Imperfect Competition and Government Policy

It should be fairly obvious at this point the appeal that market power has to firms.  It is in market power where firms find economic profit. They can pursue market power two ways.  The first is that they could attempt to cooperate with other sellers.  They could collude to raise prices, lower output, and raise profit.  In essence they could form a cartel.  At RIU, we may find Tammy organizing the other tutoring services and having them agree to restrict the number of hours of tutoring supplied, which should drive up the price.  You could also find that Tammy was able to reduce competition through a program of mergers and acquisitions - buying up her competitors.  Tammy could grab control of the market by buying up the competitors.  The advantage of this approach is she would not need to worry about the possibility of some of the cartel members cheating. 

Just as the prospect of economic profit drove Tammy to gain control over the tutoring market, it will drive other firms in other industries to do the same.  The US government, recognizing the potential loss to consumers due to the concentration of power in the hands of a few, has taken on the responsibility of restricting the accumulation of market power through its antitrust laws. There are also instances where the government sets out to actively discourage the competitive outcome in markets.  When it does limit competition and contributes to the accumulation of market power in the hands of a few firms, it must step in and regulate behavior to protect consumers from an abuse of power.  Back at RIU, we will find that there are some instances where the administration would want Tammy to have a monopoly on tutoring because it believed the students would be better off with a single seller.  If this were the case, however, the administrators would need to set some guidelines to protect the students from Tammy's natural instinct, which would be to exercise the market power and raise prices.

It is no accident that both the antitrust and industry regulation movements in the US emerged in the late 19th Century in the midst of what has been referred to as the "Robber Baron" era - the era of the likes of Rockefeller, Carnegie, Gould, Vanderbilt, and Mellon who built those summer homes along Bellevue Avenue in Newport, RI.  This was a time where the structure of industry was being radically transformed as the geographical scope of the market expanded and market power became increasingly concentrated in the hands of a few industry titans.   Any balance of power that had existed between employers and employees, and between businesses and consumers, was being lost as the scale of operations expanded.  Before we talk about the specifics of industry regulation and antitrust policies, however, we will take some time to examine the setting of the late 19th Century.

The Setting

The late 1900s was a time of rapid economic growth fueled by immigration of workers from abroad. In the 1880s the US experienced a dramatic surge in the number of immigrants with nearly 525,000 entering the country each year. In addition to being markedly larger than earlier immigration flows, the flow also differed in terms of area of origin. In this second wave of immigration, the majority of the immigrants were from southern and central Europe, whereas in the earlier period they were centered in northwestern Europe. It is in this period that tens of  thousands of immigrants came from Ellis Island to Rhode Island to work in the state's mills.

This was also a period dominated by the processes of urbanization and industrialization. Whereas in 1860 more than 4 of every 5 Americans lived in rural areas, by 1920 the majority of the nation's population was urban. As in England in the early days of the industrial revolution, the urbanization was associated with concentrated rather than dispersed growth. By 1900, the major cities of the US were large by international standards. New York City with its 3.5 million inhabitant was three quarters the size of London, up from approximately one quarter only fifty years earlier, while Chicago and Philadelphia, both with populations exceeding 1 million, were all larger than Glasgow, the UK's second largest city. In all of the US, by 1920 there were 144 cities with a population exceeding 50,000, up from only 16 in 1860, and over 60 percent of the urban population was living in one of these larger cities. A full 18 percent of those living in urban areas were living in the three cities with more than 1 million people, New York City, Chicago, and Philadelphia.

As you can see from the table below, it was also a period of westward movement. By 1900 Chicago had become the nation's second largest city and Cleveland, San Francisco, Detroit, and Milwaukee had joined the list of the fifteen largest cities.

Population of America's Cities
(1,000S)

A search for those factors most responsible for the spatial transformation of the US during this period should begin with innovations in transportation technology, or more specifically in intercity transportation. At the top of the list would have to be improvements in, and expansion of, the railroad system. Railroad track mileage increased an impressive 800 percent as the railroad made its entry into the west with the opening of the first transcontinental railroad in 1869. The opening of the Union Pacific's line, together with two additional lines opened by 1900, increased access to the West. This was also the era in which we saw the emergence of the iron-and-steel frame construction process that allowed for a substantial increase in the height of buildings. This would have been an uninteresting architectural development had it not been for Elisha Otis's elevator, which he introduced at the Crystal Palace Exposition in New York City in 1853. This innovation allowed buildings to be built higher, increasing sharply the potential employment in the city by increasing the potential floor space. [You might want to revisit the discussion of land to see what this would do to the level of rents in the center of cities]  The first modern 'skyscraper' appeared on the scene in 1885, a ten story building erected in Chicago for the Home Insurance Company of Chicago.

A second factor contributing to the urbanization was the continued industrialization of the economy. In the previous periods the US could be best thought of as a vast supply of resources that needed to be tapped for the developed world in Europe. The cities that developed were primarily mercantile cities - they were the exit points of resources from the region and the ports of entry for the immigrants and manufactured commodities into the region. What little manufacturing that was done, was done primarily to clothe and feed the people so they could exploit the resources, and it was done primarily in the cities in the Northeast. The wealth and size of the cities was dependent upon the value of the resources in its hinterland which in turn depended upon the transportation network (ex. New York City and Erie Canal).

This changed dramatically, however, in the post Civil War period as the manufacturing sector expanded rapidly and underwent significant structural changes. The industrialization of the economy was characterized by changes in the industrial and occupational mix, the scale of operation, the form of ownership, and the location of production. At the aggregate level, in 1870 the US ranked second behind the UK with 23 percent of the world's manufacturing output. In little more than a decade the US had surpassed the UK and by 1913 the US accounted for 42 percent of the manufacturing output of the world. It should not be surprising that between 1860 and 1920 the share of our exports that were manufactures increased from 11.4% to 39.7%, while manufactured goods' share of imports declined from 50% to 17%. By 1920 we were exporting cotton manufactures, automobiles, iron and steel, and machinery.

An additional indicator of the meteoric growth of the manufacturing sector was the changing composition of the labor force. In the period 1840-1910, the share of employment in agriculture fell from 2 of 3 to 1 of 3. The main gains in employment were in the manufacturing sector. During this same period, the share of jobs in the manufacturing sector increased from less than 9 percent to more than 22 percent of total employment. 

In addition to moving from the farms to the factories, the factories were also getting much larger, and it was only in the major cities where these firms were likely to find the workers for their factories. There was also a definite pattern of specialization among the major industrial cities. For example, at the end of this period Chicago had become the center for agricultural implements, Pittsburgh was the center of the iron and steel industry, and Detroit was the auto making capital of the country.  This was the era of substantial merger activity when the corporation emerged as the dominant form of business ownership as individuals sought to finance the rapid expansion of these capital intensive industries. By 1919, nearly 7 of every 8 workers was employed by a corporation.

To counteract the growing power of the country's employers, labor began to organize. In 1869 the Knights of Labor,  the nation's first labor union was established, but it proved to be unsuccessful.  The first successful union was the American Federation of Labor founded in 1886.  The success of the union has been attributed to the fact it was a true business union that avoided social causes. This ushered in a bloody period of conflict between workers and management in this country - a conflict that at times erupted into violence. Some of the more notable disturbances were the 1877 national strike called in response to the Pennsylvania Railroad's decision to cut wages 10% in recession, the Haymarket violence of 1886 triggered by a lockout at a McCormack reaper factory, and the Pullman strike called in 1893 because Pullman wanted to raise rents on his tenants' apartments at the same time as he lowered wages.

This concentration of powered was also responsible for the Progressive movement at the turn of the century. It was out of this national movement that we saw the emergence of policies to regulate existing big business and preserve competition. In the next section we will look at the regulation of American industry which will be followed by a discussion of antitrust legislation.

Regulation

The consolidation of market power in the late 19th Century was nowhere more evident than in the oil industry that had become dominated by the Rockefellers and their company, Standard Oil of Ohio.  In an effort to solidify their control of the industry, in 1879 an agreement was drawn up that established a trust to manage the properties of Standard Oil that already controlled 90 percent of the refining capacity in the country.  While possibly the most notable, the concentration of market power in the oil industry was in no way unique.  In tobacco the consolidation was led by James Duke, in meat-packing it was Swift and Armour, in steel it was Andrew Carnegie, in copper it was Guggeheim, and in explosives it was DuPont. In each case the consolidation was accompanied by the amassing of great fortunes.  One manifestation of the magnitude of these fortunes would be the mansions in Newport which were the summer cottages of these titans of industry. 

It should not be surprising that many viewed this as the time for Big Government to rise up and reign in the power of these industrial giants, and the government responded by embarking on a number of programs designed to 'protect' the American way.  Where Europe moved in the direction of nationalization of their industries, the US moved in the direction of regulation.  The first of these was passage of the Interstate Commerce Act in 1887 that established the Interstate Commerce Commission (ICC) to prohibit anti-competitive practices. From this beginning, the regulation of American industry has evolved as the government attempted to control certain aspects of private sector behavior for public interest. The move toward regulation of industry emerged from a belief that economic and social problems created by a conflict between private interests and public goals could not be solved by unrestrained competition. The regulation of American industry can be roughly divided into two categories - economic regulation and social regulation. 

Economic regulation tends to be industry specific and focuses on government control of economic decisions. This type of action is justified to limit the actions of monopolies, promote universal service, restrict competition, and nurture infant industries.  We are going to look at the first two of these and we will begin by returning to Tammy's Tutoring.  We will focus our attention on economic regulation.

Social legislation,  tends to be product specific and cuts across industry lines. Here the focus is on specific attributes of the product. The justification for this type of government activity is most often the existence of externalities or the existence of imperfect information.

The regulation of American industry took place in two waves centered in the 1930s and the 1970s. The first wave was economic regulation that began with the formation of the Interstate Commerce Commission in 1887.  The movement did not gain much momentum, however, until the 1930s with legislative actions taken as part of the New Deal.  The earliest piece of social regulation came in 1906 with establishment of the Food and Drug Administration, but it was not until the 1970s that we saw the big push behind social legislation.

History of Regulation of American Industries

Economic Regulation

The obvious question to be asked here is: Why would a government want to restrict competition in certain industries given what we have seen about the advantages of competition?  To understand the basics of the argument, let's look at the situation the RIU administrators see in the tutoring market.  According to Tammy's read of the market, the best tutoring will require the purchase of a new interactive software package and a few workstations at which students can work.  The software and hardware are not cheap though.  To service a maximum of 1,000 students a week, the software will cost $6,000 and the hardware will cost $14,000.  To make life easy, we will assume that each tutor can service twenty students, the tutor will be paid $120 per student, and Tammy must pay for the hardware and software in the first year, although in a more "real" problem, it would be paid off over a longer time horizon.  The financials of the firm appear below and to the casual observer they look very much like what we have seen before.

The fixed cost (FC) column represents the capital outlay that will not be affected by the number of students.  The variable (VC) column is derived by dividing the number of student by 20 to obtain the number of tutors.  With 400 students, there will need to be 20 tutors and each will receive $120 bringing variable cost to $2,400.  The average fixed cost (AFC) and average variable cost (AVC) are derived by taking the totals and dividing by the number of students.  If we add the two together we have average total cost (AC).

Tammy's Tutoring: A Natural Monopoly Case

To see the difference between what we have here and the more traditional situation, the graph of AC is provided.  Rather than the traditional U-shaped curve, we have a downward sloping AC curve.  What this means is that the cost per unit of production continues to decline as the market expands.  If Tammy had 200 students, then the cost per student would be $106, but if Tammy could expand to 600 students, the average cost would drop to $39 per student. 

Natural Monopoly / Decreasing Cost Industry

The situation that we see at Tammy's has a name.  The downward sloping average cost curve is the dominant characteristic of a natural monopoly.  It is called a natural monopoly since you would expect a monopoly would emerge as the natural outcome of a competitive process.  Since AC continues to fall as output increases, a competitor would lower price which would expand demand and this would tend to lower cost which would be passed on as lower prices...  The end result of the price war would be one survivor.  If this would be where the market would end up, in the case of tutoring at RIU, you could expect to see the administration may very well be interested in reducing competition and establishing Tammy as the sole provider of tutoring services.

Another local example of government regulation of a natural monopoly would be the Block Island Ferry which many may end up taking to the island. This ferry service is regulated by the state because of the belief that the island is best served by a single provider of ferry services. The rationale is that since there is a high fixed cost of the boat, the average cost of providing service declines with more travelers.  For example, if the boat costs $10 million and it must be paid by the customers, the cost will be lower if there was one boat with 50,000 travelers than if there were two boats with 25,000 people.  This is likely to be the situation where an industry has exceptionally high fixed costs.  In the US the classic historic examples of natural monopolies have been utilities - electric and telephone.  The idea was simple - it made no sense having many companies string lines on poles that would clutter our streets and raise our bills when one set of lines and poles was all that was needed.  

The University also has another problem that it is worried about.  It has been trying to merge its three campuses into one university.  At the present time there is the main campus that is 50 miles from the state's major urban center, an urban campus in the middle of the center city, and a remote rural campus.  The University is interested in providing fiber optics to each campus so they would be connected via a high speed data line.  The problem is they have received bids for the services and the costs at the main and urban campuses are low, while the costs at the remote campus are high because there are simply not enough students there to lower the cost per student.  The private market system will want to see a link between price and cost, while for equity and political reasons the university wants uniformity in rates.  The problem facing the university is an example of a broader class of issues known as universal access.   In addition to the potential cost savings due to the declining costs of the natural monopoly, governments also got into the regulation business because they wanted to maintain universal access. 

To provide an incentive for the universal access the university would contract out with a firm and set a pricing structure that would allow the company to make a profit on the low cost campuses and use that profit to cover the losses on the high cost, remote campus. This behavior is called cross-subsidization of prices, and if this pricing scheme is to be regulated, then there needs to also be a restriction of entry and exit.  The restriction is necessary because a potential competitor could be expected to appear who would provide service for the high profit activities - a process called cream-skimming. 

For another example, we can return to the Block Island ferry service.  The problem should be apparent to anyone who has been to Block Island.  It is a wonderful place to be in the summer, but you could get very lonely in the winter.  As for the ferry service, potential suppliers would most likely be interested in the summer business when the tourist flow to the island is heaviest and not in the long winter months when the seas are heavy and the passengers few.  If it was your ferry service and you had your choice, you would likely shut down the operation in the winter or move it South  following the people and the sun.  The problem from the state's point of view with this "rational" profit maximizing behavior is that it would deny year-round residents year-round access. The same was true in the phone business where it would be much cheaper to supply service to an individual living in downtown Providence calling someone in New York City than to someone on Block Island calling a friend in Presque Isle, Maine.  As for the possibility of cream-skimming, in the Summer of 1998 the regulatory agency received a proposal for a second ferry service to the island that would operate only in the summer months.  

The solution in both cases would be cross-subsidization of prices.  In the case of the ferry, the service would be able to charge a price above costs during the peak season to offset the loss in the slow season where the firm would charge a price below cost.  In the phone example, the profit made on the long distance call between cities would help offset the loss made on the rural service. 

Once regulatory agencies became involved in specifying restrictions to competition, they needed to set acceptable prices because there would be no market to prevent price gouging on the part of the seller.  Tammy could be expected to follow her good business instincts and exercise her market power to drive up prices and profit.  Similarly, once the monopoly had been granted to the Block Island Ferry, there was nothing to prevent it from raising its price to the level that a monopolist would charge.  If the monopoly were to be preserved, there would be a need to regulate the price.  This setting of prices turned out to be unexpectedly difficult for economists since in a declining cost industry there are serious problems with the P = MC rule. This is the socially optimal pricing solution adopted by perfect competitors and it would therefore seem to be the natural choice for a pricing scheme.  The problem is that  if costs are declining, MC is less than AC and now you can do the math.  If P is set equal to MC, then P is less than AC and on each unit of output the price is set below cost so the firm will by definition lose money.

One proposed approach was to set prices equal to average cost, but this was extremely difficult in situations where firms produced many products.  For example, when you are producing a number of products, how do you assign the costs of a machine used in the production of all of the products.  Or how do you divide up the time of a manager?  One proposed solution was the Ramsay Pricing Rule.  For a firm producing many products, the ratio of P to MC should be inversely related to elasticity of demand for the products. Where demand is inelastic, prices should tend to be higher which is what we would expect in an unregulated world - just what we found a price discriminating monopolist would do.  In the case of Tammy's tutoring, you would expect to see prices set highest for those who needed the service the most, not exactly what the university had in mind.

Fortunately for the University, there are other options.  An alternative approach to pricing that has been quite common and controversial is the guaranteed rate of return. The idea behind this approach is simple - people are in business to make money and this should be no different in regulated industries. If the government kept the rates of return lower in regulated industries, no one would invest in them. The government thus needed to establish a rate of return that the company could earn, and allow the firm to set prices to achieve this rate or return. 

In the case of Tammy, let's assume Tammy needed to invest $10,000 of her own money to get the business off the ground.  The university could then allow Tammy to recover the lost interest income in the prices set for the tutoring.  In addition to covering the operating costs (labor), Tammy could build into her prices $700 to cover the lost interest income on the $10,000. [You could expect a heated debate over what would be the appropriate return. Tammy would be proposing that the rate be set higher while consumer groups would push for the lowest possible rates].  In the case of the Block Island ferry, if the owners of the ferry had invested $1,000,000 in the company and the regulatory authorities believed that the owners should be able to earn the same 8 percent return as owners in other industries earned, then they would allow the ferry to set the price so that at the end of the year the ferry earned a "profit" of $80,000. 

No surprise this solution creates its own problems. The first is the lack of any incentive to minimize costs. The firm could simply charge some mark-up on the cost and thus there was no incentive to cut costs since the cost savings would not show up as profit but as lower mandated prices.  You could envision the perks  - the fancy corporate dining room and information gathering junkets  or 'fat' salaries to its managers - that would show up on the income statements.  It would not be too difficult to envision Tammy building in trips to Hawaii to "observe" how other tutoring operations are run.  Or she could have that nice corner office with the upscale furnishings to provide students with the correct image of success that her operation is encouraging.  In a competitive environment, these perks would disappear as lower cost competitors "stole" the customers with their lower prices, but in a regulated monopoly there is no comparable competitive pressure. 

Some economists have argued that the inefficiency argument is overstated because of what they refer to as regulatory lag.  Given that prices are set by some commission, price changes are infrequent and thus an efficient firm will earn the extra profit from its efficiencies until the next round of price hearings where the lower, more efficient costs will be reflected in the new prices.  There is also a rather new approach to regulation in which price caps are set by the regulatory agency.  The prices are set at levels expected to cover projected costs of operation and if the firm can beat the cost projections through efficiency gains, it can keep the difference, providing an incentive to seek out efficiencies.  You could certainly see RIU setting a price for Tammy and then Tammy was on her own to drive down prices and keep any of the newly created profit.

The rate of return criterion also introduced a bias into the decisions of regulated industries.  If the rate of return were regulated, then the size of the profit that could be earned was dependent upon the size of the capital base - a higher capital base meant a higher allowed profit. This tended to bias production decisions in terms of high fixed cost operations. In the ferry business it meant large outlays for ferry, in the electric utility business it meant investment in capital intensive generating facilities - a real push behind nuclear power generating plants. In Tammy's business, it would tend to push Tammy toward the computer intensive approach and away from the individualized instruction. 

Social Regulation

The government has also been actively involved with social regulation.  The earliest piece of social regulation came in 1906 with establishment of the Food and Drug Administration at a time when the delivery of food was undergoing exceptional change.  In 1934, in the midst of the Great Depression that many saw as the result of speculative excesses and abuses in the financial markets, the Securities and Exchange Commission was established to regulate the industry.  By the end of the Depression decade the airline industry was operating under the auspices of the Civil Aeronautics Board and soon after the end of WW II, the Atomic Energy Commission was established to regulate the nuclear power industry. 

It was not until the 1960s, however, that we saw the big push behind social legislation. This was a period where America turned to the government for solutions to its problems and Washington became home to a "brotherhood of scholars," "action intellectuals" who would lead the attack on social and economic problems. These were clearly good times to be an economist - and a liberal.  On the macroeconomic front, passage of the Revenue Act of 1964 ushered in the "Zenith of Keynesian Economics." By mid decade there was talk that the business cycle, the scourge of capitalist systems, had been tamed and an active government could defeat the problem of economic instability. There may have been room for refinement, for fine-tuning the model, but it was firmly in place so that there was little surprise when President Nixon, a conservative Republican, announced "Now I am a Keynesian."

Buoyed by their success and confident that government could right the wrongs of the market system, economists and policy officials turned their attention elsewhere.  The Occupational Safety and Health Administration (OSHA) in 1972 was charged with the task of providing safety in the labor market, the same year the Consumer Product Safety Commission was established to protect individuals in the output markets.  Michael Harrington's book The Other America had brought poverty to the attention of the American people at a time when they were increasingly insulated from it in their rapidly growing suburban communities and President Johnson sought to address it with his War on Poverty. There were also the problems of the environment, popularized in Rachel Carson's book The Silent Spring, that ultimately led to Earth Day and the formation in 1972 of the Environmental Protection Agency (EPA). In the following year Occupational Safety and Health Administration (OSHA).  And if that were not enough, the science community had delivered on Kennedy's promise to put a man on the moon before the end of the decade.

By the mid 1970s, however, there was a backlash against regulation and we began to see the move toward deregulation. In part this was a reaction to the stagflation that hit the American economy in the 70s. We were experiencing for the first time unacceptably high levels of inflation and unemployment, and one of the oft-mentioned culprits was regulation that was seen as raising the costs of industry and lowering the rate of productivity advances. 

The attack on regulation came from many directions.  One idea was that the balance of power between small groups of producers being regulated and the many consumers would favor the producers who could effectively lobby for their position.  Others were concerned with the balance of power because you would actually find industries that wanted to be regulated since regulators could be controlled by the industries. This was likely to happen because the agencies were often staffed by industry experts and the regulators often went on to lucrative private sector jobs in the industry. Still others were concerned with the problem of inefficiency mentioned earlier. Firms had little incentive to lower costs if profit was regulated away so there was a tendency to "accumulate substantial managerial slack or 'X-inefficiency'" and retard innovations in marketing, operations, and technology. Regulated industries would not be too likely to help in the battle to constrain price inflation. 

In addition to retarding innovations, regulation also retarded operating efficiency.  According to Winston, "entry barriers prevented firms, such as airlines and motor carriers, from developing their networks optimally; exit barriers prevented firms, such as railroads, from shedding excess capacity; and price regulations prevented firms, such as natural gas pipelines, from efficiently marketing their capacity during peak and off-peak periods." 

This movement toward deregulation in the US translated into a move toward privatization in those countries that had gone the nationalization of industry route. In both instances we were seeing a roll back in the power exerted by the government. The major deregulation decisions in the US are listed in the table below.

Major Deregulation Decisions

What are some generalizations we can make as a result of the deregulation?  Winston and Peoples in their articles in the Journal of Economic Perspectives (summer 1998) describe the impact deregulation has had on the affected industries and on the labor market.  According to Winston, the adjustment of industries to deregulation has been slow, but there has been a general increase in efficiency in the deregulated industries that has benefited consumers.   One result has been increased competition among existing firms and new entrants.  "The net result of entry, exit, and mergers has generally been that competition in actual markets becomes more intense." This in turn has been accompanied by innovations and improved corporate governance as new, younger, more entrepreneurial managers entered the industries.  A summary of the improvements in industry efficiency appearing in Winston appears below. 

Improvements in Industry Efficiency and Consumer Welfare

What remains to be seen is whether the consolidation movement in the airline industry in 1998 will reverse some of the earlier gains in competition  It is also a bit early to call what will be the impact of the deregulation in telecommunications, electricity, and cable television.  In its September 26, 1998 volume, the Economist reported that the formation of a new alliance, Oneworld, will give the four big alliances control over nearly 80 percent of the revenue passenger miles. 

In the telecommunications, electricity, and cable television industries the deregulation has been associated with technological change that has changed the perception of these industries as natural monopolies.  The expectation is that consumers should once again benefit, but there will be significant transition difficulties including the problem of "stranded assets" - assets previously regulated firms have that were only optimal in the regulated environment. 

One example of that has been the debate over the deregulation of the telecommunications industry - the subject of three articles in the Fall 1997 volume of the Journal of Economic Perspectives.  In the United States the provision of phone service has been done by a system of private sector companies that the state has regulated - a far different approach than taken in most countries where there are government owned phone companies.  The US "developed a system of 'rate of return' regulation with two purposes: to promote large-scale sunk investment in private infrastructure by reducing political, legal, regulatory, and competitive risk through an assured rate of return; and to protect ratepayers from prices higher than those required to generate that rate of return."  The goals of the Telecommunications Act of 1996, a revision of the Communications Act of 1934, were maintenance and expansion of universal service, promotion of competition and its associated benefits (price reductions, quality improvements, and new service innovations), and stimulate investment in the "National Information Infrastructure."  The goal of increased competition has been promoted by the FCC since the 1960s and in 1994 the FCC began to hold auctions for portions of the radio spectrum to promote competition in long distance phone service.  Whether these goals will eventually be realized, however, is an open question - one addressed by Harris and Kraft (Journal of Economic Perspectives, Fall 1997). 

To see what has been happening in the telecommunications industry, we can return one last time to Tammy's operation.  The arrival of the internet and the arrival on campus of the high speed network has changed dramatically the tutoring business and we can expect that it will change the structure of the industry.  Now a tutoring service can distribute the software over the network and avoid the hardware costs.  In fact, the software could be located at some central source and simply pushed into the RIU campus.  This would take away the rationale for a sole supplier of tutoring services.  In this new technological environment, there is no natural monopoly and there is no problem with universal access so you could expect the university to get out of the regulation business. 

Before leaving the discussion of deregulation, we will look briefly at the impact that the deregulation has had on the labor markets.  Unfortunately there are no easy generalizations since the impact of deregulation on average earnings, employment, and unionization has varied sharply across the trucking, railroad, airlines, and telecommunications industries.  The extent of the changes between 1973 and 1996 are apparent in the table below based on Peoples' article.  Unionization has declined most rapidly in trucking and telecommunication - down from nearly 1/2 to 1/4 in trucking and 60% to 30% in telecommunications - while it has declined most slowly in railroad - down from 83% to 74% and airlines - down from 46% to 36%. 

The employment and earnings situation across industries looks quite different.  Workforces in trucking and airlines expanded sharply faster than the national average while employment in the railroads declined by nearly 50%.  Earnings, meanwhile fell most in the trucking industry and airlines, held fairly constant in railroads, and rose in telecommunications.  

Where do we go from here?  It is too early to call on the impact of deregulation and the reconsolidation on telecommunications and the electric industry, but there is reason to be optimistic that the gains that have accompanied previous rounds of deregulation.  What we certainly can expect is the deregulation and privatization movements to continue as the battle over the correct boundary between the market and the government continues. 

Antitrust

Although there may have been a few instances where it was in society's interest to restrict competition, in general the sentiment was that competition should be maintained wherever possible.  With passage of the Sherman Antitrust Act in 1890, the US government set about the task of influencing the ways firms compete.  The legislation passed in 1890 states:

• Section 1 "every contract, combination in the form of trust or otherwise, or conspiracy in restraint of trade or commerce among the several states, or with foreign nations, is declared to be illegal"
• Section 2 "every person who shall monopolize, or attempt to monopolize with any other person or persons, to monopolize any part of the trade or commerce ...shall be deemed guilty of a felony"

While the government has in "theory" had antitrust legislation on the books since 1890, in "practice" the enforcement and interpretation has been anything but constant.  Antitrust law has been the subject of continuing debate since 1890 as the thinking about competition has evolved through four distinct phases outlined by Koviac and Shapiro₁.  The four phases are delineated in the diagram below.  

In the first phase 1890-1914, economists' tended to support consolidation and concentration and their attitude on the statute ranged from "[it] seemed a harmless measure incapable of halting an irresistible trend toward firms of larger scale and scope" to it "would impede attainment of superior efficiency promised by new forms of industrial organizations."   In time the deficiencies inherent in the law became apparent. There were no definitions for the terms used in the law, such as monopolization,  and there was no agency assigned the task of overseeing enforcement of the law.  There was some activity during this period as the courts were able to identify illegal activities ( price-fixing), but they were unable to slow consolidation and staggering market shares.  In the sugar market, for example, 98 percent of the market was  controlled by the Sugar Trust.  The era closed with the Standard Oil case where the government forced the break up of Standard Oil into 34 parts.  

Phase two begins with passage of the Clayton Act and the Federal Trade Commission Act in 1914.  The Clayton Act was designed to remove judiciary discretion in antitrust cases by specifically outlawing certain behavior

The first of these laws declared illegal four specific practices that may substantially lessen competition or tend to create a monopoly. The illegal practices were:

• price discrimination: This would have outlawed the rebates received by Rockefeller as he drove his competitors from the market. 
• tying contracts: This made it illegal for a seller to force a buyer to buy other products sold by the seller. It also outlawed the practice whereby a seller would force a company not to sell a competitors product if it wanted to sell its product.
• interlocking directorates. This prohibits competitors from having the same people on their corporate boards.
• acquisitions of competing companies: Firms were restricted in their ability to buy up other companies if it reduced competition.

In the second act, a five member commission was established to eliminate unfair competition in commerce by investigating unfair practices and issuing cease and desist orders.  Despite passage of this legislation, there was no effort to increase prosecution of cases.  In fact, this was an era where "the courts relied heavily on reasonableness tests to evaluate business conduct and often treated suspect behavior permissively."  It was also a time where cooperation among competitors was encouraged  - a policy supported by Herbert Hoover who served as Secretary of Commerce before his inauguration as President.   In this environment, the economic collapse of 1929 was viewed as a painful example of the deficiencies competition and "verified the associationalist preferences that the government take stronger steps to orchestrate commerce."  Some of the steps to be taken by the government were built into the National Industrial Recovery Act (NIRA) that was a part of Roosevelt's early New Deal program.  At the same time, the "hands off" attitude was generally reflected in the Supreme Court's decisions of the time.  Some behaviors such as price fixing were treated as unacceptable, but there was little effort to restrict cooperation and virtually no effort to aggressively increase competition by narrowly defining market areas.  

The Robinson-Patman Act of 1936 further strengthened the restrictions on price discrimination, although some would say that the act was really aimed at preserving small businesses in the face of growing chain stores and mass retailers.  Support for government planning tended to erode in the 1930s in the midst of a "trustbusting revival" centered at the University of Chicago.   "The invigoration of antitrust enforcement in the late 1930s reflected both a heightened suspicion of corporate gigantism and a search for ways to simplify the government's burden of proof."  As a result, in this period the "rule of reason" was replaced with "per se tests"  and the courts "grew more willing to find that dominant firm had acted improperly."  In 1945 "the fulfillment of new demand through preemptive addition of capacity" (US v. Aluminum Co. of America) was deemed illegal as was the "use of localized price cuts to challenge the leading local producer."  The Celler-Kefauver Act of 1950 placed further restrictions on mergers that would reduce competition and by the 1960s market share was increasingly used as a deterrent to mergers and acquisitions and "antitrust's pendulum had swung dramatically away from the permissiveness of the 1920s and early 1930s."  

Enforcement of antitrust is entrusted to the Federal Trade Commission and the Antitrust Division of the Department of Justice. One of the interesting features of the system is their use of private law system.  Suits can be initiated against one company for anticompetitive behavior by another company that will seek treble damages. An example of this would be MCI which sued AT&T over access to phone service. 

The fourth phase began in 1973 with the Chicago school once again providing the theoretical basis for a shift in antitrust policy.  The thrust of antitrust legislation was weakened, however, with the adoption of the rule of reason that was at the core of the Chicago School's approach.  .  Size by itself was eliminated as a "bad" and monopoly was only to be restricted when it was accompanied by 'objectionable' policies. Here we often saw the conflict between equity and efficiency, with the Chicago School tending to side with the efficiency.  One of the driving forces behind the switch was the stagflation of the 1970s that appeared to weaken the competitiveness of US companies.  Cases against Kodak, International Harvester, IBM, and Microsoft have all been dropped because of this rule of reason, but the US v. AT&T in the early 1980s forced the break up of AT&T.  The Department of Justice opened an investigation of AT&T which controlled phone service in the US and who was suspected of antitrust violations.  The settlement that appeared in the Modification of Final Judgment, commonly known as MFJ, forced AT&T to divest itself of seven Regional Bell Operating Companies.  These seven 'baby bells' [Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis, Southwestern Bell, and U.S West] each controlled a share of the market that was divided into 161 local access and transport areas (LATAs).  In New England phone service was supplied by NYNEX until the merger between NYNEX and Bell Atlantic.  Each of these companies was given control over all local calls and toll calls originating and ending in a specific LATA, but was restricted from carrying calls across LATAs.  The MFJ also ordered the separation of the manufacture of telecommunications equipment from the delivery of telecommunications service.

The result was increased competition in the provision of long-distance phone service and phone equipment as new start-ups appeared on the scene.  Local service, however, remained free of most competition until the late 1990s when we began to see large, existing players such as AT&T and MCI moving into local networks.  In that period we also saw the emergence of "self-supply" or "contract carriage" where large companies and owners of multifamily dwelling units purchased a private branch exchange or made direct connections to long-distance service through satellites.  Chevron and Toyota, for example, link their corporate offices and local stations and dealers using wireless transmissions.  We have also seen new companies that are actually building their own fiber-optic network in some of the large metropolitan areas. 

In 1998 the Department of Justice launched another high profile antitrust suit - this time against Microsoft.  Microsoft has been accused of violating the Sherman Act by illegally seeking to protect its dominance in the market for desktop software and using that power to expand it into their markets.  According to the suit, Microsoft attempted to work with Netscape to divide up the market for internet browsers.  Microsoft is also accused of "threatening' computer makers with withdrawing their Windows licensees if they refused to install Microsoft's browser.  Others see Microsoft's practice of bundling software, coupled with predatory pricing, as abuses of its monopoly power.  By bundling the software Microsoft essentially drives the price to zero and drives out competition.  It promises to be an interesting case in which we can expect to see whether the claim made in Fortune at the outset of the trial holds true. According to the Fortune article, antitrust has changed substantially since the IBM case of the 1970s and 80s and now "the courts have become much more rigorous about what constitutes a violation of the Sherman Antitrust Act.  Companies that gain monopolies through legitimate means deserve praise rather than condemnation, the courts now believe."

What happens next with antitrust will be determined in part by what happens with the actions brought in 1998 against Microsoft and Intel that dominate the computer operating and processor markets.  The Microsoft case will offer us insight into the current thinking in antitrust.  If you have followed it in the past you have seen a bit of the debate between those who believe it s structure that matters and those who believe it is conduct that matters.  In fact it was not the structure of the industry, Microsoft's near domination of the operating systems that triggered the latest round of actions, but rather Microsoft's tying and exclusive dealing which are being attacked.  It has been years since there has been such a high profile case, and we will know much more about the future of antitrust after the case has been settled.

1 William E. Koviac and Carl Shapiro, "Antitrust Policy: A Century of Economic and Legal Thinking," Journal of Economic Perspectives, 14.1 2000