Chapter 13 Imperfect competition

The degree to which monopolistically competitive prices can stray from the competitive ideal depends on • the number of other competitors • the ease with which competing firms can expand

Imperfect Competition and

e have so far considered two distinctly different market structures: perfect

competition, characterized by producers that cannot influence price at all

because of extreme competition; and pure monopoly, in which there is only

one producer of a product with no close substitutes and whose market is protected by

prohibitively high barriers to entry Needless to say, most markets are not well described

by either of those theoretical structures Even in the short run, producers typically

compete with several or many other producers of similar, if not identical, products

General Motors Corporation competes with Ford Motor Company, Chrysler Corporation, and a large number of foreign producers McDonald’s Corporation competes with

Burger King Corporation, Hardees, and a lot of other burger franchises, as well as with

Pizza Hut, Popeye’s Fried Chicken, and Long John Silver’s People’s Drug stores

compete directly with other drug chains and locally owned drugstores, and indirectly with department and discount stores that sell the same non-drug products In the long run, all these firms must compete with new companies that surmount the imperfect barriers to

entry into their markets In short, most companies competing in the imperfect markets

can cause producers to be more efficient in their use of resources than under pure

monopoly, although less efficient than in perfect competition One word of caution,

however: The study of so-called real-world market structures can be frustrating

Although models may incorporate more or less realistic assumptions about the behavior

of real-world firms, the theories developed from them are conjectural At best, they

allow economists to speculate on what may happen under certain conditions Real-world markets are imperfect, complex phenomena that often do not lend themselves to hard-

and-fast conclusions

Monopolistic Competition

As we have noted in our study of demand, the greater the number and variety of

substitutes for a good, the greater the elasticity of demand for that good—that is, the

more consumers will respond to a change in price By definition, a monopolistically

competitive market like the fast-food industry produces a number of different products,

W

most of which can substitute for each other If Burger Bippy raises its prices, then,

consumers can move to another restaurant that offers similar food and service Because

of consumer ignorance and loyalty to the Big Bippy, however, Burger Bippy is unlikely

to lose all its customers by raising its prices It has some monopoly power Therefore, it can charge slightly more than the ideal competitive price, determined by the intersection

of the marginal cost and demand curves Burger Bippy cannot raise its prices too much,

however, without substantially reducing its sales

The degree to which monopolistically competitive prices can stray from the

competitive ideal depends on

• the number of other competitors

• the ease with which competing firms can expand their businesses to

accommodate new customers (the cost of expansion)

• the ease with which new firms can enter the market (the cost of entry)

• the ability of firms to differentiate their products, by location or by either

real or imagined characteristics (the cost differentiation)

• public awareness of price differences (the cost of gaining information on

price differences)

Given even limited competition, the firm should face a relatively elastic demand curve—

certainly more elastic than the monopolist’s

Monopolistic Competition in the Short Run

In the short run, a monopolistically competitive firm may deviate little from the

price-quantity combination produced under perfect competition The demand curve for

fast-food hamburgers in Figure 13.1 is highly, although not perfectly, elastic Following the

same rule as the perfect competitor and pure monopolist, the monopolistically

competitive burger maker produces where MC = MR Because the firm’s demand curve

slopes downward, its marginal revenue curve slopes downward too, like the pure

monopolist’s The firm maximizes profits at M m c and charges P m c, a price only slightly

higher than the price that would be achieved under perfect competition (P c) (Remember, the perfect competitor faces a horizontal, or perfectly elastic, demand curve, which is also its marginal revenue curve It produces at the intersection of the marginal cost and

marginal revenue curves.) The quantity sold with monopolistic competition is also only

slightly below the quantity that would be sold under perfect competition, Q c Market

inefficiency, indicated by the shaded triangular area, is not excessive

The firm’s short-run profits may be slight or substantial, depending on demand

for its product and the number of producers in the market In our example, profit is the

area bounded by ATC1Pm c ab, found by subtracting total cost (0ATC1bQ m c) from total

revenues (0P m c aQ m c), as with monopolies

FIGURE 13.1 Monopolistic Competition in the

Short Run

Like all profit-maximizing firms, the monopolistic

competitor will equate marginal revenue with

marginal cost It will produce Q mc units and charge

price P mc, only slightly higher than the price under

perfect competition (The perfect competitor’s

combined demand and marginal revenue curve

would be horizontal at price P c.) The monopolistic

competitor makes a short-run economic profit equal

to the area ATC1P mc ab The inefficiency of its

slightly restricted production level is represented by

the shaded triangular area

Monopolistic Competition in the Long Run

Because the barriers to entry into monopolistic competition are not excessively costly to

surmount, substantial short-run profits will attract other producers into the market

When the market is divided up among more competitors, the individual firm’s demand

curve will shift downward, reflecting each competitor’s smaller market share As a

result, the marginal revenue curve will shift downward as well The demand curve will

also become more elastic, reflecting the greater number of potential substitutes in the

market (These changes are shown in Figure 13.2.) The results of the increased

competition are:

• The quantity produced falls from Q m c2 to Q m c1

• The price falls from P m c2 to P m c1

Profits are eliminated when the price no longer exceeds the firm’s average total cost (As long as economic profit exists, new firms will continue to enter the market Eventually

the price will fall enough to eliminate economic profit.)1

Notice that the firm is not producing and pricing its product at the minimum of its

average total cost curve, as the perfect competitor would (nor did it in the short run). 2 In

this sense the firm is producing below capacity, by Q m – Q mc2 units

In terms of price and quantity produced, monopolistic competition can never be as efficient as perfect competition Perfectly competitive firms obtain their results partly

because all producers are producing the same product Consumers can choose from a

great many suppliers, but they have no product options In a monopolistically

competitive market, on the other hand, consumers must buy from a limited number of

producers, but they can choose from a variety of slightly different products For

example, the pen market offers consumers a choice between felt-tipped, fountain, and

ballpoint pens of many different styles This variety in goods comes at a price—the

higher price illustrated in Figure 13.2

FIGURE 13.2 Monopolistic Competition in the

Long Run

In the long run firms seeking profits will enter the

monopolistically competitive market, shifting the

monopolistic competitor’s demand curve down from

D1 to D2 and making it more elastic Equilibrium

will be achieved when the firm’s demand curve

becomes tangent to the downward -sloping portion

of the firm’s long-run average cost curve At that

point, price (shown by the demand curve) no longer

exceeds average total cost; the firm is making zero

economic profit Unlike the perfect competitor, this

firm is not producing at the minimum of the

long-run average total cost curve In that sense it is

underproducing, by Q m – Q mc2 units

Oligopoly

In a market dominated by a few producers, where entry is difficult—that is, in an

oligopoly—the demand curve facing an individual competitor will be less elastic than the

monopolistic competitor’s demand curve (see Figure 13.3) If General Electric Company raises its price for light bulbs, consumers will have few alternative sources of supply A

price increase is less likely to drive away customers than it would under monopolistic

competition, and the price-quantity combination achieved by the company will probably

be further removed from the competitive ideal In Figure 13.3, the oligopolist produces

only Q o units for a relatively high price of Po, compared with the perfect competitor’s

price-quantity combination of Q cPc The shaded area representing inefficiency is fairly

large

Exactly how the oligopolist chooses a price is not completely clear We will

examine a few of the major theories proposed In contract, we had to examine only a

2

The perfect competitor produces at the minimum of the average total cost curve because its demand curve

is horizontal—and therefore the demand curve’s point of tangency with the average total cost curve is the low point of that curve

single theory each for perfect competition, pure monopoly, and monopolistic

competition

_

FIGURE 13.3 The Oligopolist as Monopolist

With fewer competitors than the monopolistic

competitor, the oligopolist faces a less elastic

demand curve, D o Each oligopolist can afford to

produce significantly less Q o and to charge

significantly more than the perfect competitor, who

produces Q c , at a price of P c The shaded area

representing inefficiency is larger than that of a

monopolistic competitor

Theories of Price Determination

Because each oligopolist is a major factor in the market, oligopolists’ pricing decisions

are mutually interdependent The price one producer asks significantly affects the others’ sales Hence when one oligopolistic firm lowers it price, all the others can be expected to lower theirs, to prevent erosion of their market shares The oligopolist may have to

second-guess other producers’ pricing policies—how they will react to a change in price, and what that might mean for its own policy In fact, oligopolistic pricing decisions

resemble moves in a chess game The thinking may be so complicated that no one can

predict what will happen Thus, theories of oligopolistic price determination tend to be

confined almost exclusively to the short run (In the long run, virtually anything can

happen.)

The Oligopolist as Monopolist

Given the complexity of the pricing problem, the oligopolistic firm—particularly if it is

the dominant firm in the market—may simply decide to behave like a monopolist

(because it does have some monopoly power) Like a monopolist, Burger Bippy may

simply equate marginal cost with marginal revenue (see Figure 13.3) and produce Q o

units for price Pc Here the oligopolist’s price is significantly above the competitive price

level, P c, but not as high as the price charged by a pure monopolist (If the oligopolist

were a pure monopoly, it would not have to fear a loss of business to other producers

because of a change in price.) Inefficiency in this market is slightly greater than in a

monopolistically competitive market—see the shaded triangular area of Figure 13.3

The Oligopolist as Price Leader

Alternatively, oligopolists may look to others for leadership in determining prices One

producer may assume price leadership because it has the lowest costs of production; the others will have to follow its lead or be underpriced and run out of the market The

producer that dominates industry sales may assume leadership Figure 13.4 depicts a

situation in which all the firms are relatively small and of equal size, except for one large

producer The small firms’ collective marginal cost curve (minus the large producer’s) is

shown in part (a), along with the market demand curve, D m The dominant producer’s,

marginal cost curve, MC d, is shown in part (b) of Figure 13.4

FIGURE 13.4 The Oligopolist as Price Leader

The dominant producer who acts as a price leader will attempt to undercut the market price established by

small producers (part (a)) At price P1 the small producers will supply the demand of the entire market, Q2

At a lower price—P d or P c—the market will demand more than the small producers can supply In part (b), the dominant firm determines its demand curve by plotting the quantity it can sell at each price in part (a)

Then it determines its profit-maximizing output level, Q d, by equating marginal cost with marginal revenue

It charges the highest price the market will bear for that quantity, P d , forcing the market price down to P d in

part (a) The dominant producer sells Q3-Q1 units, and the smaller producers supply the rest

The dominant producer can see from part (a) that at a price of P1, the smaller

producers will supply the entire market for the product, say, steel At P1 the quantity

demanded, Q2, is exactly what the smaller producers are willing to offer At P1 or above,

therefore, the dominant producer will sell nothing At prices below P1, however, the total quantity demanded exceeds the total quantity supplied by the smaller producers For

example, at a price of P d the total quantity demanded in part (a) is Q3, whereas the total

quantity supplied is Q1. Therefore the dominant producer will conclude that at price Pd, it

can sell the difference, Q3-Q1 For that matter, at every price below P1, it can sell the

difference between the quantity supplied by the smaller producers and the quantity

demanded by the market.

As the price falls below P1, the gap between supply and demand expands, so that the dominant producer can sell larger and larger quantities If these are plotted on

another graph, they will form the dominant producer’s demand curve, D d (part (b)) Once

it has devised its demand curve, the dominant producer can develop its accompanying

marginal revenue curve, MR d, also shown in Figure 13.4(b) Using its marginal cost

curve, MC d, and its marginal revenue curve, it establishes its profit-maximizing output

level and price, Q d and P d

The dominant producer knows that it can charge price P d for quantity Q d, because

that price-quantity combination (and all others on curve D d) represents a shortage not

supplied by small producers at a particular price in part (a) Q d, as noted earlier, is the

difference between the quantity demanded and the quantity supplied at price P d So the

dominant producer picks its price, P d And the smaller producers must follow.3 If they

try to charge a higher price, they will not sell all they want to sell

Price Stability and the “Kinked” Demand Curve

Several decades ago, economists believed they had noticed something quite significant

about oligopolies For relatively long periods of time, prices in these industries seemed

to remain more or less fixed This observed “stickiness” of oligopolistic prices gave rise

to the theory of the “kinked” demand curve—a theory that tries to explain not how prices are determined, but why they do not move very much

Figure 13.5 shows the hypothetical kink in the oligopolist’s demand curve that

was thought to produce price stickiness The notion was that the interdependent nature of

oligopolistic pricing decisions gave rise to the kink Suppose the price of steel is P1 An oligopolistic firm can reason that if it lowers its price, other firms will follow suit to

protect their shares of the market Therefore, the demand curve below that point is

relatively inelastic If the firm raises its prices, however, it will lose customers to the

other firms, who have no reason to follow a price increase The demand curve above P1

is therefore relatively elastic

Because of the kink at P1 the marginal revenue curve is discontinuous At an

output of Q1, a gap develops between the upper and lower portions of the curve (see

Figure 13.5) The existence of this gap is easier to understand if one thinks of the kinked demand curve as two separate curves intersecting at the kink The curve’s bottom half

3

Consider market equilibrium with and without the dominant producer In the absence of the dominant

producer, the market price will be P1 , the equilibrium price for a market composed of only the smaller

producers The dominant producer adds quantity Q d , which causes the price to fall, forcing the smaller

producers to cut back production to Q1 in part (a)

_

FIGURE 13.5 The Kinked Demand Curve

The theory of the kinked demand curve is based on the

questionable premise that an oligopolist’s prices are

relatively rigid, or unresponsive to cost increases

According to the theory, the individual oligopolist

reasons that other oligopolists will match a price

reduction in order to protect their market shares, but will

not match a price increase The individual oligopolist’s

demand curve is therefore kinked at the established price:

the bottom part is less elastic than the top, where even a

small increase in price will cause customers to go

elsewhere Given the kinked demand curve, the firm’s

marginal revenue curve will be discontinuous Even if the

oligopolist’s marginal cost curve shifts upward from MC1

to MC2, the firm will not change its price-quantity

combination, P1Q2

belongs to demand curve D1 in Figure 13.6, and its top half to demand curve D2 Seen

that way, the two-part marginal revenue curve in Figure 13.5 is simply the composite of

the relevant portions of the marginal revenue curves MR1 and MR2 in Figure 13.5 At that

output level, marginal cost can shift all the way up to MC2 and the oligopolist will still

maximize profits As long as output remains at Q2, the price will remain P1 A price

increase would not benefit the firm unless its marginal cost curve rose higher than MC2–

say to MC3 In that case the firm’s profit-maximizing price would be only slightly

higher, P2

_

FIGURE 13.6 The Kinked Demand Curve as Two

Separate Curves

The oligopolist’s kinked demand curve can be

viewed as the composite of two different demand

curves The portion above the kink comes from the

top of a demand curve (D2 ) that is relatively elastic

The portion below the kink comes from the bottom

of a demand curve (D1 ) that is less elastic.

Economists at one time thought they had explained the rigidity of oligopolistic

prices The only problem is that further observation has cast doubt on the evidence that

motivates the development of the theory Research conducted over the last three decades

suggests that prices in industries dominated by a few firms are no stickier than prices in

other industries Because there is some disagreement on the interpretation of the data, the theory remains with us At best, it is a theory in search of reasonable confirmation

The Oligopolist in the Long Run

In an oligopolistic market, significant barriers to entry face new competitors Firms in

oligopolistic industries can therefore retain their short-run positions much longer than can

monopolistically competitive firms

Oligopoly is normally associated with the automobile, cigarette, and steel

markets, which include some extremely large corporations There the financial resources required to establish production on a competitive scale may be a formidable barrier to

entry One cannot conclude that all new competition is blocked in an oligopoly,

however Many of the best examples of oligopolies are found in local markets—for

instance, drugstore, stereo shops, and lumber stores—in which one, two, or at most a few competitors exist, even though the financial barriers to entry could easily be overcome

Even in the national market, where the financial requirements for entry may be

substantial, some large firms have the financial capacity to overcome barriers to entry If

firms in the electric light bulb market exploit their short-run profit opportunities by

restricting production and raising prices, outside firms like General Motors Corporation

can move into the light bulb market and make a profit In recent years, General Motors

has in fact moved into the market for electronics and robotics

Oligopoly power remains a cause for concern The basis for competition,

however, is the relative ability of firms to enter a market where profits can be made—not the absolute size of the firms in the industry The small regional markets of a century

ago, isolated by lack of transportation and communication, were perhaps less competitive than today’s markets, even if today’s firms are larger in an absolute sense In the

nineteenth century the cost of moving into a faraway market effectively protected many

local businesses from the threat of new competition

Cartels: Monopoly through Collusion

In either a monopolistically competitive market or an oligopolistic market (or even

sometimes in a competitive market), firms may attempt to improve their profits by

restricting output and raising their market price In other words, they may agree to

behave as it they were a unified monopoly, an arrangement called a cartel A cartel is an

organization of independent producers intent on thwarting competition among themselves through the joint regulation of market shares, production levels, and prices The principal purpose of their anticompetitive efforts is to raise their prices and profits above

competitive levels In fact, however, a cartel is not a single unified monopoly, and cartel

members would find it very costly to behave as if they were

Incentives to Collude and to Cheat

The size of monopoly profits provides a real incentive for competitors to collude—to

conspire secretly to fix prices, production levels, and market shares Once they have

reduced market supply and raised the price, however, each has an incentive to chisel on

the agreement The individual competitor will be tempted to cut prices in order to expand sales and profits After all, if competitors are willing to collude for the purpose of

improving their own welfare, they will probably also be willing to chisel on cartel rules to

enhance their welfare further The incentive to chisel can eventually cause the demise of

the cartel If a cartel works for long, it is usually because some form of external cost,

such as the threat of violence, is imposed on chiselers.4

Although a small cartel is usually a more workable proposition than a large one,

even small groups may not be able to maintain an effective cartel Consider an oligopoly

of only two producers, called a duopoly A duopoly is an oligopolistic market shared by

only two firms To keep the analysis simple, we will assume that each duopolist has the

same cost structure and demand curve We will also assume a constant marginal cost,

which means that marginal cost and average costs are equal and can be represented by

one horizontal curve Figure 13.7 shows the duopolists’ combined marginal cost curve,

MC, along with the market demand curve for the good, D The two producers can

maximize monopoly profits if they restrict the total quantity they produce to Q m and sell

it for price P m Dividing the total quantity sold between them, each will sell Q1 at the

monopoly price (2 x Q1 = Q m) Each will receive an economic profit equal to the shaded

area bounded by ATC1Pm ab, which is equal to total revenues (P m x Q1) minus total cost

(ATC1 x Q1)

FIGURE 13.7 A Duopoly (Two-Member Cartel)

In an industry composed of two firms of equal size,

firms may collude to restrict total output to Q m and

sell at a price of P m Having established that

price-quantity combination, however, each has an

incentive to chisel on the collusive agreement by

lowering the price slightly For example, if one firm

charges P1 , it can take the entire market, increasing

its sales from Q1 to Q2 If the other firm follows suit

to protect its market share, each will get a lower

price, and the cartel may collapse.

Once in that position, each firm may reason that by reducing the price slightly

say to P1 and perhaps disguising the price cut through customer rebates or more

attractive credit terms, it can capture the entire market and even raise production to Q2

4

A cartel may provide members with some private benefit that can be denied nonmembers For example, local medical associations can deny nonmembers the right to practice in local hospitals In that case, the cost of chiseling is exclusion from membership in the group

Each firm may imagine that its own profits can grow from the area bounded by

ATC1P m ab to the much larger area bounded by ATC1P m cd This tempting scenario

presumes, of course, that the other firm does not follow suit and lower its price Each

firm must also worry that the other will chisel, cut the price, and steal its market

Thus each duopolist has two incentives to chisel on the cartel The first is

offensive, to garner a larger share of the market and more profits The second is

defensive, to avoid a loss of its market share and profits Generally, firms that seek

higher profits by forming a cartel will also have difficulty holding the cartel together, for

much the same reason As each firm responds to the incentive to chisel, the two undercut each other and the price falls back toward (but not necessarily to) the competitive

equilibrium price, at the intersection of the marginal cost and demand curves Just how

far price will decline depends on the firms’ ability to impose penalties on each other for

chiseling

The strength and viability of a cartel depend on the number of firms in an industry and the freedom with which other firms can enter The larger the number of actual or

potential competitors, the greater the cost of operating the cartel, of detecting chiselers,

and of enforcing the rules If firms differ in their production capabilities, the task of

establishing each firm’s share of the market is more difficult If a cartel member believes

it is receiving a smaller market share than it could achieve on its own, it has a greater

incentive to chisel Because of the built-in incentives first to collude and then to chisel,

the history of cartels tends to be cyclical Periods in which output and prices are

successfully controlled are followed by periods of chiseling, which lead eventually to the

destruction of the cartel

Government Regulation of Cartels

Government can either encourage or discourage a cartel Through regulatory agencies

that fix prices, determine market shares, and impose penalties for violation of rules,

government can keep competitors or cartel members from doing what comes naturally—

chiseling In doing so, government may be providing an important service to industry

Perhaps that is why, in most states, insurance companies oppose deregulation of their rate structures In seeking or welcoming regulation, an industry may calculate that it is easier

to control one regulatory agency than a whole group of firms plus potential competitors

Thus in 1975, the airline industry opposed President Ford’s proposal that

Congress curtail the power of the Civil Aeronautics Board to set rates and determine

airline routes As the Wall Street Journal reported,

The administration bill quickly drew a sharp blast form the Air Transport

Association, which was speaking for the airline industry The proposed

legislation “would tear apart a national transportation system recognized as the

finest in the world,” the trade group said, urging Congress to reject it because it

would cause “a major reduction or elimination of scheduled air service to many

communities and would lead inevitably to increased costs to consumers.”5

5

“Less Regulation of Airline Sector Is Urged by Ford,” Wall Street Journal, October 9, 1975, p 3.

The real reason the airlines opposed deregulation became clear in the early 1980s, when

several airlines filed for bankruptcy Partial deregulation, begun in 1979, had increased

competition, depressing fares and profits Fares began to rise again in 1980, mainly

because of rapidly escalating fuel costs Real fares have nonetheless fallen since

deregulation

Government can suppress competition in many other ways that have nothing to do with price Prohibiting the sale of hard liquor on Sunday, for example, can benefit liquor

dealers, who might otherwise be forced to stay open on Sundays In Florida, a state

representative who managed to get a law through the legislature permitting Sunday liquor sales was denounced by liquor dealers As one dealer commented, the legislator had

“pulled the boner of the year.”6

Cartels with Lagged Demands

Our analysis of cartels has been based on the presumption of a “standard good,” one not subject to the forces of lagged demand introduced in an earlier chapter Under market

conditions of lagged demand, the pricing strategies of a cartel are potentially different

When the market is split among two or more producers, then each firm can understand

that if it lowers its price, then more goods will be sold currently, but even more goods

will be sold in the future, when the benefits of the lagged demand/rational addition kick

in However, each can reason that the additional future sales generated by its current

price reduction could be picked up by one of the other producers The benefits are, in

other words, external So each producer can reason that it should not incur the current

costs of a lower price for the benefit of others Each producer individually has an

impaired incentive to lower the price

On the other hand, each producer can also see that they all have a collective

incentive to lower the price currently Why? To stimulate future demand and to raise

their future price and profits A cartel under such circumstances would be organized to

do what they all have an interest in doing, lower the price (not raise the price as is true in

conventional markets) The problem is that the incentive to not go along with or chisel

on the cartel remains strong for each firm, as is true in the conventional case, which

suggest that consumers may not get the lower current price because of cartel cheating

However, not all is lost If firms are inclined to chisel on such a cartel, there is a

potential solution that might be seen as perfectly legal by the antitrust authorities One

firm can buy the other firms simply because their profits and stock prices will be

suppressed by the inability of the firm to develop a workable cartel Once one firm

controls the market, then that one firm can lower the current price for the purpose of

stimulating future demand This one firm might end up as the sole producer but might

escape prosecution as a monopolist in violation of the antitrust laws (in spite of the fact

that it does what a cartel of firms can’t do) simply because the net effect of the buyouts is

a lower price and expanded market

6

St Petersburg Times, June 7, 1975, p 1-B.

Antitrust Legislation

As we have seen, monopoly power often leads to market inefficiencies, or a misallocation

of resources Reductions in monopoly power should therefore improve consumer

welfare The U.S government’s antitrust policy is designed, ostensibly, to improve

market efficiency by reducing barriers to entry, breaking up monopolies, and reducing the

monetary benefits of conspiring to reconstruct production or raise prices It is based on

three major laws, which have been amended and modified by court decisions: the

Sherman, Clayton, and Federal Trade Commission Acts

PERSPECTIVE: A Real-World Case of Price Fixing

During the 1950s, General Electric Company, Westinghouse Electric Corporation, Allis -Chalmers, Southern States Equipment, and other firms and their executives were accused of conspiring to set prices and divide the market for electrical equipment 1 Their conspiracy, which covered everything from two-dollar insulators to turbine generators, illustrates the incentives for competitors first to collude and then to chisel on their collusive agreement As a result of a court case brought against them, which ended in 1961, fines of nearly $2 million were levied against the conspirators and the companies they represented Six corporate executives were sent

to prison, and twenty-four others were fined or given suspended sentences It was the largest case brought to trial in the history of antitrust law, a classic examp le of the benefits and pitfalls of industrial conspiracy The seeds of the conspiracy were planted during the Second World War, when the prices of various types

of electrical equipment were regulated by the Office of Price Administration (OPA) Under the auspices of the National Electrical Manufacturers Association, firms met on a regular basis to determine how they could supply the heavy wartime demand for electrical equipment After their meetings, executives would regroup to talk about how they could get the OPA to raise prices

When the war was over and prices were no longer controlled, these manufacturers faced competition from a growing number of smaller companies Increasingly, buyers were asking for sealed bids as a means of getting the lowest possible prices The major manufacturers continued their meetings, this time to talk about price fixing and methods of dividing the market They decided to agree on their bids ahead of time and to rotate the privilege of making the lowest bid After learning what the lowest bid would be, the others would make higher bids The business was divided on the basis of past sales volume In the circuit -breaker market, for example, General Electric received 45 percent of the business, Westinghouse 35 percent, Allis -Chalmers 10 percent, and Federal Pacific 10 percent

For a more detailed account of this case, see Richard Austin Smith, “The Incredible electrical Conspiracy,”

parts I and II, Fortune, April and May 1961, pp 132 ff (April) and pp 161 ff (May).

The Sherman Act

The Sherman Act was passed in 1890, after a series of major corporate mergers It

contains two critical provisions The first, Section 1, declares illegal “every contract,

combination in the form of trust or otherwise, or conspiracy, in restraint of trade or

commerce among several states or with foreign nations.” The second, Section 2, declares that “every person who shall monopolize, or conspire with any other person or persons to monopolize any part of trade or commerce among the several states, or with foreign

nations, shall be guilty of a misdemeanor .” In short, the first section outlaws any

form of cooperative behavior that restrains competition; the second outlaws

monopolization or any attempt to acquire monopoly power

The language seems clear enough, yet the courts were initially reluctant to rule

against violations of the law, citing prosecutors’ loose interpretation of the words

“restraint of trade” and “conspire .to monopolize.” In 1911, however, the Supreme

Court ruled that Standard Oil Company, which then controlled 90 percent of the nation’s refinery capacity, should be broken up By dividing the firm along geographical lines

(which explains the names Standard Oil of Ohio and Standard Oil of California), the

court effectively nullified the economic benefits of the breakup In place of one large

monopoly, the justices created smaller monopolies Later, the court broke up the United States Steel Corporation and American Can Company on the grounds that they and

followed “unfair and unethical” business practices

The Clayton Act

Because the Sherman Act did not specify what constituted unfair and unethical business

practice, and because the courts generally took a very narrow view of what constituted

restraint of trade and commerce, Congress passed a new law in 1914 The Clayton Act listed four illegal practices in restraint of competition It outlawed price discrimination,

or the use of price differences not justified by cost differentials to lessen competition or

create a monopoly This provision was intended to prevent firms from cutting prices

below cost in a particular geographical region in order to drive competitors out of the

market Railroads and department stores were allegedly involved in such “predatory

with customers might be considered a typing contract An exclusive dealership is an

agreement between a manufacturer and its dealers that forbids the dealers from handling

other manufacturers’ products The Clayton Act is applicable only to exclusive

dealerships that reduce competition “substantially,” however As long as other

manufacturers’ products are sold in the same area, manufacturers may organize exclusive dealerships covering designated territories, as is common in the automobile industry

Since 1985, the antitrust enforcement agencies and the courts have been more lenient

toward such nonprice vertical restraints as tying contracts and exclusive dealerships

Section 7 of the Clayton Act forbids mergers, or the acquisition by a firm of its

competitors’ stock, if the effect of the merger is to reduce competition substantially The act applies only to horizontal mergers, however

A horizontal merger is the joining of two or more firms in the same market—for

example, two car companies into a single firm Vertical mergers were excluded from

the act A vertical merger is the joining of two or more firms that perform different

stages of the production process into a single firm For example, the Clayton Act would

permit the merging of an oil-drilling firm with a refining firm So would conglomerate

mergers A conglomerate is a firm that results from the merging of several firms from

different industries or markets The combining of firms in tow entirely different

markets—washing machines and light bulbs, for instance, would be considered a

conglomerate merger These loopholes in the Clayton Act—vertical and conglomerate

mergers—were closed in part by the Celler-Kefauver Antimerger Amendment, passed in

1950 Although the act has since been applied to vertical mergers, it has never been

applied to conglomerates

Finally, the Clayton Act declared interlocking directorates illegal An

interlocking directorate is the practice of having the same people serve as directors of

two or more competing firms If the same people direct competing firms and advise

policies that effectively reduce industry output, they constitute a defacto monopoly

Section 8 of the Clayton Act prohibits such arrangements if they “substantially reduce”

competition

The Federal Trade Commission Act

The original purpose of the Federal Trade Commission Act, passed in 1914, was to

thwart “unfair methods of competition” among firms The act empowered the Federal

Trade Commission to investigate cases of industrial espionage, bribery for the purpose of obtaining trade secrets or gaining business, and boycotts.7 Later the Wheeler-Lea

Amendment expanded the commission’s mandate to cover “unfair or deceptive acts or

practices” that harmed customers, including the sale of shoddy merchandise and

misleading or deceptive advertising

The Purposes and Consequences of Antitrust Laws

The ostensible purpose of all these laws is to fight monopoly power by outlawing

business practices that prevent or retard competition By forcing firms to restrict

production or fix prices surreptitiously, antitrust legislation makes collusion among

competitors more costly Violations of the law carry fines and penalties on conspiring

firms and their employees

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Not all boycotts are prohibited, of course—only efforts designed to prevent goods from reaching their intended designation That is, a union cannot prevent goods from crossing its picket lines, and firms cannot organize restrictions on the purchase of other firms’ products

PERSPECTIVE: Economic Consequences of Treble Damages

Section 4 of the Clayton Act states that

Any person who shall be injured in his business or property by reason of anything forbidden in the antitrust laws may sue therefore in any district court of the United States in the district in which the defendant resides

or is found or has an agent, without respect to the amount in controversy, and shall recover threefold the damages by him sustained, and the cost of suit, including a reasonable attorney’s fee

In other words, the successful private plaintiff in an antitrust case is to be paid treble the damages done to him by the defendant This provision of the Clayton Act means that thousands of private firms and individuals join the Department of Justice and the Federal Trade Commission in the enforcement of antitrust laws For many years the treble damages provision generated no controversy; it accorded well with the notion that victims should be compensated and apparently served an important deterrent to potential violators Beginning in the 1970s, criticism of treble damages began to appear in the law and economics literature

Critics have pointed out that the law has costs as well as benefits A proper assessment must take account of both costs and benefits Economists William Breit and Kenneth G Elzinga find three principal costs of treble damage suits: the perverse incentives effect, the misinformation effect, and reparations costs

Perverse incentives Treble damages can reduce the incentives of consumers to take private steps to avoid the

harm done by the monopolistic firm If the expected gains from the successful antitrust suit are high relative to the costs of buying from a monopoly seller, the buyer has a positive incentive not to avoid the monopoly seller, even if it is possible to do so To put it another way, the treble damage provision encourages private enforcement

of antitrust laws but discourages the private prevention of monopoly behavior

Misinformation A private party has an incentive to claim damages from anticompetitive behavior even when

such behavior has not taken place The treble damages provision generates many “nuisance suits” in which the plaintiff sues in the hope of forcing an out-of-court settlement Such tactics have a fair chance of success in antitrust cases because in many instances the definition of anticompetitive behavior is quite vague Moreover, in

a jury trial anything can happen, giving the defendant (even if innocent) a strong incentive to settle before going

to court

Reparations costs Considerable resources are devoted to determining and allocating damages in private

antitrust suits The judicial, clerical, and legal costs associated with compensating private plaintiffs all represent costs incurred solely because of the private enforcement provisions of the antitrust laws

Although treble damages have its defenders, many students of law and economics have suggested that the provision be done away with Richard Posner and others have suggested reducing private antitrust claims to single damages Others have supported severely limiting the types of cases subject to the treble damage

provision Elzinga and Breit support pure public enforcement of the antitrust statutes

The courts themselves seem to have grown wary of treble damages Judges have in several recent rulings reduced damage awards in treble damage cases The behavior of the judges in such cases may reflect the belief that the broad application of the treble damage provision generates more costs than benefits to the economy

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