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the price increase is unprofitable and must be rescinded.”).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

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