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The legal battle between Microsoft and the U.S. Justice Department is an interesting instance of the concepts of monopoly and monopoly power. There is little doubt that Microsoft holds a position of near-monopoly in the market for operating systems. The Windows operating system is used in about 80% of the world’s personal computers. Hewlett-Packard’s operations manager claims that “absolutely there is no choice” when it comes to selecting an operating system for its Pavillon computers. The world depends on Windows.

Yet, Microsoft claims it “cannot charge a monopoly price because it faces competition from rival operating systems, potential entrants, its own installed base, and pirated software.” In other words, Microsoft has a (near) monopoly market share but virtually no monopoly power, it claims. Richard Schmalensee, one of Microsoft’s main witnesses in the recent antitrust case, calculates that an unchallenged-monopoly profit-maximizing price would fall in the $900 to $2000 range. Because Microsoft is a profit-maximizing concern and charges substantially less than that, the argument goes, it follows that Microsoft has no monopoly power.

Microsoft’s distinction between monopoly market share and monopoly power in operating systems is based, among other things, on the idea that soft-ware is a durable good. Unlike breakfast cereals and gasoline, consumers don’t need to buy a new operating system every week. If Microsoft were to set a high price for Windows 98, PC users would simply carry on with Windows 95, delay-ing the upgrade until prices came down to more reasonable levels. In other words, Microsoft’s monopoly power is curtailed by its own installed base and its inability to commit to not setting a low price. (This issue is discussed in greater detail in chapter10.)

However, it seems difficult to deny that Microsoft has used its monopoly power in operating systems to extend its dominant position to other areas of busi-ness. Alleged anticompetitive practices include exclusionary agreements with PC makers and online service and content providers. For example, in 1997, Microsoft forced an agreement on Intuit Inc. that prohibited the financial-software maker from promoting Netscape’s browser. This sort of agreement, together with the policy of bundling Windows with Microsoft’s Internet Explorer, has eroded Netscape’s mar-ket share in the browser marmar-ket to an extent that would probably not have been reached if Microsoft didn’t control the operating systems market.

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by the Federal Trade Commission (FTC). Much of the preliminary discussion seemed to mimic previous merger cases: Staples argued that the relevant market definition is that of stores that sell office supplies, in which case the combined market share of Staples and Office Depot would be very low. The FTC in turn argued that the relevant market definition is that of office-supplies superstores, in which case the combined market share of Staples and Office Depot would be greater than 70%. However, what eventually clinched the decision to block the merger was the econometric evidence that prices would be substantially greater in areas where the merger would increase the concentration of superstores ownership. Generally, there is a move toward giving greater importance to the impact of mergers on prices (market power) than to the impact of mergers on market shares.^e

eFurther discussion on merger policy may be found in chapter15.

5.2 REGULATION ⁵²

It is well known that monopoly pricing implies allocative inefficiency. The price set by a monopolist is greater than marginal cost. Or, to put it differently, the output set by a monopolist is lower than the optimal output: An increase in output would increase social welfare, for the marginal willingness to pay (price) would be greater than the marginal cost.

Competition is a way of achieving the efficiency lost in monopoly pricing (as we will see in greater detail in the next chapters). However, if fixed costs are large—or, more generally, if scale economies are very significant—then competition may not be a viable alternative. An extreme situation is given by a natural monopoly, the case when the cost structure is such that costs are minimized with one supplier only. In these cases, direct regulation of the monopolist (or dominant firm) may be the optimal solution.

Let us start by considering the simplest case of monopoly regulation. There is a firm with a cost function given by C= F + cq, where F is the fixed (capital) cost and c marginal cost (for simplicity, we assume marginal cost to be constant). Absent regulation, the monopolist sets price at the monopoly level, p^M, as shown in figure5.3. Because the social optimum would be to set price at marginal cost, monopoly price implies that output is lower than optimum and that allocative efficiency is lower than optimum by the area E. As for the monopolist, it receives a variable profitπ = q^M(p^M− c), so that net profit is given byπ − F.

A first natural solution for a regulator is to force the monopolist to set price equal to marginal cost: p^R= c, where R stands for “regulated.” In this case, output is given by q^Rand maximum allocative efficiency is achieved (i.e., the area E is equal to zero). One problem with marginal cost pricing is that it may imply negative profits for the firm. This is certainly the case when marginal cost is constant: Variable profit,π, is zero, and total profit is therefore−F.

Figure 5.3 Unregulated and Regulated Monopoly.

Clearly, a firm that makes losses of F cannot survive. To solve this problem, the reg-ulator might give the firm a subsidy of F . However, this would likely create additional problems. First, to obtain the value F , the regulator may have to raise taxes elsewhere in the economy. The efficiency loss implied by these taxes, E^, may be greater than the effi-ciency loss that marginal cost pricing is supposed to eliminate, E. Second, the possibility of transfers from the regulator to the regulated firm gives the former more discretion, and opens the doors for the possibility of regulatory capture. By regulatory capture, we mean the situation whereby firms invest resources into influencing the regulator’s decisions, to the point that the latter reflect the objective of profit maximization more than that of welfare maximization. In fact, even if the regulator is not actually influenced, the use of resources attempting to do so is socially wasteful.^f

fSee also the discussion on rent seeking presented in chapter1.

Given the problems of marginal cost pricing, an interesting alternative is that of average cost pricing. Under this regime, the firm is forced to set the lowest price consistent with making non-negative profits, that is, price is equal to average cost. This situation is depicted in figure 5.4, where p^A= AC(q^A) and q^A= D(p^A). As can be seen, this solution is intermediate between those of marginal cost pricing and unregulated monopolist. In the United States, the mechanism that in the past has mostly been used for regulating utilities is that of rate-of-return regulation. This is a mechanism whereby prices are set so as to allow the firm a fair rate of return on the capital it invests. Roughly speaking, this corresponds to average cost pricing.^g

gIf there is only one output and capital is the only input, then this is exactly the same mechanism as average cost pricing.

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Figure 5.4 Average Cost Regulation.

One major problem with rate-of-return regulation is that it gives the firm very few incentives for cost reduction. In fact, lowering cost implies that the allowed price will be accordingly lowered, leaving the firm with the same rate of return. In practice, there is a gap between the time when the firm reduces its cost and the time when the new regulated prices take effect—what might be called a regulatory lag—and this may provide the firm with some transitory gains. But the mechanism of rate-of-return is fundamentally flawed when it comes to incentives for cost reduction.

In the terminology of regulation theory, we say that rate-of-return regulation is a low-power incentive mechanism: Price varies in the same exact measure as cost, a fact that minimizes the incentives for cost reduction. At the other extreme, we have the most high-power incentive mechanism: This is the mechanism whereby price is set beforehand and does not change at all, even if cost changes. Roughly speaking, this is the essence of the price cap regulation mechanism. This mechanism provides maximum incentives for cost reduction: A one-dollar saving in costs implies a one-dollar increase in profits.⁵³

Or does it? Imagine that the regulator sets a price, or a price path, for a period of five years. During that period, the firm invests heavily in cost reduction. By the end of the five-year period, the firm’s cost is, say, one half of what it was initially. It is difficult to imagine how the regulator can ignore the extent of this cost reduction at the time of setting the price cap for the new five-year period. In fact, the greater the cost reduction achieved by the regulated firm during the first five-year period, the lower the price cap set for the second five-year period.

Following this line of argument, a somewhat extreme appraisal of price-cap regu-lation is to view it as rate-of-return reguregu-lation with a long regulatory lag (five years in the preceding example). The discussion is then focused on the length of the period that the regulator commits to a price-cap (or a price path). Ten years would seem like a reasonable period, sufficient to make price cap regulation substantially different from rate-of-return regulation. But the experience of several countries—including Great Britain, where the mechanism was first implemented—suggests that revisions of the price cap normally oc-cur at smaller intervals. This in turn casts some doubt about the effectiveness of price-cap regulation as an incentive scheme.

Another problem with price-cap regulation is that it creates few incentives for the provision of product or service quality, an aspect we have ignored until now. Unable to increase price, the regulated firm may have an incentive to reduce quality, thereby effectively increasing price “per unit of quality.”

Finally, implementing price-cap regulation raises the problem of determining the price cap. A high price cap implies the allocative inefficiency of a price greater than marginal cost (in addition to a transfer from consumers to the regulated monopolist). A low price cap may not be sustainable, as the regulated firm suffers losses. More generally, a high-power incentive scheme—of which price-cap regulation is an extreme—implies a high degree of risk for the regulated firm. In this sense, rate-of-return regulation is a better mechanism: The risk for the regulated firm is minimal. In summary:

A high-power regulation mechanism provides strong incentives for cost reduction but few incentives for quality provision. In addition, it implies a high degree of risk for the regulated firm and requires strong commitment on the regulator’s part.

5.3 ESSENTIAL FACILITIES AND ACCESS PRICING

Competition is the best way of recovering the allocative inefficiency lost in monopoly pricing. Regulation, in turn, is the best alternative when, because of natural monopoly conditions, competition is not feasible. The question is then when and to what extent we are in a natural monopoly situation.

The classification of many industries as natural monopolies has come into ques-tion. Take, for example, electricity. It is generally agreed that the basic network for the transmission of electric power is a natural monopoly—the costs of having two parallel networks would be much too high. However, there is little evidence of natural monop-oly at the stage of generation of electric power. Gas and railways are also examples of industries in which only one part is subject to natural monopoly (the gas transportation

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network and the railway track network, respectively). Still another example is given by telecommunications, where the natural monopoly would be the local network.^h

hThe latter example is open to debate, however. Some argue that not even the local network is a natural monopoly.

Suppose that competition is allowed in the parts of those industries where natural monopoly is not an issue (electricity generation, long-distance telecommunications, and so on). The problem that typically arises is that these parts cannot exist independently from the part that is a natural monopoly: An electricity generator needs the distribution network to sell its power; a long-distance carrier needs to place its calls through the local network; and so forth. Specifically, what we have is a monopolist (e.g., the local telecommunications operator) selling services to firms in the competitive segment (e.g., long-distance telecommunications) who in turn sell to the final consumer. In these cases, we say that the monopolist is an upstream bottleneck and that the monopolist’s assets or output is an essential facility. Seen from this perspective, the list of examples goes beyond that of public utilities (as considered in the preceding discussion). An airport, for example, is an essential input for transportation services into a certain city. Although there may be many competing airlines (downstream firms), there is frequently only one airport in each city, the owner of which is the upstream firm. In summary, essential facilties are a fairly common situation.

The regulation of essential facilities shares the same problems as those of monopoly regulation, which we addressed in the previous section. Moreover, it is frequently the case that the owner of an upstream essential facility also competes downstream. For example, France Telecom owns the essential facility (local network) and competes in the market for long-distance telecommunications. This type of situation raises a number of additional issues.

One possible concern is that the upstream firm may use its monopoly power to extend it downstream, thus creating monopoly power at the lower level as well. For one reason or another, the upstream firm may be unable to extract from the downstream competitors all of the monopoly rents in the value chain. By foreclosing its downstream competitors from the market, the upstream firm is able to recapture its maximum mo-nopoly profits.

From a social welfare point of view, foreclosure would seem to decrease consumer welfare (and total welfare): Consumers pay a higher price and have less product variety to choose from. One way of avoiding this is to force the upstream firm to divest its interests in the downstream market. For example, AT&T was broken up in 1984, resulting in a long-distance carrier (the new AT&T) and a series of regional telecom operators (the

“baby bells”). Competition was opened in the downstream markets (long-distance), while monopoly was preserved in the upstream, (local) markets.ⁱ

iThe 1996 Telecommunications Act allows for the possibility of local operators entering into long-distance telecommunications as well.

However, as we saw in chapter3, there may be important efficiency gains from vertical integration. For example, if the U.S. government had barred the merger between GM and Fisher Body, it is likely that the industry would have become much less efficient, on account of the difficulty to contract for investments in specific assets. As in many other instances of industrial organization, we have a trade-off between efficiency and market power.