Antitrust authorities in Washington and the states have been busy in the past several years scrutinizing mega-mergers in the banking, communications and defense industries, among others. As the number of competitors in certain markets dwindles, the potential combination of former rivals raises concerns about market concentration and the consequent implications for consumers and other firms.

But mergers aren't the only business activities that have drawn regulators' attention of late. Antitrust authorities are also examining allegations of exclusionary actions—like predatory pricing, exclusive dealing and tying arrangements—in a host of industries and firms. This stepped-up action by regulators has put them on the hot seat because they're taking on some of the nation's best known and widely respected companies. Indeed, the recent antitrust suits filed against Microsoft by the Department of Justice and 20 state attorneys general promise to generate renewed debate about the role government has in ensuring a competitive marketplace. Because the application of antitrust law relies heavily on economic principles and analyses of potential outcomes, it's worthwhile to take a look at what economists have to say about the structure and operation of American business.

Antitrust Basics

Antitrust economics is part of a branch of economics known as industrial organization, which attempts to explain the structure and competitive behavior of firms and industries. When economists talk about the structure of any industry, they are generally referring to the number of firms that provide products or services to a given market; the barriers to entry for new firms; and the degree of product differentiation.

The structure of an industry selling a homogeneous, or similar, product or service can be described in one of three ways: 1) perfectly competitive (no barriers to entry, many sellers with no pricing power); 2) oligopolistic (barriers to entry, a few sellers with some pricing power); or 3) a pure monopoly (barriers to entry, one seller with complete pricing power).1 More recently, economists have also defined a structure called the dominant firm with a competitive fringe, which consists of a single firm with a large market share and some price-setting power that competes with smaller, price-taking firms.2 Examples of dominant firms are IBM in the market for mainframe computers and Kodak in the photographic film market.

Since it is the exercise of monopoly or market power that is problematic, economists and policymakers are more concerned about the way firms in an industry behave than the structure of the industry per se. Indeed, in some circumstances, a monopoly structure yields the most efficient, socially desirable outcome. Natural monopolies are one example. They occur in markets in which additional output can be produced at a lower per-unit cost, such as the public utility industries. Monopolies are even encouraged in other types of markets.3

According to the nation's antitrust laws, a monopoly is not—strictly speaking—illegal. Rather, the laws are used primarily by federal authorities—the Department of Justice and the Federal Trade Commission (FTC)—both to rein in firms that exercise excessive market power and to limit the way in which firms compete with one another.

Antitrust officials are guided by three major federal statutes: the Sherman Act of 1890, the Clayton Act of 1914 and the Federal Trade Commission Act of 1914. Section 1 of the Sherman Act prohibits restraint of trade. On its surface, the more widely invoked Section 2 of the act appears to outlaw monopoly outright ("every person who shall monopolize or attempt to monopolize.... shall be deemed guilty of a felony"). The courts, however, have interpreted the act less literally, saying that it merely forbids monopolistic behavior.

The Clayton Act is more specific than the Sherman Act; it describes the type of conduct and practices that will get a firm (or group of firms) into trouble. Sections 2, 3 and 7 of the act forbid any price discrimination, tie-ins, exclusive dealing or mergers that would lessen competition (see chart) for descriptions of these and other exclusionary practices). The act also entitles plaintiffs that successfully bring antitrust suits to treble damages and attorneys fees.4 The Federal Trade Commission Act created the FTC, whose Bureau of Competition enforces the act and other antitrust laws. Section 5 of the act prohibits "unfair" methods of competition; these activities are not defined in the act, however, so it has been up to the courts to make those determinations.

There are very few business practices that are blatantly illegal. The few that are, like price fixing, are called per se violations. When a per se violation is alleged, it is not necessary for a plaintiff to show that actual harm was done. Rather, in most antitrust cases, the courts have applied a rule of reason analysis, which means that the conduct is examined for two things: 1) to see if it restricts competition in a significant way; and 2) to determine if it has any overriding business justification. Many arrangements among competitors, like organized exchanges (e.g., the Chicago Board of Trade) and trade associations, meet a rule of reason test and, thus, are not illegal.

Leave Them Alone?

Most antitrust officials—and the economists who advise them—believe that the antitrust laws have two main purposes: to ensure that markets operate efficiently and that consumers are not harmed by a firm's actions toward them or the firm's competitors. It has not always been this way, however. At the turn of the century, when Standard Oil, U.S. Steel and other huge monopoly trusts prevailed, bigness was equated with badness. During this era, policymakers were more concerned about protecting small company competitors than they were about encouraging economic efficiency.

Such thinking dominated antitrust policy until the mid-1970s and 1980s, when antitrust officials in Washington adopted a laissez-faire approach to antitrust policy. They argued that a firm's size did not matter and that the benchmark for bringing an antitrust case should be the exertion of market power that demonstrably hurts consumers. Moreover, they held that justifiable antitrust cases would be rare since market forces would deter firms from engaging in inefficient behavior.

This market-based approach to solving antitrust problems is predicated in part on contestable markets theory. A contestable market is one in which firms can costlessly enter or exit it in response to high profits and challenge the dominant firm or firms for market share. If a market is determined to be contestable, then most economists believe that the threat of competition is enough to deter a dominant firm from engaging in anticompetitive practices.

It's Still A Fine Line

Antitrust policy and analysis have evolved yet again in the 1990s. Economists have increasingly agreed, for example, that easy and costless market entry and exit—a necessary condition for a contestable market—rarely exists in the real world because of the presence of sunk costs. Sunk costs are the fixed costs—like the funds that are expended on real estate and legal services—that cannot be recovered if a business fails. The greater the sunk costs, the less incentive there is for new firms to enter a market and compete against a dominant incumbent. Without competition, the incumbent may then be tempted to exercise its market power by restricting output and raising prices.

In addition to putting more emphasis on real world obstacles to competition like sunk costs and asymmetric information—when the seller has information that the buyer does not—economists have also designed increasingly sophisticated, dynamic models of strategic competition. With these models, economists are better able to predict interaction over time between and among competitors. Technological improvements have also aided antitrust officials in determining whether a particular business practice or merger is likely to be anticompetitive. For example, by using scanner data from the retail outlets of several competitors in a given geographic market, economists can calculate how prices are likely to be affected by the addition or subtraction of one of those competitors in a different geographic market.5

Despite all the advances made in antitrust economics since the turn of the century, it's still as much of an art as it is a science. There remains a very fine line between good, hard-nosed competition and illegal, anticompetitive practices. Economists have much to contribute to the analysis, and the better they are able to incorporate new tools and real world imperfections into theoretical models, the easier that line will be to see.

Thomas A. Pollmann provided research assistance.

Endnotes

1. Monopoly, price or market power all refer to the ability of a firm to profitably set the price of its good or service above the marginal cost of producing it. See Posner (1976), Chapter 2, for an excellent elementary description of monopoly. See Carlton and Perloff (1994) or any basic undergraduate microeconomics textbook for a fuller treatment of industry structure. [back to text]
2. Firms with monopoly power are referred to as price setters, while firms operating in a competitive industry are referred to as price takers—they take the market price as given. [back to text]
3. For example, a pharmaceutical company that is issued a patent for a new drug is essentially given a limited-life monopoly over the product. This is so because, without patent protection, pharmaceutical firms would possibly not be able to recoup their very significant research and development costs, thus discouraging socially desirable innovation. [back to text]
4. Treble damages are three times actual damages. [back to text]
5. See "The Economics of Antitrust" (1998) for more detail on the new tools economists are using in antitrust cases. [back to text]

References

Carlton, Dennis W., and Jeffrey M. Perloff. Modern Industrial Organization, 2nd edition (New York: HarperCollins College Publishers, 1994).

Kwoka, John E., Jr., and Lawrence J. White, eds. The Antitrust Revolution: The Role of Economics, 2nd editions (New York: HarperCollins College Publishers, 1994).

Posner, Richard A. Antitrust Law: An Economic Perspective (Chicago: The University of Chicago Press, 1976).

"The Economics of Antitrust," The Economist (May 2, 1998), 62-4.