolist would earn economic or monopoly profits, and consumers would be harmed, receiving a lower output at a higher price. This is the major argument for regulation.

Marginal Cost Pricing Rule Ideally, regulators would like to invoke the P = MC rule of competitive markets and force the firm to sell Q_C units for a price of P_C. This is the marginal cost pricing rule and would be the optimal resource allocation solution. Yet, because price P_C is below the average total cost of production for output Q_C, this would force the firm to sustain losses of cd per unit, ultimately driving it out of business. The public sector could subsidize the firm by an amount equal to area P_CC_Cdc; this subsidy allows the firm to supply the socially optimal output at the socially optimal price, while earning a normal return. This approach has not been used often in the United States. Amtrak, with its history of heavy subsidies for maintaining rail service, may be the one major exception.

Average Cost Pricing Rule The more common approach to regulation in the United States has been to insist on an average cost pricing rule. Such a rule requires that the monopolist produce and sell output where price equals average total cost. This is illustrated by point b in Figure 10, where the demand curve intersects the ATC curve and the firm produces output Q_R and sells it for price P_R. The result is that the firm earns a normal return. Consumers do lose something, in that they must pay a higher price for less output than they would under ideal competitive conditions. Still, the normal profits keep the firm in business, and the losses to consumers are significantly less than if the firm were left unregulated.

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Regulation in Practice The United States has a long history of public utility regulation. For most of this history, regulation has been accepted as the lesser of two evils. Monopolists have long been viewed with distrust, but regulators have just as often been portrayed as incompetent and ineffectual, if not lapdogs of the industries they regulate.1 Although this characterization is probably unfair, a number of economists, including Nobel Prize–laureate George Stigler, viewed regulation with skepticism and proposed changes on improving the efficiency of regulation.

1 See George Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics, 1971, pp. 3–21.

Regulating a large enterprise always presents immense difficulties and tradeoffs. For one thing, finding a point like b in Figure 10 is difficult in practice, given that estimating demand and cost curves is an inexact science, at best, and markets are always changing. In practice, regulators must often turn to rate of return or price cap regulation.

Rate of return regulation allows a firm to price its product in such a way that it can earn a normal return on capital invested. This leads to added regulations about the acceptable items that can be included in costs and capital expenditures. Can the country club memberships of top executives be counted as capital investments? Predictably, firms always want to include more expenses as legitimate business expenses, and regulators want to include fewer. Regulatory commissions and regulated firms often have large staffs to deal with such issues, and protracted court battles are not uncommon.

Alternatively, regulators can impose price caps on regulated firms, which place maximum limits on the prices firms can charge for products. These caps can be adjusted in response to changing cost conditions, including changes in labor costs, productivity, technology, and raw material prices.

Today, the pace of technological change is so rapid that regulation has lost some of its earlier luster and is not used as often. In fact, many utilities such as telephone services and cable television are so competitive that regulation is not as necessary compared to when they were once monopolies. Therefore, rather than regulate natural monopolies, government has sought to prevent monopolies and monopolistic practices from arising at all—what is called antitrust policy.

Rather than regulatory tinkering, governments have tried a broader approach to deal with monopolies and their market power. The goal of antitrust law is to preserve competition and prevent monopolies with their maximum market power from arising in the first place.

The origin of antitrust policy came in the late 1800s, when many large trusts were established, which brought many firms under one organizational structure allowing them to act as monopolists. Massive wealth accumulations by such “robber barons” as John D. Rockefeller (Standard Oil) and Jay Gould (railroads and stock manipulation) sparked resentment and fear against trusts and the growing inequity of income and wealth. Trusts had become so powerful—and so hated—that Congress passed the first antitrust act, the Sherman Act, in 1890. Antitrust laws and policies thus had their origins in trust-busting activity. Many of these laws still are in existence today with their primary role of preventing the inefficiencies associated with monopoly behavior.

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Several major statutes form the core of the country’s antitrust laws. The most important provisions of these laws (as amended) are described in Table 1.

The intensity of antitrust enforcement has varied over the past century, from an early focus on monopolies, then on mergers, and more recently on price fixing—conspiracies by firms to agree on industry prices to suppress or eliminate competition. Although price-fixing cases have been prominent, it is merger policy developed in the 1950s that has really stood the test of time. Mergers occur for many reasons, such as to eliminate competition from a former rival, to enlarge the size of a company, to achieve more market power, or to merge with a foreign company to pay lower taxes abroad. Regardless, economists and judges generally agree that the reason for antitrust enforcement is to prevent the inefficiencies associated with significant market power. Premerger notification for approval or challenge by the Department of Justice is designed to prevent mergers that have a reasonable likelihood of inhibiting market competition. This is easier said than done.

The first problem involves defining market power. What is the relevant product market? Some markets can be severely limited geographically, such as concrete, with its extremely high transport costs, and dry cleaning, limited by the unwillingness of consumers to travel far for this service. Other markets are national in scope, like airlines, breakfast cereals, and electronics. Still others extend beyond the borders of a country, with the forces of global competition increasingly reducing domestic market power.

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The second problem is determining the proper measuring device of market power. As an industry moves from competition to monopoly, pricing power rises from zero to total. One of the challenges economists have faced is developing one measure that accurately reflects market power or concentration for all these market structures.

Industries that become more concentrated increase the losses to society. Therefore, any measure of concentration should accurately reflect the ability of firms to increase prices above that point which would prevail under competitive conditions.

Concentration Ratios A widely used measure of industry concentration is the concentration ratio. The n-firm concentration ratio is the share of industry sales accounted for by the industry’s n largest firms. Typically, four- and eight-firm concentration ratios (CR-4 and CR-8) are reported.

Although useful in giving a quick snapshot of an industry, concentration ratios express only one piece of the market power distribution picture: the market share enjoyed by the industry’s four or eight largest firms. Table 2 shows the market shares of the four largest firms in two different industries. Industry 1 contains a dominant firm with 65% of the market, followed by a bunch of smaller firms. Industry 2 consists of four fairly equal-sized firms, followed by a bunch of smaller firms. In both industries, however, the four-firm concentration ratio is 85; that is, the top four firms control 85% of industry sales. But do the two industries exhibit the same level of monopoly power? Hardly! The second industry, whose top four firms are roughly equal in size, would be expected to be more competitive than the first, in which 65% of the market is controlled by one firm.

Without more information about each industry, concentration ratios are not overly informative, except to point out extreme contrasts. If one industry’s four-firm concentration ratio is 85, for instance, and another’s is 15, the first industry has considerably more monopoly power than the second.

Economists and antitrust enforcers, however, need finer distinctions than concentration ratios permit. For this reason, the profession has developed the Herfindahl–Hirschman index.

Herfindahl–Hirschman Index The Herfindahl–Hirschman index (HHI) is the principal measure of concentration used by the Department of Justice to evaluate mergers and judge monopoly power. The HHI is defined by the equation

HHI = (S₁)²+ (S₂)² + (S₃)² + … + (S_n)²

where S₁, S₂, … S_n are the percentage market shares of each firm in the industry. Thus, the HHI is the sum of the squares of each market share. In a five-firm industry, for instance, in which each firm enjoys a 20% market share, the HHI is

HHI = 20² + 20² + 20² + 20² + 20²

= 400 + 400 + 400 + 400 + 400

= 2,000

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The HHI ranges from roughly zero (a huge number of small firms) to 10,000 (a one-firm monopoly: 100² = 10,000). By squaring market shares, the HHI gives greater weight to those firms with large market shares. Thus, a five-firm industry with market shares equal to 65, 15, 10, 5, and 5 would have an HHI equal to

HHI = 65² + 15² + 10² + 5² + 5²

= 4,225 + 225 + 100 + 25 + 25

= 4,600

The HHI is consistent with our intuitive notion of market power. It seems clear that an industry with several competitors of roughly equal size will be more competitive than an industry in which one firm controls a substantial share of the market.

Applying the HHI The Hart-Scott-Rodino Act (1976) requires prenotification of large proposed mergers to the FTC and the antitrust division of the Department of Justice. Prenotification gives federal agencies a chance to review proposed mergers for anticompetitive impacts. This approach prevents some mergers from taking place that would ultimately have to be challenged by Sherman Act litigation, a far more costly alternative for the government and for the firms involved.

The Department of Justice and the FTC in 2010 issued revised merger guidelines based on the HHI. These guidelines classify industries as follows:

Mergers where the resulting HHI is below 1,500 will often be approved. Mergers with postmerger HHIs between 1,500 and 2,500 will be closely evaluated; they are often challenged if the proposed merger raises the HHI by 200 points or more. When the HHI for the industry exceeds 2,500, a postmerger rise in the HHI of 100 points is enough to spark a challenge.

These guidelines have worked well, giving businesses a good idea of when the government will challenge mergers. Most mergers are rapidly approved; the remainder often require only minor adjustments or more information to satisfy government agencies. In the end, only a few proposed mergers are seriously challenged.

Sometimes what looks like a monopolist does not act like a monopolist. Markets that are contestable fit this description. Contestable markets are those markets with entry costs low enough that the sheer threat of entry keeps prices low. Potential competition constrains firm behavior. For example, Microsoft might charge more for its latest version of Windows if Linux were not nipping at its heels. Similarly, the Around the World from earlier in this chapter showed how ABC stores in Hawaii keep prices low due to the threat of market entry.

Another common example of a contestable market is the airline industry. Small regional carriers often fly unique routes from small airports to major tourist destinations such as Las Vegas and several spots in Florida. Although many of these routes are unique (in that only one airline serves the route), airlines tend to keep fares reasonable rather than exploit their market power for that route. Airlines realize that if fares are priced at the monopoly level, another airline might enter and compete. The ability to change airline service routes quickly forces airlines to keep prices at a competitive level, even if they are the only airline providing service between two cities.

Today’s economy differs from the old economy in many ways. The old economy was grounded in manufacturing and selling physical goods such as steel, automobiles, appliances, and shoes, which involved significant production and distribution costs. Much of the new economy involves intellectual property, or the use of innovation to provide valuable services such as mobile apps, streaming services, and online education. When distribution costs for services are nearly zero, monopolies can be vulnerable when new ideas are created.

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Antitrust laws and policy therefore need to be adjusted to new market realities. Rather than regulate traditional natural monopolies such as electricity or taxi services, opening these services to competition is seen as a more efficient solution that reduces the need for bureaucratic rules. One federal judge and economist, Richard Posner, argues that all antitrust laws should be repealed and replaced with a simple statute that prohibits “unreasonably anti-competitive practices.”2

2Richard A. Posner, Antitrust Law, 2nd ed. (Chicago: University of Chicago Press), 2001, p. 260.

This and the last chapter looked at the polar opposite market structures, competition and monopoly, with the characteristics of each shown in Table 3. The next chapter examines the market structures in the middle and also a more modern approach to analyzing firm behavior, game theory.