The Economic Rationale for Antimonopoly Law and Policy

• Pages: 7-42

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CHAPTER II

THE ECONOMIC RATIONALE FOR

ANTIMONOPOLY LAW AND POLICY

This chapter provides an overview of the economic principles

underlying the law of monopolization and abuse of dominance. The first

section discusses in general terms the concept of market power, a

prerequisite for violating monopolization law in the United States and

elsewhere. The second section delves into some of the standard economic

models involving market power that can be applied to different industries

to help evaluate its presence and effect. The final section concludes by

discussing some of the implications of market power for producer and

consumer welfare.

A. Introduction to the Economic Concept of Market Power

1. Market Power and Efficiency

A firm with market power can profitably increase its price above the

competitive level for a sustained period of time. 1

1. See, e.g., ABA SECTION OF ANTITRUST LAW, MARKET POWER

HANDBOOK: COMPETITION LAW AND ECONOMIC FOUNDATIONS 9 (2d ed.

2012) [hereinafter MARKET POWER HANDBOOK] (“Economists often

define market power as the ability of a firm or group of firms within a

market to profitably charge prices above the competitive level for a

sustained period of time”); William M. Landes & Richard A. Posner,

Market Power in Antitrust Cases, 94 HARV. L. REV. 937, 939 (1981) (“A

simple economic meaning of the term “market power” is the ability to set

price above marginal cost.”); id. at 937 (“The term “market power” refers

to the ability of a firm (or a group of firms, acting jointly) to raise price

above the competitive level without losing so many sales so rapidly that

the price increase is unprofitable and must be rescinded.”). Economists

often use the terms “market power” and “monopoly power”

interchangeably. See, e.g., DENNIS W. CARLTON & JEFFREY M. PERLOFF,

MODERN INDUSTRIAL ORGANIZATION 92 (3d ed. 2000) (“The terms

monopoly power and market power typically are used interchangeably to

8 Monopolization and Dominance Handbook

Market power is an important economic concept, because its presence

signals a potential market failure. When a firm sets its price above its

marginal cost, it creates a gap between the price and how much it costs to

produce the product. Because of the gap, it is possible that some

consumers value the product less than its price, but more than its cost to

produce. Those consumers will not buy the product, even though they

would be willing to pay the firm enough to cover its costs. Such a failure

to trade is inefficient. Because those consumers do not buy the product,

their welfare will be lower than it has to be.

In economics, this type of market failure is called a loss in allocative

efficiency. The failure to make all efficient trades means that current

resources could be reallocated to better represent consumer preferences.

Allocative efficiency is a short-term concept, because it concerns the

allocation of current resources. A loss in allocative efficiency is also called

a deadweight loss.2 All else equal, the greater the firm’s market power, the

larger the gap between its profit maximizing price and its marginal cost,

the larger the deadweight loss, and the lower total (producer plus

consumer) welfare.

On the other hand, a firm in a perfectly competitive market has no

market power. In a theoretical perfectly competitive market, a firm’s rivals

will undercut any price above marginal cost, and thereby constrain the firm

to choose a price equal to marginal cost. When price equals marginal cost,

there is no gap. When there is no gap, there are no consumers that value

the product less than its price, but more than its cost to produce. When

there is no gap, all the consumers who value the product more than its cost

to produce can buy the product, so there is no inefficient failure to trade.

Thus, a perfectly competitive market can achieve allocative efficiency and

maximize total welfare.3

mean the ability to profitably set price above competitive levels (marginal

cost) . . . .”). Note that if a firm can only temp orarily maintain a price above

its marginal cost before it loses enough business to be unprofitable, then

that firm does not have market power. Hence the requirement that the price

be maintained for a significant period of time.

2. Deadweight loss is a reduction in total surplus and therefore can include

both a reduction in consumer surplus and a reduction in producer surplus.

Deadweight loss will be discussed in more detail in the next section.

3. Perfect competition does not always achieve allocative efficiency. For

Economic Rationale 9

In 1934, Abba Lerner described how the allocative inefficiency caused

by a monopolist’s market power depended on the difference between the

monopolist’s price and its marginal cost.4 Because of his work, the

percentage margin between price and marginal cost is known as the Lerner

Index. It is defined as (p – c) / p, where p is the firm’s price and c is the

firm’s marginal cost. In a perfectly competitive market, p is equal to c and

the Lerner Index is equal to zero. When a firm can increase its price above

its marginal cost, there is a gap between p and c, and the Lerner Index is

positive, but no more than 1. All else equal, firms with a larger Lerner

Index typically have more market power.5

In the long-term, firms with market power can make profits by

charging prices above marginal costs. The profits can create incentives for

investment by would-be rivals seeking access to a share of those profits.

The profits are a signal from the economy about where future investment

would be valuable to consumers. To the extent that such signals lead to

efficient investment and a better use of resources in the future, current

profits from market power are dynamically efficient, and limiting those

current profits may lead to lower investment and less dynamic efficiency,

even if it leads to more allocative efficiency. Thus, there can be a tradeoff

between short-term allocative efficiency and long-term dynamic

efficiency.

Market power can be a consequence of “willful acquisition or

maintenance,” or of “a superior product, business acumen, or historic

example, perfectly competitive markets may not achieve allocative

efficiency in the presence of public goods, or when there are production or

consumption externalities, such as network effects. See, e.g., CARLTON &

PERLOFF, supra note 1, at 115 to 123.

4. See, e.g., Kenneth G. Elzinga & David E. Mills, The Lerner Index of

Monopoly Power: Origins and Uses, AMERICAN ECONOMIC REVIEW:

PAPERS & PROCEEDINGS 2011, 101:3, 558–564.

5. Citing the work of other economists, Elzinga and Mills discuss some

limitations of the Lerner Index as a measure of market power. For example,

it does not consider monopsony power in factor markets, it does not

consider “departures from cost-minimizing behavior”, it does not consider

dynamic effects, it does not consider non-price competition, it does not

consider non-linear pricing, and it does not consider the impact of

increasing returns to scale or fixed costs. See Elzinga & Mills, supra note

4, at 559-560.