Monopoly, Competition, and Public Policy - Final Review

How might a monopoly arise?

• natural monopoly (economies of scale, scope, & subadditivity)

• exclusive gov’t deal (e.g. USPS)

• networks (demand-side economies)

• anticompetitive behavior (i.e. price fixing, bid-rigging, horizontal & vertical mergers, ED, predatory pricing)

• intellectual property (rewards innovators, grants limited exclusive rights)

characteristics of a natural monopoly

• economies of scale

• economies of scope

• subadditivity

issues with first-best (competitive) pricing

1B pricing requires that regulators subsidize the monopoly so it breaks even (and stays in the mkt)

• subsidizing NM may reduce social welfare

• a firm knowing it will be “reimbursed” has poor incentives to control costs

• controversy surrounding use of public taxes to subsidize a private company

• taxes create DWL in other mkts

issues with second-best (break-even) pricing

monopoly may inaccurately report its costs to move up demand curve

rate-of-return regulation shortcoming

the Averch-Johnson Effect: regulated firm may have an incentive to overcapitalize—it will spend more on capital inputs to inflate its allowed return

alternatives to second-best pricing

• Demsetz franchise bidding

• contestable mkts

• intermodal competition

• public enterprise

• price discrimination (by NM)

Demsetz franchise bidding

gov’t auctions off exclusive rights in the form of a franchise; cost of collusion must be prohibitively high to legitimize the auction

issues w/ Demsetz auctions

• winning firm only needs to outbid runner-up, so may create DWL

• auctions work best with many bidders and ample competition

• competition may drive down price and quality; lower bid → desire for lower costs → lower quality

• gov’t hesitancy to cancel a franchise contract

contestable mkts

• assumes new firms face no disadvantage vis-a-vis existing firms;

• zero sunk costs;

• entry lag is less than price adjustment lag

intermodal competition

within-market regulation may be unnecessary if other modes effectively limit any firm’s market power

e.g. industrial transport: railroad vs trucks vs pipelines vs air freight vs ships

public enterprise

create a publicly-owned service; changes firm’s focus from profit maximization to social welfare maximization

price discrimination

firm separates potential buyers into submkts

types of collusion

• price-fixing

• bid-rigging

• market allocation

• tacit cooperation

• joint ventures

• information exchanges

Stackelberg first-mover advantage

if F1 can commit to producing an arbitrary q1, thereby making its threat to produce that much credible, then F2 will cede much of the market

ED: capacity commitment

Incur a large sunk cost today to build a factory that you can credibly threaten to switch on → thereby ramping up production and flooding the market → driving down price and capturing demand

learning by doing

overproduce now to slide down the “learning curve”

i.e. gain expertise via trial & error → cost advantage over future entrants

• note that, if entrant can catch up quickly, advantage might be short

raising rivals’ costs (RRC)

non-price predation

increases the residual demand for the predator’s product, allowing it to charge a higher price and/or sell a larger quantity

variants of RRC

• make technologies incompatible

• raise minimum wage

• exploit judicial process

• raise switching costs

• rase advert. costs

• sign LR contracts

• direct sabotage

aggressive reputation

convince potential entrants that you are tenacious by making a statement

respond forcefully to minor provocations

predation theory

an incumbent oligopolist induces exit by rivals to arrive at monopoly––but this process is costly

predation strategies are designed to deter rival firms

predatory pricing

set low prices to kill of firms that are already in the market

i.e. undercut rivals’ prices, forcing rivals to incur losses and eventually exit

predatory pricing vs limit pricing

predatory pricing is to eliminate existing competitors, whereas limit pricing is setting low prices to deter entry

explicit collusion

coordination that occurs using express communication

tacit (implicit) collusion

collusion that appears as the equilibrium of a noncooperative, repeated game

(e.g. an infinitely repeated Cournot game)

cartel stability inequality

(1-k)(n-k)² + (6-4k)(n-k)+(9-4k) >= 0

cartel formation

if there are at least 3 firms in the industry, a cartel will not form

a duopoly will form a cartel, but anything bigger will not

conditions for collusion

• high industry concentration

• entry barriers

• stable mkt conditions

• rapid mkt growth

• tech/cost symmetry

• product homogeneity

merger paradox

if the merger doesn’t reduce costs, firms would prefer to stay separate and earn greater profit

anti-trust analysis

• substitutes exercise

• cross-price elasticity: could a seller impose a “small but significant non-transitory increase in price”

• market shares

• concentration ratios: indication of mkt concentration

• Herfindahl Index (HHI): ranges from 0-10000, perfect comp. to monopoly

  • is sum of squared mkt shares of firms

• merger analysis & merger evaluation

policy responses to M&A

• divestiture: merger is allowed after certain assets are divested by one of the merging parties

• conduct rules/restrictions: allows merger to proceed, but imposes operating rules to control conduct

• initial conditions: merger subject to changes in initial conditions

predatory pricing rationale

• how much firm loses during predatory phase & length of phase

• discount rate, r

• gain of firm as a monopolist (recoupment profits) & length of recoupment phase before re-entry

• expected anti-trust penalties

entry/exit decisions

• enter if P > min ATC; exit if P < min ATC

• shut down when P < min ANSC

• change volume when P =/= MC

What does ‘turnover’ refer to?

The entry and exit of firms from industries due to various business reasons:

• financing

• insufficient revenue

• structural barriers

leader F1’s strategies to change tomorrow’s interactions

• merge w/ another firm

• enter a new market (or leave a current mkt)

• invest in R&D or patent licensing

• change location or product characteristics

• deter entry by potential rivals

• advertise to influence tomorrow’s demand

• collude with a rival

• vertically integrate to change relationships w/ supply chain

capacity expansion in the titanium dioxide industry

in the 1970s, DuPont was a major supplier of TiO₂

environmental laws threatened to shut down DuPont’s rivals, so DuPont announced plans to expand its current facilities and build a new one to deter entry/expansion by rivals

product proliferation

Incumbents launch new products until additional entry would not be profitable

product proliferation in the cereal industry

in the 1970s, the RTE cereal industry was highly concentrated w/ 85% of market served by Big 4

in the antitrust case, FTC found that incumbent firms had filled up the cereal aisle w a variety of brands, blocking new entrants

Rockefeller’s Standard Oil Empire

owned dozens of separate corporations, each operating in one state, and created a trust; nine trustees ran the 41 companies

Rockefeller would buy competition, improve efficiency, and undercut competition; “The Cleveland Conquest” when they absorbed 22 of 26 Cleveland competitors; Rockefeller showed comp his books and made a decent offer

Ida Tarbell exposed Standard Oil, writing 19 articles between 1902 and 1904, by revealing questionable practices and agitating the public

Standard Oil comprised 90% of mkt share, but participated in illegal monopoly activities:

• secret rebates & drawbacks

• predatory pricing

was eventually broken up into 34 smaller firms

indications of predatory pricing

conduct: F1 set price “too low” (based on some proxy)

intent: there is evidence that F1 attempted to kill of F2

probability of success: there must be substantial entry barriers

recoupment: F1 must be able to raise its price later to recover its short-run losses

The Phases of the Moon Bid-Rigging Scheme

a bid-rigging scheme that called for the automatic rotation of low bidders every four weeks

how the DOJ measures its antitrust effectiveness

level of fines collected, total jail time imposed, & pending grand jury investigations

provides insight into the objectives a bureaucracy might pursue in the absence of profit

The Clayton Act

outlaws mergers whose effect is to lessen competition or create a monopoly

Porter’s five problems revealing collusion

1. Detection by Authorities or Victims: collusion revealed by defecting members or complaints

2. Secret price cutting: cartel members undercut prices secretly

3. Entry: outsiders’ bids differ from cartel patterns

4. Reconciling disparate interests: cartels must manage internal conflict

5. Responding to changing circumstances: changing demand or costs require coordination w/o explicit communication

“killer acquisitions”

acquisitions that occur for the sole purpose of shutting down the acquired company to limit competition—leads to reduced innovation, limited consumer choice, and less long-run competition

case study: pharma

• without killer acquisitions, drug development in US could be 4% higher each year—these acquisitions are just smaller than the threshold for regulatory agencies

the case against vertical integration

• cost of VI may be higher if competitive markets are more efficient

• it is more difficult & costly to manage an expanded firm

• M&A itself is expensive

United States v. Adobe Systems, Inc., et al.

DOJ claimed Adobe, Apple, Google, and Intel (and a few others) agreed to an anti-poaching agreement involving highly-skilled technical workers

firms would cold-call other firms’ employees to poach; agreement not to recruit each other’s workers, depressing salaries & benefits

result was lower labor costs, limited labor mkt info, and standardized pay scales

How do you determine whether it is worthwhile to develop a drug?

calculate the net present value of the upfront cost and the future expected payoffs

What is the primary economic objective of a patent holder?

to maximize profit from monopoly rights through production or licensing

broad vs narrow claims (patent holder)

broad claims make it harder for rivals to invent around → stronger mkt power

narrow claims increase the probability of regulatory approval, less risk of invalidation

What is the downside of licensing to multiple firms?

downstream competition lowers margins and reduces licensees’ willingness to pay

Why might a PH prefer exclusive licensing?

It preserves monopoly pricing downstream, which maximizes royalty revenue

Why might a PH issue multiple licenses?

• to expand output

• reach more markets

• increase total royalty income

Why are ideas difficult to sell?

they are experience goods, meaning their value is known only after disclosure

Why are ideas under-provided in free markets?

They are public goods—nonrival (not depleted when consumed; MC = 0) and hard to exclude (can be consumed by those who do not pay)—which leads to the free-rider problem.

What role do patents play in public good economics?

They make ideas artificially excludable, incentivizing innovation.

How is licensing different from wholesaling?

IP is nonrival (MC=0) and PH can exclude entirely without producing, while the wholesaler must produce units.

What was the purpose of the Bayh-Dole Act?

It allowed universities to own patents from federally funded research → incentive commercialization.

• NU licensing income from Lyrica ($700M in a yr)

What is the global enforceability problem of patenting?

The enforceability of a patent is strictly national.

e.g. Elon Musk avoids patenting on SpaceX tech because China/Russia would copy it

What is a patent pool?

an agreement in which multiple patent holders bundle their patents together and license them out as a package

e.g. ~250,000 active patents in cell phone production process

What is the core allegation regarding Facebook’s acquisitions?

Facebook bought nascent competitors (WhatsApp, Instagram) to neutralize emerging threats rather than for efficiency.

How did Facebook use API restrictions anti-competitively?

It cut off data access to apps that grew too powerful or competitive, raising rivals’ costs and preventing them from expanding.

What triggered the Sarbanes-Oxley Act (SOX)?

The Enron & WorldCom accounting scandals revealing fraud, dishonest analysts, and weak governance. (SOX reinforced auditor independence, CEO sign-off, internal controls.)

Why are local newspapers considered potential natural monopolies?

High fixed costs and very low marginal costs mean one provider is often most efficient; duplicating newsrooms is wasteful.

What is a non-market failure?

Failures of government interventions—such as capture, rent-seeking, unintended consequences, or bureaucratic inefficiency.

What is Capture Theory?

Regulators become sympathetic to the firms they oversee, often due to shared culture, information dependence, or future job prospects.

What is the Revolving Door Problem?

Regulators move into industry jobs, creating incentives to favor firms during their government tenure.

What does the Ratchet Theory claim?

Regulation expands during crises and rarely recedes afterward, leading to long-term growth of regulatory bureaucracy.

Define bureaucratic entrepreneurship.

Bureaucrats expand their agency’s jurisdiction by framing new problems as requiring regulation, increasing budget and power.

Why is electricity transmission considered a natural monopoly?

Extremely high fixed costs + low marginal costs → duplicating transmission lines is inefficient.

What is merit-order dispatch?

Grid operators use lowest marginal-cost generators first; high-cost generators are used only at peak demand.

What made the Apple e-books case a clear example of price-fixing?

Apple coordinated with publishers to raise e-book prices and restrict competition with Amazon.

Why do cartels form even though they are unstable?

Joint profits under monopoly exceed Cournot profits & repeated interactions allow punishable strategies.

What is peak-load pricing and what problem does it solve?

Charging higher prices at peak times, which rations capacity and avoids using inefficient, high-MC generators. It aligns demand with system constraints; however, regulators sometimes restrict peak pricing, leading to inefficiencies or shortages.

What does electricity generation teach us about cartel allocation?

Just like a multiplant monopoly equalizes marginal costs across plants (e.g., hydro vs nuclear), a cartel maximizes joint profits by allocating production to members with the lowest MC. This real-world analogy clarifies why cartels rarely split output equally.

Why was the Interstate Commerce Commission originally justified?

In the late 1800s, railroads were essential and had monopoly characteristics in many regions. The ICC aimed to prevent exploitative pricing, discriminatory rates, and destructive price wars. Early regulation provided stability in a network industry with large fixed costs.

Why did the ICC eventually become laughable?

Over time the ICC was captured by the industries it regulated, restricting entry, keeping prices artificially high, and protecting inefficient incumbents. Instead of promoting competition, it stifled innovation and prevented new trucking firms from entering, ultimately harming consumers.

Railroads & Trucking Case — What motivated deregulation of these industries?

Advances in logistics, interstate trucking competition, and inefficiency from ICC delays made regulation burdensome. Deregulation improved price flexibility, competition, and efficiency while reducing barriers to entry.

What happened with California’s attempt to deregulate its electricity market in the early 2000s?

California’s wholesale electricity prices soared in June 2000, and high prices produced enormous profits for the generating companies, but crises for the regulated utilities that were required to buy power in the wholesale markets and sell at a much lower regulated price in the retail markets.

PG&E, the state’s largest retailer, declared bankruptcy in March 2001; state took over and spent $1B/month buying power w/ average prices 10x higher than a year earlier.

What were the characteristics of airline regulation under the CAB?

Prices were regulated, entry into routes required approval, and competition was limited. Airlines competed in quality (meals, legroom) rather than price. This created high fares, stable incumbents, and limited consumer welfare gains.

What were the major outcomes of airline deregulation?

• Lower fares and increased consumer surplus

• Route restructuring into hub-and-spoke systems

• More carriers at first, followed by consolidation

• Greater price discrimination and yield management

• More crowded cabins, occasional instability, and bankruptcies

Why did airline deregulation generate large efficiency gains?

Competition allowed pricing to reflect true marginal costs, carriers optimized networks, and entry discipline replaced CAB licensing. The industry became more flexible and innovative, leveraging technology and operational improvements.

Summarize the Spirit v. Northwest Airlines case.

Spirit alleged that Northwest Airlines slashed fares to extremely low levels and flooded capacity on Detroit routes specifically to drive Spirit out of the market.

When Spirit entered or expanded service on several Detroit routes, Northwest responded by undercutting prices and/or increasing seat capacity.

Northwest argued that it was merely competing aggressively and that costs were not “below-cost predation.”

Northwest eventually won the case; it was determined that there was no below-cost predation nor was there the plausibility of recoupment, as market barriers to entry were not significant enough.

What was the case against Tesla in the Franchising Law case?

States and dealer associations argued

• Tesla’s direct sales model violated franchise laws meant to prevent manufacturers from competing with their own dealers,

• independent dealerships were necessary to protect consumers

What was Tesla’s defense?

Tesla argued:

• franchising law doesn’t apply to a company with no franchisees

• independent dealers can’t effectively sell EVs—they have incentives to sell gas cars b/c of servicing fees, so they wouldn’t educate on EVs properly

• direct sales are pro-consumer, offering transparent, fixed prices and reducing transaction costs

• opposition was anti-competitive; incumbents wanted to block a new competitor