11. RegulationIn this chapter you will learn:

Comparing monopoly with competition;Why break up a monopolist?; Increasing returns to scale: Why trying to create competition might not work;Price regulation;Problems with regulation;Airlines, Intel, AT&T, Microsoft;Exemptions: Baseball, health insurance companies;A second look at strategic game theory: patents;Corporate accounting scandals;Energy trading and Enron;Banking and deregulation;Net neutrality.

11.1 IntroductionIn 2008 and 2009 Air India, the state run and operated airline, ran into a number of embarrassing difficulties. Rats were discovered on one flight. On another flight a fistfight broke out between the pilots and the flight attendants. At one point there was no one in the cockpit. On yet another flight to Riyadh a passenger noticed that there were sparks coming out of one of the engines.1 Passengers are right to be appalled at such goings on.

There are many instances where firms put consumers at risk, take advantage of their workers, or try to get away with shoddy products, price fixing, and false advertising. For example, workers should expect to be paid a fair price for their work, yet some companies try to shortchange them. One ploy is to force workers to work off the clock. The worker is asked to work during their break or lunch time, or to stay late but not receive overtime pay. Hair salons, restaurants, hotels, hospitals, and other firms routinely engage in this activity, also known as wage theft. For example, Walmart has used this ploy extensively and has lost several class action lawsuits.2 In other cases a company illegally altered time cards to avoid overtime pay. Taco Bell lost several major lawsuits on this issue, including one in the state of Washington.3 And the problem doesn’t go away despite the lawsuits.4

Consumers have a right to consume a product without being injured by it. Yet, there are many cases of products that have caused injury, or even death because of a design flaw, or other defect. In many cases the manufacturer knew about the problem but did nothing about it, or hid the problem. For example, car manufacturers have recalled a record number of cars and trucks in recent years as they encountered serious safety issues, some of which were covered up. In 2009 – 2011 Toyota issued a series of recalls involving millions of its cars due to a sudden acceleration problem initially put down to a faulty accelerator pedal that was sticking. They paid a whopping fine of $1.2 billion for knowingly concealing the problem for years. Over twenty people died as a result.5 And GM recalled several million cars that had ignition switch problems, where the ignition could shut off unexpectedly causing the power system to shut down. This resulted in accidents where a number of people were killed, or seriously injured. There is evidence GM

1 Source: The Times of India.2 http://consumerist.com/2014/12/16/court-affirms-151m-ruling-against-walmart-for-making-employees-work-off-the-clock/ and http://www.aboutlawsuits.com/wage-and-hour-lawsuits-against-wal-mart-settled-2211/3 http://community.seattletimes.nwsource.com/archive/?date=19970409&slug=2533047, and 4 http://www.seattletimes.com/seattle-news/seattle-fast-food-workers-file-wage-theft-complaints/5 http://abcnews.go.com/Blotter/toyota-pay-12b-hiding-deadly-unintended-acceleration/story?id=22972214

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knew about the problem for over a decade and did nothing about it.6 And a variety of car companies issued a recall due to a faulty airbag that has caused numerous accidents and some fatalities. The airbag, made by the Takata Corporation of Japan, can go off unexpectedly and improperly and injure, or kill, the passengers in the front seat. Over 30 million vehicles are under the recall.7 It was revealed that they had stopped safety audits to cut cost.8

Various federal and state agencies have been set up over the years to protect consumers and workers in various circumstances such as work breaks, lunch hours, and overtime pay, e.g., OSHA, product safety, e.g., FCC, FTC, and food and drug safety, e.g., FDA, food labeling, e.g., FDA, and restaurant food safety, e.g., Public Health. There are other actions that also break the law and yet occur from time to time. These include false advertising, discrimination, various sales tactics like bait and switch, and price fixing. Usually, the Justice Department gets involved if it comes to light.

There are two schools of thought. First, there are those who argue for what is known as self regulation. If a firm produces shoddy quality, or charges high prices, consumers will eventually find out and go to another business, or if a firm treats its workers badly they will work for someone else. The company will lose customers, or workers, and either go bankrupt, or take steps to improve its product, or work environment. In a vibrant market, self-preservation will cause good firms to survive and bad firms to go under, implicitly protecting consumers and workers from harm. The other school of thought is that there is a great deal of uncertainty about the marketplace and information is very costly to collect and understand. This being the case, firms can get away with bad behavior for quite a long period of time thus causing harm to consumers and workers. Strict regulations are needed to protect consumers and workers.

There is no doubt that self regulation works in many instances, especially when information is freely available. For example, it is hard for a car dealer to get away with overcharging customers or lying about their products because of social media and web sites that provide information about cars. A firm that takes this self regulation mechanism seriously will respond to consumer or worker complaints by improving its product or its workplace environment. If it survives, we will never know about how the mechanism forced it to improve since this is based on private actions the firm takes in the background without us knowing about them. A restaurant may add new items to its menu or hire a better cook. A manufacturer may pay its workers overtime. A hospital may hire more nurses to improve its patient care. All we observe is that the firm’s product improved without really knowing why.

In many cases self regulation doesn’t seem to work very well, as the examples of wage theft and car defects mentioned before would indicate.9 And what if there are not many firms in the local market? Will they not have some market power and try to exert their influence over the market to increase their profit at the expense of consumers or workers? What if there is only one firm, a monopolist? Won’t the monopolist charge high prices, produce low quality products, and

6 http://www.nbcnews.com/storyline/gm-recall7 http://www.consumerreports.org/cro/news/2014/10/everything-you-need-to-know-about-the-takata-air-bag-recall/ index.htm8 http://www.nytimes.com/2015/06/23/business/takata-is-said-to-have-stopped-safety-audits-as-cost-saving-move.html?hp&action=click&pgtype=Homepage&module=second-column-region&region=top-news&WT.nav=top-news&_r=09 Self regulation was the avowed policy of Alan Greenspan, longtime chairman of the Federal Reserve. One of the tasks of the Fed is to regulate certain activities of financial markets and banks. During the 1990s and early 2000s Greenspan took a very passive role as a regulator because he believed in self regulation. He recanted about his philosophy during the financial meltdown in 2008 – 09, where self regulation obviously failed, saying he no longer believed that the market in financial services could regulate itself.

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generally take actions that are detrimental to consumers? How can one firm “self regulate?” The answer is that that a monopolist doesn’t have to “self regulate” since it has no competition.10

However, there is tension here as well. Suppose the monopolist is the only firm in the market because it has a patent or copyright. In that case the tradeoff may be between obtaining new products, e.g., pharmaceutical drugs, songs and movies, the Dreamliner, versus high prices and restricted sales. Suppose one has a copyright to a popular song or movie. How can one enjoy the benefits of that ownership if anyone can listen to the song or see the movie for free? What if there was no ownership right protected by patent or copyright? Would inventors and creative people still invent and create? Maybe not. Hence the tradeoff between monopoly versus new products exists.

There are also instances where either a single firm, or a small number of firms, attempts to control a market. Standard Oil is an early example.11 At one point the Standard Oil Trust controlled most of the domestic market in petroleum. John D. Rockefeller and his partners were accused of predatory pricing and signing special deals with the railroads to eliminate any competition. In 1911 the Supreme Court ruled against the Trust and it had to dissolve its partnership into seven independent companies, the so-called Seven Sisters. This was an attempt to create competition.

We will use our analysis of the firm to study the goal of anti-trust policy and whether or not it can be achieved. We will also discuss what might happen if it does not achieve its goal and how the firm might be regulated. There are cases where it is impossible to introduce competition into the market. The airline market might be an example of this. This may call for some form of regulation. We will also discuss problems that can arise with regulation and apply these principles to various case studies.

Another tradeoff is the benefit of protecting consumers and workers and ensuring fairness in the marketplace versus the cost of regulation. Any restrictions on business will impose cost. If the government inspects produce coming from Mexico this is costly and someone has to pay that cost. If the government undertakes mileage tests of cars, inspects restaurants for health and safety violations, or studies maintenance records of airlines, there is a cost. Some would weigh the benefits of these actions more than others, while some would weigh the costs more than others. There is no doubt there are both benefits and cost to such actions and that some are impossible to quantify. How can we place a value on a human life saved by regulations imposed on car companies?

In the 1970s the economy experienced rising inflation, increasing unemployment, and slow growth, or stagflation. We saw this led to efforts to increase the aggregate supply of the economy. Two policies were pursued, supply side tax cuts, which failed, and deregulation. Regulations raise cost for a firm and firms may cut back as a result causing output to fall and price to rise, which may contribute to inflation. The goal of the deregulation movement was to eliminate wasteful regulations thus lowering cost. We began by deregulating trucking under the Carter Administration, then moved to airlines, and eventually to banks and financial service companies. Later, in the 1990s, we deregulated pharmaceutical drug companies by allowing them to advertise. We will discuss some of these cases in what follows.

It is certainly possible we went too far in deregulating the economy. A number of corporate scandals erupted in the 2000s. Some of the largest companies in the economy were caught undertaking illegal activities like WorldCom, Adelphia, and Enron, many of which were

10 Apparently, the first monopoly recorded was in olive presses by Thales in ancient Greece, 3000 years ago. http://epochproducts.com/blog/the-first-monopoly-in-the-world-was-about-olive-oil/ It is not known if it self regulated, or not.11 http://www.history.com/topics/john-d-rockefeller

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prosecuted successfully. We also deregulated the financial services sector and banks and finance companies responded by coming up with new products and new strategies that caused a massive increase in risk. Unfortunately, the large increase in risk almost caused the banking system to collapse in 2008 – 09 when interest rates started rising and the housing bubble burst.

11.2 Breaking Up a MonopolyThe government may try to use anti-trust laws to break up the monopolist. There are different ways of doing this. First, it can remove an exclusive franchise that it granted and allow other companies to compete. For example, NASA has an exclusive franchise in the United States to launch satellites into orbit. The government could allow private firms this ability. Another possibility is to allow a patent to expire. Most countries allow patent protection for a fixed period. This effectively keeps new competing products off the market. So, as an example, drug companies can earn more profit if generic drugs can be kept off the market. A third possibility is that the government may formally charge that a company is a monopolist and force a break up of the firm under the Sherman and Clayton Anti-Trust laws of the US.12

Consider the following set-up. Unit costs, e.g., wage rate, are constant and the technology exhibits constant returns to scale. The monopolist chooses output where MR = MC and this gives us output ym and price pm.

Now suppose we break up the monopolist into small firms and try to induce competition. A number of things can happen, of course, but suppose the break up is a success and new firms enter the industry inducing competitive behavior. (We would expect entry because pm > AC from the diagram. Recall, when MC is perfectly elastic, MC = AC.) If competition prevails in the long run, the technology remains the same, and factor prices like the wage are constant, the long run competitive price must be equal to MC, i.e., pc = MC = AC. Why? Because with CRS and constant costs, MC remains where it is while the industry is adjusting and price must equal MC in the long run because pc = AC so there are no profits that generate entry into the industry, and AC = MC. The total amount of output under competition will be given by yc in the diagram. Why? Because at price pc this is how much consumers are willing to buy. From the diagram, the gain to breaking up the monopoly is a lower price pc < pm and larger output yc > ym.

11.3 Consumer's Surplus and the Gain to Breaking Up a Monopolist.

12 John Sherman sponsored the law that bears his name. He was the younger brother of General William Tecumseh Sherman of the American Civil War.

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We can use consumer's surplus to calculate the gains from imposing a policy like breaking up a monopolist as long as the policy alters prices. Calculate the consumer's surplus before and after a change in the economic environment and see whether the consumer's surplus has gotten larger or smaller. If there is more consumer's surplus after the change in policy, then the change was a favorable one for consumers.

Suppose government breaks up the monopolist. Price falls to pc and output increases to yc. Above is the consumer's surplus under monopoly and under competition. Whenever the price falls, consumer's surplus increases. The difference in the two areas above is depicted below. This is the gain in consumer's surplus due to the lower price. This is what people have in mind when they talk about the gain to breaking up a monopolist. It is an actual dollar measure of the benefit to breaking up the monopolist.13

A calculation of this was made during the debate over breaking up AT&T and also when we were considering the deregulation of the airline industry. Calculations have also recently been made for the electric power industry as well. Showing that there is a large increase in consumer's surplus due to a particular policy action provides strong evidence in favor of taking the policy action. However, in some cases those calculations may not have been accurate. The airlines may be a case in point.

13 This gain is given by (pm – MC)ym + (1/2)(yc – ym)(pm – MC).

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Of course, if the monopoly exists because it is a natural monopoly, then there are increasing returns, i.e., the industry is not characterized by constant returns to scale. In that case, we cannot induce competition by breaking the monopolist up into smaller companies hoping to get a competitive industry out of the bargain. If CRS does hold, and the monopoly exists for other reasons, we can ask if there is another possible policy to use. One possibility is to allow a patent or copyright to expire. This is especially important in the pharmaceutical drug industry. After 17 years we can let the patent expire and allow generic drugs on the market at much lower cost. If the monopoly is a government franchise we can ask if there isn't a better way of providing the service. For example, we can allow other package carriers to deliver packages like UPS instead of the Postal Service. Competition from UPS might make the USPS more efficient.

11.4 Problems with Breaking Up a Monopoly.11.4.1 What if there is increasing returns to scale? It is certainly possible that the monopolist might actually experience increasing returns to scale that might be hard for the government to detect. If there are scale economies that cause the average cost curve to fall over a large range of output, it will be impossible to induce competition.

Application: Power companies. Typically, the generation of electrical power involves large fixed costs. The fixed costs of building and maintaining hydroelectric dams and nuclear power plants, power lines, generating stations, and what not, are huge. If fixed costs are high, this may keep potential competitors from entering the market when the monopoly is broken up. Prices and profits may be uncertain and risk averse firms may be unwilling to take the gamble and enter the industry even though they suspect there might be profits to be made. High fixed costs might be a barrier to entry because they create long run costs that are falling over a broad range of output.

Application: The airline industry. By the late 1970s there were eleven airlines competing nationwide. These companies included some of the most venerable "blue chip" companies in existence at the time, e.g., Braniff, Eastern, American, United, TWA, Delta, and so on. Routes and fares were regulated by the Civil Aeronautics Board (CAB), and by the Federal Aviation Administration (FAA) regulated safety. The airlines were not allowed to compete on price or routes, but competed on quality of service instead. For example, a traveler going from New York to Chicago could count on getting a hot meal of real food served with metals knives and forks. Unfortunately, whenever costs went up, the airlines asked for a fare increase, the CAB held hearings, and routinely granted the increase. Over time, costs tended to drift upward and fares increased to cover cost. The government ran the industry like a cartel. Large economic profits were being earned by the industry and it was argued by advocates of deregulation that competition would lower fares considerably.

In the mid 1970's several studies were done on the cost structure of the airline industry. Airline companies that operated exclusively within a state were not regulated by the CAB but were regulated by state agencies who were usually much more lenient in trying to maintain competition than the CAB. One study compared small airlines in California who only flew routes within the state, e.g., San Francisco to LA, with CAB regulated airlines like American and United who were also flying the same routes in California. The study found that the smaller airlines, who were not heavily regulated, charged lower prices yet experienced about the same level of average cost as the large, heavily regulated, carriers. A similar study on airline competition in Texas found the same thing; average cost appeared to be approximately constant across small and large airlines, yet fares were lower on the less regulated firms. This led some to believe that the airline industry was characterized by constant returns to scale and constant costs (wage). The main conclusion was that the fares allowed by the CAB were well above the average

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cost of production yielding large economic profits to the airlines. So breaking up the monopoly of the regulated airline industry by eliminating the CAB and all of its regulations on fares and routes would eventually lead to greater competition and thus lower ticket prices. Consumer's surplus would shift away from the monopolized airlines to the consumer.

Deregulation began in 1978 under the Carter Administration. As deregulation began companies started entering the industry quickly and the demand for airplanes and gate space at airports increased dramatically. At one time in the early 1980s there were over 30 airlines competing for customers. Competition led to lower fares and some interesting innovations like use of the hub and spoke system of flying a network of routes. (The airlines used to fly a lot of direct routes, e.g., Seattle to New York, and many times a plane would be half full. By flying all planes into a hub, e.g., Chicago, however, and having most passengers change planes at least once on route to their final destination, the average number of occupied seats increases and this increases an airline's revenue. Federal Express pioneered the use of the hub and spoke system. By flying all of their packages into a hub, e.g., Memphis, and offloading them onto another plane that then takes the packages to their final destination, occupancy of each plane is much higher and each plane becomes more profitable.

However, many quickly discovered that it is much more difficult to run an airline than they had thought and firms started dropping out of the industry. Surprisingly this included several of the original eleven companies like Eastern Airlines and Braniff, and TWA and Continental merged. By 1995 only two of the companies that had entered the industry in the early 1980s were still flying, Valujet and America West. The rest either went out of business or merged with other companies. In 1977 just before deregulation the market share of the top three airlines at the time, United, American, and TWA, was 41% but this had increased by 2015 to 49% for the top three carriers, Southwest, Delta, and United.14 So it would appear that the airline industry is more concentrated than before deregulation started meaning the top airlines control more of the market. There are some who now believe that the airline industry is subject to increasing returns that cause cost to fall thus leading to bigger firms. Clearly, an industry with only three or four firms will not behave in the same way as a competitive industry with many producers.

11.4.2 Are incentives dampened for future potential monopolists? Remember, new ideas generate new products and improvements in old products. People need an incentive to come forth with new ideas. If the government is too aggressive in breaking up a monopolist, this might send the wrong signal to future inventors.

Application: Google. The government investigated AT&T and decided to bring a case against them. The result was the break up of the company in 1982 when they gave up control of the Bell Operating System for local telephone service. In the 1990s the government went after Microsoft for predatory anti-competitive behavior and the judge found for the government in 2000. Did this have a chilling effect on Google or Apple? This is hard to say, but probably not. Google has 67% of the search market on desktop computers and 83% on mobile devices, and they are aggressively seeking to increase their share.15 Should the government investigate?

11.4.3 Costs might not be constant. Entry by new firms causes an increase in the derived demand for important inputs like skilled labor or a key resource. Higher input prices cause the MC curve to shift up. So if new firms enter and bid up the unit cost of labor, for example, then everyone's MC curve will shift up and this

14 https://people.hofstra.edu/geotrans/eng/ch3en/conc3en/airlinemarketshare.html and http://www.transtats.bts.gov/15 http://searchengineland.com/googles-search-market-share-67-percent-pc-83-percent-mobile-203937

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will reduce the gain to be had from breaking up the monopolist. If the MC curve shifts up all the way to the monopoly price, then there is no gain from breaking up the monopolist.

11.5 Price RegulationThe main objectives of price regulation are to lower the price, increase the quantity produced, and reduce the incentive to shift resources across sectors. The monopolist chooses output where MR = MC. This yields output ym and price pm. Under competition pc = MC and this occurs where the demand curve intersects the MC curve. At that point, pc < AC, so the cost structure cannot support competition. The regulated price is chosen to eliminate economic profit so pr, the regulated price, set equal to AC. This occurs where the demand curve intersects the AC curve. Either the regulator would tell regulated firm what price to charge, p r, or it would tell it what quantity to produce, yr. Both produce the same outcome. At pr = LRAC there is no incentive for any resources to move into the regulated sector, or out of that sector.

Typically, the way this works is there is a commission in charge of regulating the industry. The commission uses cost data and data on demand to determine the point where price equals average cost. When the price is said trading in the marekt can be undertaken at the regulated price. If there are changes in cost or demand, the commission holds hearings and hears the evidence for and against a rate increase.

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11.6 Problems with Regulation11.6.1 Can industry information be trusted?The regulatory agency must know the cost structure of the firms being regulated and must know the demand curve. However, the question then becomes: where do they get the information from? They must go to the industry to get the information, but the people in the industry are not stupid. They know why the government wants the information. So there's an incentive to hold back information, or give the government information that is in favor of the industry.

11.6.2 A regulated firm has no incentive to keep costs down. A typical pattern is the following: the regulated firm goes before the agency regulating it and asks for an increase in its price to cover higher costs, e.g., labor. The Commission or agency takes testimony in public hearings. Few but the industry proponents attend the hearings usually. Finally, the Commission grants the request. Knowing in advance that most of its requests for rate hikes will be granted, the regulated firm has no incentive to keep its costs down.

Example: bargaining with a labor union. The regulated firm has no incentive to be a tough negotiator with its labor unions if it can get a rate increase to cover higher labor costs.

11.6.3 Are regulated firms efficient?Regulated firms tend to be inefficient. For example, they may have plush offices for company officials, lucrative fringe benefit packages, fully equipped gyms, paid “conferences” in the Bahamas, and so on. This can occur because of a lack of competition. The profits of the firm exist but are not channeled to shareholders. Instead, management spends the profits on itself.

11.6.4 "Passive" acquiescence may exist among regulators. Where does the government go to get "experts" who can sit on a regulatory Commission? The only place is the industry itself. Yet, those people are probably going to lean in favor of the industry to begin with. This is what I call "quiet" acquiescence; this type of regulator "sees" the industry viewpoint better than they do the consumer's viewpoint. Furthermore, when someone sits on a commission, what do they do when their term of office is over? Probably they will take a job in the industry they were regulating. Who will give them a job if they take the side opposing the regulated companies? So a commission member does not have an incentive to "rock the boat" and be tough with the companies he/she is trying to regulate.

Example: The CAB regulated the airline industry from 1938 until deregulation in the late 1970's. 24 Commissioners retired from the CAB during that period and 12 of them took jobs in the airline industry. There is no evidence the commissioners took any action that hurt consumers.

Example: The CEOs of the top five investment banks met with regulators from the SEC in 2004 and asked to use their capital allowance, which is like a reserve requirement, to invest in derivative securities. The regulators allowed them do so, which meant their capital reserves were too low, a violation of the SEC code.16 It also meant that each investment bank had more assets in derivatives tied to home mortgages. The value of these loans dropped when the housing price bubble burst causing solvency problems for the investment banks, two of which no longer exist, Bears Sterns and Lehman.

11.6.5 CaptureThis is a situation where the regulator espouses the viewpoint of the firms being regulated rather than protecting the interests of the people. It is a form of political corruption, which may allow

16 http://www.nytimes.com/2008/10/03/business/03sec.html?pagewanted=all&_r=0

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firms to undertake behavior which is injurious to the public. When regulators take the position of the industry and push their agenda, it clearly violates the trust of the public.

Example: Over 200 SEC employees left the SEC between 2006 and 2010 and took jobs in the industry they regulate.17 This “revolving” door creates the distinct impression they are not working for the good of the consumers. Some of these employees advised clients and lobbied on their behalf in the specific areas where they had been regulating while they were at the SEC. This goes beyond quiet acquiescence.

Example: Some believe the FDA acts in the best interest of the food and drug industries rather than in the best interest of consumers. A number of pharmaceutical drugs like Vioxx have been pulled from the market because of severe adverse side effects and in the case of Vioxx, the scientific evidence supporting the drug was faked.18 Perhaps the FDA has been captured by the drug industry.

Example: Has the NHTSA that regulates automobile safety been captured? Some critics charge the auto industry has undue influence on NHTSA’s decisions, e.g., rulings involving faulty airbags, which did not require a total recall of affected cars, but only some in warm climates.19

11.6.6 CorruptionOutright corruption may exist among regulators. Are regulators doing their job? Or are they simply protecting the vested interests of the regulated industry?

Example: EPA. Anne Gorsuch Burford was appointed head of the EPA by Ronald Reagan in 1981. Burford was a strong advocate of reducing regulations imposed on business. She refused to enforce many of the environmental laws and dramatically reduced her own budget by 22% and cut the EPA staff by 23%, facts she was proud of. The cuts were steepest for research and enforcement. There were large decreases in cases brought against polluters, and an attempt was made to soften the Clean Air Act. She was held in contempt of Congress when she refused to release documents pertaining to the Superfund because of Executive Privilege. The Superfund was designed to finance toxic clean up sites, including Hanford. The Justice Department refused to support her and began an investigation into corruption at the EPA. After a short tenure in the job of less than two years, she and a number of her top level staff were forced to step down due to allegations of financial impropriety involving the Superfund.20

11.7 Anti-Trust ActionUnder the anti-trust laws of the US the Justice Department can bring suit in federal court to force a large company to divest itself of some of its holdings because the company is trying to dominate a market and create a monopoly for itself. The first "Trust" broken up of any real consequence was the Standard Oil Trust created by John D. Rockefeller. Within thirty years each of the separate companies, e.g., Standard Oil of New Jersey, became larger than the original parent company because the demand for gasoline increased dramatically.

Application: Certain activities are illegal. Price fixing, for example. A famous case involved Robert Crandall, CEO of American Airlines. He made a phone call to another CEO (of Braniff

17 http://www.pogo.org/our-work/reports/2011/fo-fra-20110513.html and http://www.pogo.org/our-work/videos-and-podcasts/2011/fr-fra-20110523.html18 http://www.npr.org/templates/story/story.php?storyId=1621194719 It was initially thought that the airbag was most vulnerable in hot humid climates like the deep South in the US. Interestingly, the recalled airbag was replaced with one with the same propellant, which some experts blamed for the problem to begin with.20 Washington Post, 7/22/04

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Airways) suggesting that the two companies end the price war they were currently engaged in. The other CEO told him to call back, and then proceeded to call the FBI who taped a subsequent phone conversation where Crandall tried to get the other company to end the price war. This is illegal.21

Application: The local movie theater market. At one time in Pullman-Moscow there were seven independent theaters showing movies, the U-4 (Now closed), the Kenworthy, the Nuart, the Micro (Now a tattoo parlor), the Audian (Now closed), the Cordova (now a church), and the Old Post Office (now the Wine Bar) with a total of ten screens. By 1988 a large company, Carmike Theaters, had bought out all but the Micro in Moscow and the Old Post Office in Pullman, controlling 80% of the screens. The company then attempted to buy the Old Post Office. Consumers protested to the Attorney General of the State of Washington. The response after an "investigation" was that ticket prices did not appear to have been affected by previous buyouts so they allowed Carmike to buy the Old Post Office. The company immediately raised the ticket price at the Old Post Office from $1.50 to $5.00, the price they were charging in their other theaters at the time. People boycotted the Old Post Office and the company finally backed down lowering its price to $2.50. Eventually, the OPO went under and transformed itself into the Wine Bar.

Fortunately, there was new entry into the industry in the 1990s when the Eastside Cinema opened up in the mid 1990s. Interestingly enough, the ticket price of a movie increased after they entered the market. Why? They chose to compete on quality dimensions, e.g., good popcorn, nice chairs with cup holders, rather than on price. In the late 1990s Carmike at the U-4 lowered its matinee price and began selling off some of its theaters nationwide. The Village Centre Cinemas entered the local market in 2004 and charged a higher ticket price than the going rate. It offered stadium seating, a real novelty on the Palouse at the time. Several theaters shut down because they couldn't compete, including the Nuart, the Kenworthy (which now shows specialty films), the Cordova, and the U-4 in 2007. The Village Centre Cinema bought the Audian and used it for children’s matinees and specialty movies, but shut it down in 2008 since it was too costly to heat. The owners of the Village opened a new multiplex in Lewiston, ID in 2008 and bought the only other theater in town to show second run movies, controlling all of the screens in Lewiston. They also opened a multiplex with stadium seating near Newport north of the “Y,” to capture the demand from the new communities that are developing to the north of Spokane. Eventually, the Village bought the Eastside. The Village Centre now controls all of the screens in Pullman and Moscow with the only exception being the Kenworthy. So it would appear that the Village Cinema is the new “monopolist” in eastern Washington.

Application: Movie production companies, e.g., MGM, 20th Century Fox, Paramount, Universal, and Warner Brothers, in the 1930's also owned chains of theaters. So in addition to making the movies, they also showed their own movies in their own theaters. Occasionally, they would "trade" movies and show their competitors' movies. However, the Justice Department brought suit arguing that this created a monopoly for a particular movie, e.g., "Gone With the Wind," especially in small towns where there might only be one theater. Eventually, the courts forced the major studios to sell off their theater chains. Interestingly enough, there has been a long period of consolidation and right now there are only three large companies that own and operate theaters nationwide in the US. Finally, the explosion of demand for videos has reduced the demand for seeing movies in the theater and shifted emphasis away from theaters to VCR equipment, later DVD players, and "home entertainment theaters." Did the movie companies and the theater companies drive the demand for their product away by exploiting consumers,

21 http://www.nytimes.com/1983/02/24/business/american-airlines-target-of-us-suit.html

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e.g., charging high ticket prices and high prices for popcorn? (Theaters still control concessions and thus have a monopoly on popcorn sales in the theater. Unfortunately, no one in government seems to care about this monopoly even though they clearly charge an arm and a leg for soft drinks and candy.)

Example: new technology. Does technology make monopoly obsolete? Sometimes. The cell phone would surely have eliminated AT&T’s monopoly on phone service. Energy trading has changed pricing for electrical power. Video conferencing has altered the use of air travel.

Application: Intel, the maker of microprocessors, has come under attack from several competitors including its main rival Advanced Micro Devices. To settle a lawsuit and end anti-trust action and patent infringement charges, Intel will pay A.M.D. $1.5 billion. In return, A.M.D. will withdraw all anti-trust complaints world wide, including Japan where there were two lawsuits filed. To quote the article in the NY Times, “The complaint filed in 2005 in Delaware accused Intel of bullying dozens of computer makers, retailers and distributors by threatening to retaliate against them if they did business with A.M.D. The complaint also accused Intel of using improper tactics, like discriminatory rebates and subsidies to win and keep customers.”22

Application: AT&T In 1974 AT&T was cited by the Justice Department for violating the Sherman Anti-Trust Act. The Justice Department claimed that AT&T engaged in illegal practices in an attempt to eliminate competition for telephone equipment and long distance telephone service. After eight years of legal battling, it was agreed in 1982 that AT&T would divest itself of 22 local phone companies, 65% of AT&T’s assets, and give up its monopoly on long distance phone service. It was allowed to keep its research division, Bell Laboratories, and its manufacturing division, Western Electric. They were also allowed to enter other industries like cable television, computers, and digital data networking. As a result of the break-up, long distance rates came down while local calling rates went up. This was because AT&T had traditionally subsidized local service by charging slightly higher rates for long distance calls, which ended when AT&T was stripped of its local companies. Sprint and MCI immediately entered the long distance phone market. Ten years after the break up MCI and Sprint had captured about 50% of the long distance market and long distance rates fell about 25% between 1982 and 1996.

New technologies can also have a major effect on breaking a monopoly. If there are positive economic profits, we should expect new firms to enter the market and some of them will enter the market with new technology. Internet phone calls, e.g., Vonnage, is an example of a new technology that competes with the traditional land line. This kind of competition can easily break the grip of the phone companies. Cell phones are another perfect example. It is very possible that the advent of the cell phone would have caused AT&T to lose much of its land line business and threatened its monopoly on phone service.

11.8 MicrosoftDuring the 1990s there was incredible competition in the software market and the desktop computer market. Microsoft, Apple, Netscape, Sun Microsystems, IBM, and others all vied for market share. Microsoft had an edge because it produced the operating system Windows, in addition to software like Internet Explorer, Word, and Excel. An operating system controls the basic functions of a computer and is somewhat special as a result. Why? Because the operating system is a “standard” that other software developers can use in developing software programs to

22 See “Intel Will Pay $1.25 Billion to Settle Disputes With Rival”, NY Times 11/12/09.

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be used on a desktop computer.23 If there are ten standards, rather than one, then software developers don’t know which one to use in developing applications. However, if there is only one, then they do. The question is who will develop the standard?

When one company has such a dominant position, competition may not prevail and that company may undertake actions that are injurious to competition. For example, to combat competition Microsoft started incorporating its internet browser software, Internet Explorer, directly into its operating system, Windows, making it the preferred choice for any PC software developer. Sun, Netscape, and the Justice Department, argued that this gave Microsoft an unfair advantage. One proposal would separate the operating system, e.g., Windows, from its other software products like Word and Excel by breaking Microsoft into two companies. Another company would continue to develop the operating system, while the other would develop products like Word. Microsoft argued that programs like Internet Explorer are an integral part of the operating system and cannot be separated from it. The court eventually ruled against Microsoft. In addition, courts in Europe have also ruled against Microsoft for predatory behavior.We should expect to see entry occur in any industry where there are economic profits being made. That is exactly what happened in the 2000s with the introduction of the iPod, iPad, iPhone, tablets, and the Samsung smart phone, among others. Consumers can use a tablet for a variety of computer tasks that they used to do on their PC or laptop, e.g., online banking, reading the “newspaper,” or an e-book, checking movie show times, playing games, and texting. So the operating system on these new devices now competes with that of Microsoft’s PC system; it has lost its monopoly on the operating system. In fact, Microsoft was so worried about this that they introduced their own tablet called the Surface. However, it is finding it difficult to compete against other brands like Apple.24

This illustrates an important point. Economic profit will generate entry. It is only a question of time. Other firms will think of ways to compete for those monopoly profits. Another interesting question is what is the role of government regulation in such an environment? This is somewhat unclear and is the subject of ongoing research. How should the government regulate such a firm like Microsoft in the 1990s? Should it regulate it at all? That is difficult to answer. In hindsight we know the cell phone would compete with AT&T or the iPad would compete with Microsoft’s operating system on the PC. Unfortunately, we didn’t know that beforehand.

11.9 Exemptions from Anti-TrustSome industries receive an anti-trust exemption. Baseball is one notable case. The health insurance industry is another. Mergers between health insurance companies must be approved by the Justice Department. However, over the last decade many mergers were routinely approved with little or no concern for whether the result would increase competition or reduce it. In most cases mergers led to higher concentration, which one might think would reduce competition.

The anti-trust exemption for health insurers comes from the McCarran-Ferguson Act, passed in 1945. This law protected states’ rights to regulate insurance companies. Second, it also allowed insurance companies to share claims data. Firms are generally not allowed to share data within an industry since they may be able to use such data to reduce competition. American

23 Other examples of “standards” include the QWERTY typewriter keyboard, use of one language in the school system, and driving on the right hand side of the road. The operating system of a computer is an example of a dynamic standard that must evolve over time with the technology, whereas the QWERTY typewriter, or driving on one side of the road rather than the other, are static standards that do not need to evolve. All standards are an example of a “public good,” which we will study at the end of the semester.24 See http://www.pcworld.com/article/2056713/microsoft-downplays-rt-and-hides-the-desktop-on-its-surface-tablets.html

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Airlines, for example, does not share its passenger data with United. Intel does not share research data with its rival A.M.D.

James Robinson, a health economist, found that the three largest health insurance companies controlled more than half the market for health insurance in almost every state in the US in 2003. The American Medical Association stated that by 2008 the largest insurer controlled over 30% of the local market in 90% of the major metropolitan areas in the US. This coincided with an increase of 131% of premiums for family coverage from 1999-2009.

Interestingly enough, the McCarran Act may not have been the culprit. Federal regulators may not have been doing their job in closely scrutinizing mergers and their impact on the health insurance market. From 1999 – 2008 there were over 400 mergers of health insurance companies and only two were challenged by the Justice Department. State authorities have been more aggressive in challenging mergers. However, the problem is that state regulators’ are limited in their jurisdiction.25

11.10 Is "Free Trade" Always Optimal?Under free trade the price in country A is equal to the price in country B and under competition, price is equal to MC and AC. If price were higher in A, then firms in B would export the good to A lowering the price in A and raising the price in B until they are equal.

Consider the following scenario. Suppose good x is produced by a monopolist in country A and good y is produced by a competitive industry in country B. A exports x to B and B exports y to A. Furthermore, suppose no one in country A consumes x; the only people who consume x live in country B. Question: should country A break up or regulate the monopolist in its own country? Probably not, because country A benefits from the monopoly at the expense of the residents of country B.

In this case free trade is not optimal. Free trade would require that the government in country A somehow induce competition in industry x to get the price down to the AC. However, doing so makes the people living in country A worse off and the people living in country B better off. Why should country A do that?

Suppose some of x is sold in country A. Should A break up the monopolist?Current US policy is contradictory, or confusing. Big surprise that, huh? Ford and GM cannot

form a partnership to fight imports from Japan. However, GM and Toyota are allowed to form a partnership to build cars in California that compete against Ford.

Application: AT&T in Europe. Most European countries have phone systems that are either run by the government or heavily regulated by the government and the quality of telephone service is not very high. There is a move to deregulate the Telecoms industry in Europe and the one time monopolist AT&T wants to compete in Europe.

Question: What meaning does anti-trust action have in a global economy? If the government in a country attempts to break up a company owned and operated in that country, the company can move offshore and export back to the country that threatened it in many cases. And can one country truly affect a multinational firm doing business in other countries? Whether or not anti-trust action makes sense in a global economy is an open question. It may require international agreements amongst the developed countries of the world in order to be effective. Even so, different standards may be applied in different countries. What one country is willing to put up with in terms of anti-competitive behavior may differ from what other countries are willing to endure. Traditionally, European countries have been much more involved in their economies than the US. Thus, US companies typically have to deal with more regulation in 25 Source: “Blame less insurance competition on antitrust regulators, not a law,” by Michael Hiltzik, 11/2/09, http://articles.latimes.com/business

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Europe than they do in the US. For example, the chipmaker Intel was fined $1.45 billion by the Europeans for taking advantage of its market power in Europe. Nothing was done about their use of the same practices in the US. The Justice Department is still investigating.

Application: International banking industry. Central banks regulate the financial services industry. Many countries in Europe, e.g., Spain, Ireland, were caught up in the housing boom in the early 2000s. In 2006, the ECB, European Central Bank, began raising interest rates in Europe to cool off the housing market. However, Japan had reduced its interest rates in the mid 1990s to fight its decade long downturn. This created a world wide incentive to borrow at the low rate in Japan, convert Yen to local currency, e.g., Euros, and make loans at a higher interest rate. When the ECB raised rates in Europe, Spanish banks decided to maintain their heavy lending in the local housing market by borrowing from Japan, converting the Yen to Euros, and making mortgage loans in Spain. The ECB was powerless to stop this subversion of its policy and the housing bubble in Spain continued unabated until it crashed in 2008.26 The extra borrowing it did before the crash made banks in Spain even more vulnerable after the bubble burst.27

11.11 Game Theory and uncertainty: Protecting new ideas.Suppose there is a law that protects patents but because of costs the government doesn’t protect all patents; they cannot afford it. So they only protect some of the patents and this creates uncertainty for a patent holder.

Consider the inventor's decision. There are two actions she can take: develop the idea into a product, or don't develop the idea. Nature chooses whether there is protection of the idea or not. The payoffs are,

where = economic payoff from developing the idea, c = cost of developing the idea, I = resources spent in defending your idea by yourself, e.g., legal costs. Let p = probability the government protects your invention and (1 - p) = probability the government doesn't protect your invention. Calculate the expected payoffs from each action,

EP (develop )=p ( π−c )+(1−p ) ( π−c−I )¿ pπ−pc+ (1−p ) π−(1−p ) c− (1−p ) I¿ π−c−(1−p ) I

EP (do n' tdevelop )=p (0 )+ (1−p ) (0 )=0Next compare the expected payoff from the two actions. This gives us the following decision rule:

Develop the idea if EP(develop) ≥ EP(don't develop) or - c ≥ (1 - p)I,Don't develop the idea if EP(develop) < EP(don't develop) or - c < (1 - p)I.

26 http://www.bbc.com/news/business-1754997027 In 2015, even years after the housing bubble burst, the general unemployment rate in Spain was about 25% and among young people, almost 50%!

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Example: Suppose = 100, c = 50, and = 75. Then EP(develop) = p50 + (1-p)(-25) = 75p - 25, and EP(don't develop) = 0. Develop the idea if 75p - 25 > 0, or, after rearranging, p ≥ 1/3. To check that this makes sense, suppose the inventor believes p = 1. What should she do? She should develop the idea. If instead she believes that p = 0, she shouldn't. In a sense, p = 1/3 is a "break even" probability. If the inventor believes the true probability of protection by the government is equal to this or greater, then she should develop the idea. For example, if she believes the true probability of protection is 2/3 then she should develop the idea because 2/3 > 1/3. If she believes the true probability of protection is 1/10, she should not develop the idea.

Example: Same as the last example except c = 25. What is the break even probability? What should she do if she believes the true probability of protection is 1/4?

Example: Same as the first example except the government subsidizes legal costs of protecting one’s idea so I = 50. What is the breakeven probability?

What can we conclude about the impact of c and I on the decision to develop a new idea?

Let's interpret the decision rule: develop if π−c≥ (1−p ) I . The payoff to developing the idea net of cost is - c regardless if someone steals the idea or not. However, if someone tries to steal the idea resources have to be spent defending it, I. This latter possibility occurs with probability (1 - p). So when the inventor is making her decision, (1 - p)I = expected cost of defending the idea. If the net benefit of the idea, - c, is greater than or equal to the expected cost of defending the idea, then she should develop the idea.

The higher p is, the higher is, the lower c is, or the lower I is, the more likely it is that she will gain from developing the idea. The government can affect this decision by spending resources to increase p, or lower c, or I. Since new ideas are important, the government might want to subsidize this behavior. It can spend resources to raise p, lower c, or lower I.

11.11 Game Theory with strategic players: Patent ProtectionThere are two players, the inventor and the government. The actions available to the inventor are develop the idea, or not. The actions available to the government are to protect the idea, or not. The payoffs are listed in the table. Recall, the first number in an ordered pair of payoffs is the inventor's payoff and the second number is the government's payoff. For example, if the government chooses to protect the idea and the inventor develops the idea, the payoff are (5, 2). The inventor receives 5 and the government receives 2. The game is played once. Each player wants to maximize her own payoff and has to figure out what the other player will do.

A Nash equilibrium for the game is an action for each player in the game such that no one has an incentive to unilaterally change their action. We have to check each of the four possible outcomes depicted in the table to see if either player has an incentive to deviate by themselves. If a player has an incentive to unilaterally deviate, then those actions cannot be a Nash equilibrium.

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If neither player has an incentive to unilaterally deviate, then that set of actions is a Nash equilibrium. Keep in mind there may be more than one equilibrium in a game.

Is there a Nash equilibrium in the "Patent Protection" game? Is (don’t develop, protect) with payoffs (0, 0) a Nash equilibrium? Suppose the inventor thinks the government will choose to “protect” the idea. Should they choose the action “don’t develop,” or should they choose “develop?” Since 5 > 2, they should develop the idea. If the government believes that the inventor will choose the action “don’t develop,” what should the government do? Since 1 > 0, the government should choose “don’t protect” the idea. So (don’t develop, protect) cannot be a Nash equilibrium.

How about the actions (develop, protect) with payoffs (5, 2)? If the inventor thought the government would choose “protect” the idea they would choose to “develop” it. However, if the government believed the inventor would “develop” the idea, it would choose “don’t protect” because 4 > 2. So this cannot be an equilibrium. Using the same logic, (develop, don’t protect) with payoffs (-2, 4) is not a Nash equilibrium. Finally, (don’t develop, don’t protect) is a Nash equilibrium. If the inventor thinks the government will not protect ideas, then they won’t develop their idea and if the government believes the inventor will not develop the idea, it will choose not to protect it. So this is a Nash equilibrium. It is the only equilibrium. What happens if (5, 2) is (5, 5) instead? In that case, (5, 5) and (0, 1) are both a Nash equilibrium of the game. Make sure you can figure out why. So a game may have more than one Nash equilibrium.

In this application, Game Theory instructs us that it may be difficult to get inventors to believe that the government will protect ideas and that this may have a chilling effect on the development of new ideas. The government, however, can try to convince them by developing a reputation for protecting ideas by enforcing laws that do just that. Unfortunately, in many countries the burden is on the inventor to show that someone else has infringed on his copyright or patent and then to spend his own money to sue in order to protect his rights.

11.16 The wave of corporate scandals“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Adam Smith, The Wealth of Nations, 1776.

It would probably surprise a lot of people to know that Adam Smith did not trust people in business, as indicated by the quotation at the beginning of this section. Smith lived at a time when businesses could do just about whatever they wanted to with impunity in terms of price fixing, selling shoddy products, lying about their wares, and generally taking advantage of their customers. There was very little government oversight of business in Britain during the eighteenth century when Smith wrote his magnum opus, The Wealth of Nations. This explains his lack of trust.

To be sure, there is a great deal of oversight now and there are many laws that protect consumers and workers in most advanced economies. However, the examples at the beginning of this chapter strongly suggest that business will try to get away with as much as they can to keep cost and hence price down. For example, no company will reduce the pollution it causes of its own accord since that will raise its cost relative to its competitors. No individual firm will pay its low skill workers a $15 minimum wage unless all are forced to do so. And no firm will invest in high quality customer service for the same reason. And sometimes firms will engage in illegal activities if they think they can get away with it.

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The period 2001-2002 saw the corporate world shaken to its core by a series of scandals involving fraudulent accounting practices, huge payments to corporate executives, illegal shredding of documents, and obstruction of justice, while workers were losing their pensions and health benefits with some of companies caught up in the scandals. Essentially, executives of Enron, WorldCom, Adelphia, and Global Crossing, lied about their company's performance. For example, WorldCom listed $3.8 billion in payments it made to other phone companies for use of their lines as a 'capital expense' and thus hid the money in plain sight. This lowered their operating cost and improved their profits. WorldCom's auditor, Arthur Anderson, claimed it knew nothing of what was going on. However, an internal auditor discovered the problem almost immediately. The accounting scandal went further than this, however, since many companies including the accounting firm of Arthur Anderson, and a number of banks such as JP Morgan, helped them cover up the lies. And many other companies were guilty of understating their cost and thus overstating their profit. However, the magnitude and extent of the problem makes previous scandals small by comparison because it involves the integrity of the financial reporting system, i.e., the information all companies reveal to potential investors.

Application: Enron. We deregulated the energy industry in the 1980s to induce competition to lower price. Enron found a way to profit by bringing buyers and sellers together to sell futures contracts locking in the price. For example, on the supply side of the energy market, a natural gas supply company would be worried about the future price of gas it supplied falling. It would buy a contract to supply gas 6 months in the future at $5 per unit, for example. After 6 months it would buy gas on the spot market and complete the contract with Enron. If the price it paid was lower than $5 it made money since it could sell at the contract price of $5; if the price it paid was higher it would lose money. On the demand side of the market, electricity companies are worried about the price of natural gas going up and so they would buy a contract with Enron to purchase natural gas at $5 per unit, for example. If the spot price in 6 months is above $5 the electricity company wins since it can buy energy at $5, but it loses if the spot price is lower, say $4.75. So gas suppliers are worried about warm weather in the winter since this will force natural gas prices lower and electricity companies are worried about cold weather driving up the price of their main input, gas. Both companies can use the futures market to lock in a price. Enron charged commissions on both transactions.

By 1993 about 25% of all energy was traded by Enron. The company began expanding into other commodities and wanted to grow rapidly. Unfortunately, it began using some illegal means to do so. For example, Enron would set up a dummy company in a tax haven like the Caiman islands, and finance it using its own stock. The new company would issue bonds to Enron using the stock Enron gave it as collateral essentially borrowing from Enron. Effectively, Enron was actually borrowing from itself. It would then list the bonds as an asset on its books even though the collateral backing the bonds was Enron's own stock. Using hidden techniques like this, Enron quickly grew to be the seventh largest company in the US by 1999. In fact, it was named "America's Most Innovative Company" by Forbes magazine six years in a row, 1996 – 2001.

The scheme collapsed when energy prices starting falling in 1999. Slowly the story leaked to the press and it was revealed that most of Enron's growth was due to illegal financial transactions with itself. Its share price started falling and CEO Lay assured investors and employees, who had most of their 401k retirement money in Enron stock, that the company was sound, even as he was frantically selling his own stock in Enron. By October, 2001 Enron announced it was taking a huge write off. This started frenzied selling and the share price plummeted from $90 to $0.50 as details of the scandal emerged. The collapse of Enron was the largest in corporate history until

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the firm WorldCom failed shortly after as part of the accounting scandals. The political fallout was that Enron made huge contributions to both political parties.28

Lax regulation is cited as the major reason why Enron was able to get away with some of its actions. Regulators found themselves in an anti-regulatory, politically charged environment in the 1990s. No one had the courage to suggest that we needed to regulate industry at the time. Enron’s auditor, Arthur Anderson, was also complicit in allowing questionable practices to occur and later in trying to cover up the scandal. There is a moral hazard issue here. If an accounting firm is too strict in its interpretation of the law and its application of accounting practices it might lose a customer. Arthur Anderson “looked the other way” to keep Enron as a customer. We’ll discuss moral hazard in greater detail in Chapter 14.

11.17 The Deregulation Movement and Banking Traditionally, a bank receives short term deposits that it pays interest on, and then makes long term loans to people buying houses and cars. The bank's profit is the difference between the rate it charges on its loans to homebuyers and the rate it pays depositors. Borrowing short term from depositors and lending long term to home buyers tends to make banking very risky; depositors might want their money back right away, like when they write a check, while homebuyers won’t fully repay their loan for a long time. Regulatory agencies used to regulate the types of loans banks could make, and the interest banks charged on loans and paid on deposits.

Deregulation changed all that. Banks could charge whatever the going market interest was, invest deposits in a broad range of activities, e.g., office buildings and strip malls, and design various types of contracts with its customers, e.g., adjustable rate mortgages, interest only loans. For example, it became quite common for a bank to sell part, or all, of a mortgage to another bank in order to adjust the riskiness of the assets on its own balance sheet. Computer technology had developed enough by 1980 to track where the mortgage payment was supposed to go to make sure the right bank got paid. Buying and selling mortgages allows a bank to share some of that risk with other banks and finance companies.

Another quite common activity is repackaging loans. A perfect example of this is the mortgage backed security or MBS for short. An originator of mortgage loans, e.g., Countrywide Financial, will package a group of its mortgages into a bundle and take the bundle to a ratings agency, e.g., Standard and Poor’s, or Moody’s. The ratings agency studies the riskiness of the package and rates it, e.g., AAA. Countrywide can then sell the package to an investment bank like Goldman Sachs. The bank can then borrow against the mortgages by issuing bonds that are backed by the package of mortgages. The bank can then use the proceeds from selling the bonds to invest in more assets. The bonds are known as “derivatives” because they derive their value from the underlying mortgages; the greater the value of the mortgages, the greater the value of the derivatives. Any asset that has a cash flow, e.g., student loans, credit card receivables, rental car payments, can be packaged as a derivative. It gets even more complicated than this because a bank can combine derivatives into another derivative.29 Yes, that’s right. A bank can bundle a

28 Skilling, CFO of Enron was convicted of 19 of 28 counts of fraud and sentenced to over 24 years in prison. CEO Ken Lay was convicted on 6 counts and sentenced up to 45 years in prison but died before he could be incarcerated. 16 people pleaded guilty to various crimes and 6 more were tried and convicted. (The case became noir-ish when one possible witness who was going to be extradited to the US to testify was found dead in a London park.) Arthur Anderson was found guilty of obstruction of justice for massive document shredding and other actions. The company no longer exists as one of the big accounting firms. See http://www.investopedia.com/financial-edge/1211/the-enron-collapse-a-look-back.aspx29 Imagine taking a bundle of student loans to make a derivative, taking a bundle of car loans to make a derivative, and then combining the two derivatives into a third derivative. Now imagine trying to figure out how risky that new derivative is and you can understand the problem ratings agencies have in calculating risk.

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collection of derivatives, have the new collection rated by Moody’s, and then issue new bonds based on the value of the derivatives.

Creating derivatives was so lucrative that the big five investment banks, e.g., Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns, were allowed to forego their capital requirements and get more heavily involved in the subprime derivative business. What is a subprime derivative? Interest rates adjust for risk; the riskier the asset the higher the interest rate. A subprime borrower is someone who has defaulted on a loan, or has low income, or no income. Subprime borrowers are very risky and therefore do not get a prime lending rate from a bank, but a subprime rate, which is much higher. The high rate keeps many such borrowers from borrowing to buy a house, or car. If a bank can somehow spread the risk, however, it may be able to get the interest rate down. Subprime derivatives are assets that derive their value from subprime mortgages and the big banks were all invested in this business.

Why were we in a housing bubble in the early 2000s? After 9/11 the Fed kept interest rates low to keep the economy from going into a recession. And the Fed lowered rates to historic lows after the tech bubble burst. This made a house much less expensive and fueled the housing bubble. Prices in some markets, e.g., Arizona, Florida, Las Vegas, increased dramatically. Then inflation started to creep upward and the Fed raised rates in 2005-‘06. Eventually, mortgage rates went up and all of a sudden people couldn't afford their mortgages. Foreclosures started going up and this caused the housing bubble to burst. When the bubble burst and house prices started falling, the whole superstructure of this market collapsed. Everyone wanted to get out of housing but few were buying. As house prices started falling it became impossible to value the derivatives that were based on the value of those mortgages. This caused the derivatives market to collapse as well. Bear Sterns and Lehman Brothers, two of the largest investment banks, collapsed as a result. Many of the other big banks had to be bailed out in 2008, the last year of the Bush Presidency.

Why did the new financial innovations like derivatives not adequately spread the risk of lending to homebuyers, even subprime borrowers? Consider a bank before 1980. How did it make a loan? An expert would carefully evaluate the borrower’s ability to repay the loan by determining their income and wealth, occupation, and equity in another property. Great care was taken in assessing the risk. The loan officer’s bonus was based on the riskiness of their loans, e.g., the foreclosure rate. A low rate meant a large bonus. If the bank made local loans, then another source of risk was the local housing market. If a recession hit the local economy borrowers might default creating a problem for the bank.

If the bank can sell some of its mortgages to a bank in a different part of the country where the housing market is not connected to the first bank’s market, the first bank could spread its risk. This was the main justification for ratings agencies to give such good ratings to a package of mortgages that was spread across different local housing markets. After deregulation lenders could package loans and sell them to a bank so the initial lender did not really bear the risk of the package. As long as they diversified their mortgage package they could get a good rating and sell it. So loan officers were paid on the basis of how many loan contracts they signed, not on the quality of the loans in order to generate more mortgages. Eventually, they began tapping the subprime market believing the risk could be spread.

What happened? An economy growing everywhere generated rising house prices everywhere. Banks became overconfident and became overextended as a result. When rates rose in 2006 – ’07 housing markets in all parts of the country began collapsing. All of a sudden the housing market in Florida was tied to the market in Arizona, and so on. The risk was not spread because all housing markets are tied to growth in the national economy; system wide risk still existed. Second, loan officers were paid not on the quality of their loans but on how many loans they

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signed. This gave rise to the so-called liar loan where the loan officer simply asked the individual what their income was without proof. Third, some derivative contracts were so complicated even the bank designing the contract like Goldman couldn't assess the risk.

The credit meltdown of 2008 could possibly have been avoided if the banking committees in the House and Senate and regulators like the SEC and the Fed had done their jobs properly. Unfortunately, Alan Greenspan really believed in self regulation, but recanted when he admitted he was wrong.30 Both Democrats and Republicans were at fault in generating the anti-regulation fervor of the 1990s. A contributing factor was the low interest rates provided by the Fed in the early to mid 2000s, which fueled the housing bubble.31

There are several suggestions for re-regulating the banking and finance industries. First, generic derivatives should be traded on an open market so everyone would know how much exposure a particular bank had. This would discipline banks since the information would be public knowledge. Second, if loan originators like Countrywide and other banks had to keep some of the mortgages on their books, they would take more care in making the loans in the first place. Third, incentives need to be adjusted. Loan officers need to assess the risks more carefully. A fourth possibility is to separate commercial banking from investment banking, as we did with the Glass – Steagall Act during the Great Depression of the 1930s. Commercial banking involves making small consumer loans for houses and cars and small business, while investment banking primarily involves financing mergers and acquisitions of one firm by another. The line between the two became blurred under the deregulation movement of the 1980s and early 1990s and was completely eliminated by the Clinton Administration in the late 1990s. This may also have been a mistake in hindsight.

11.19 Net neutralitySome companies like Netflix and Amazon-Prime want to be able to pay a premium to obtain faster internet speeds and then turn around and charge their customers for that additional speed. Those who don’t pay for the higher speed would receive slower speeds. So when purchasing content like movies from Netflix, one is also purchasing the speed and reliability at which the content is delivered to you. “Net neutrality” refers to treating everyone the same on the internet so all subscribers to Netflix would receive content at the same speed.

Some have argued that a two-tiered pricing policy for internet service from Netflix and others would make it much harder for start up companies to bring a new product to market. Consider a start up company that wants to provide a service or product on the internet that competes with an established firm. The start up will have trouble competing if the established company can afford to pay for higher internet speed and the start up company cannot. Those that support net neutrality argue that the internet is a public utility like electric power and water and should be regulated as such. When you turn on your tap you received the same water as everyone else. When you use an electronic device you receive the same electricity. When you make a phone call on a landline you receive the same service. You can’t pay to receive better water, or faster electricity. Why not receive the same service for the internet?

Internet speed can be quite contentious. Recently, an issue involving a conflict of interest has arisen in providing access to the internet, e.g., Time Warner, Comcast, and content shown on the internet, e.g., Amazon, Netflix, HBO. History shows that those who provide content like movies and tv shows will earn greater returns than those simply providing access. HBO started out as a simple cable channel thirty years ago providing access to movies owned by others. It realized 30 http://www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=031 At one point the Fed was buying private assets from banks to stave off the collapse of the system. In fact, they acquired more than $1 trillion during the crisis in an effort to stave off the complete collapse of banking.

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that content was where the profit is and began producing its own shows, e.g., The Wire, Game of Thrones, and its profit soared. Time Warner also offers pay per view movies on its web site in addition to offering basic cable and internet service. This gives Time Warner an incentive to slow down internet speeds for any company offering competing content like movies. Netflix has presented evidence that Time Warner is slowing down its internet speed.32 Clearly, this is an area that could use some regulation to maintain fairness in competition.

11.20 ConclusionCan business regulate itself? Do companies have an incentive to clean up their own pollution, advertise fairly and accurately, produce products that are safe, and not engage in deceptive and unethical practices, and in some cases illegal actions? In many cases the answer is yes; most people in business are honest. However, there are plenty of examples of companies that take advantage. It follows that there is a role for government to play in ensuring that consumers and workers are protected.

Whenever there are economic profits, we can expect entry to occur. Eventually, new entry will force the monopolist to alter its behavior and in many cases it will lose its monopoly power. However, this may take time. This strongly suggests that the market place does not provide enough incentive for firms to behave properly; it does not discipline firms enough. In addition, there may be some uncertainty about the firm’s actions. Some of the actions firms take are hidden from view. So regulation is necessary. Clearly, we may have moved too far in deregulating the economy. In 2008 our financial system almost completely melted down because of lax regulation and poor oversight. Now the issue is how should we best re-regulate the system.

Important ConceptsGains to breaking up a monopolistConsumer's surplusIncreasing returns to scaleIncreasing costsFuture incentivesPrice regulationProblems with regulationAnti-trustGame theory

Review Questions1. Why are there gains to be had from breaking up a monopolist? How large are the gains?2. What is consumer's surplus? Why is consumer's surplus a good way of calculating the

gains to breaking up a monopoly?3. Why might increasing returns to scale make it difficult to induce competition in a

monopolized industry?4. Why might costs, e.g., wage rate, increase when the government attempts to break up a

monopolist?5. How does price regulation work?6. List some of the problems with price regulation.

32 See “Is your Netflix running slower than ever? You’re far from alone” in Digital Trends.

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Practice Questions1. Suppose a regulatory agency chooses a price half way between the monopoly price and

the competitive price for an industry that is a natural monopoly. Which statement is true?a. Economic profit will be positive at the regulated price.b. Economic profit will be negative at the regulated price.c. Economic profit will be exactly zero at the regulated price.d. Economic profit is not a relevant concept when the industry is regulated.

2. Calculate the expected payoffs in the following game against nature,

3. Given the information of the last question, what should the inventor do if p = 1/4?

4. German utility companies are monopolists who produce very inefficiently.a. True.b. False.

5. Two firms are competing to produce an innovation. Each company can choose the size of its research and development budget. The payoffs are listed in the following table. What are the equilibria? A small budget will allow development of a relatively simple product while a large budget will lead to a more significant product.

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Answers1. a.2. EP(develop) = 100p - 25(1-p) = 125p - 25

EP(don't develop) = 03. Since p = 1/4 = 25%, the inventor should develop the idea.4. a.5. There are two equilibria: (small, large) and (large, small) with payoffs of (5, 0) and (0, 5), respectively. The firms are avoiding direct competition.

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