Ift4pstrial Organizationo

Don E. WaldmanColgate University^

Elizabeth J. JensenHamilton College

PEARSON

Pearson Education InternationalBoston Columbus Indianapolis New York San Francisco Upper Saddle River

Amsterdam CapeTown Dubai London Madrid Milan Munich Paris Montreal TorontoDelhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

CONTENTS

PREFACE xxi

PARTI THE BASICS OF INDUSTRIAL ORGANIZATION

CHAPTER Introduction

1.1 Two Approaches to the Study of Industrial Organization 3

1.1.1 THE STRUCTURE-CONDUCT-PERFORMANCE (SCP) APPROACH 3

1.1.2 THE CHICAGO SCHOOL APPROACH 6

1.2 Static Versus Dynamic Models 7

1.3 Theory and Empiricism 7

1.4 Government and Industrial Organization 8

1.4.1 THE CONTENT OF THE ANTITRUST LAWS 8

1.4.2 ENFORCEMENT PROCEDURES 11

1.5 The Global Economy and Industrial Organization 12

1.6 General Approach of This Book 13

SUMMARY 13

CHAPTER 2 The Firm and Its Costs 16

2.1 The Neoclassical Firm 16

2.2 The Theory of the Firm 17

2.2.1 A FIRM'S BOUNDARIES 17-'

APPLICATION 2.1 A Chip of Its Own 20

2.3 The Structure of Modern Firms 21

2.3.1 SEPARATION OF OWNERSHIP AND CONTROL 22

2.3.2 MANAGERIAL OBJECTIVES 22

APPLICATION 2.2 Executive Compensation: Pay for Performance? 23

APPLICATION 2.3 X-Inefficiency Goes Extreme: Putting Masseuses, Christmas

Trees, Renoirs, and Monets on the Company Payroll 24

2.3.3 FEASIBILITY OF PROFIT MAXIMIZATION 25

APPLICATION 2.4 How Do Firms Use Rule-of-Thumb Pricing? 262.3.4 CONSTRAINTS ON MANAGERS 28

APPLICATION 2.5 Stockholder Revolt at the Happiest Place on Earth: The DisneyStockholders Versus Michael Eisner 28

CONTENTS

2.4 The Profit-Maximizing Output Level 31

2.5 Cost Concepts: Single-Product Firms 312.5.1 ACCOUNTING COSTS VERSUS ECONOMIC COSTS 31

2.5.2 SHORT-RUN COSTS OF PRODUCTION 32

APPLICATION 2.6 When Do Sunk Costs Matter to a Firm? 33

2.5.3 LONG-RUN COSTS OF PRODUCTION AND ECONOMIES OF SCALE 37

APPLICATION 2.7 A Measure of Economies of Scale 39

2.6 Cost Concepts: Multiproduct Firms 41

APPLICATION 2.8 A Measure of Economies of Scope 42

APPLICATION 2.9 Are There Economies of Scope in Institutions of Higher

Education? 43

SUMMARY 44

CHAPTER 3 j Competition and Monopoly 50

3.1 The Economics of Perfect Competition 50

3.1.1 THE ASSUMPTIONS OF PERFECT COMPETITION 51

3.1.2 THE FIRM'S SUPPLY CURVE 53

APPLICATION 3.1 Short-Run Losses in the Airline Industry 55

3.1.3 THE MARKET SUPPLY CURVE AND EQUILIBRIUM 56

3.1.4 PROPERTIES OF COMPETITIVE EQUILIBRIUM 57

3.2 Introduction to Welfare Economics 58

APPLICATION 3.2 Consumer and Producer Surplus and the Basic Theory of theGains from Trade 58

3.3 The Economics of Monopoly 61

3.3.1 THE RELATIONSHIP BETWEEN MARGINAL REVENUE AND PRICE 61

3.3.2 ELASTICITIES, THE DEGREE OF MARKET POWER, AND THE LERNER

INDEX 63

3.4 Welfare Comparison 65

3.4.1 MEASUREMENT OF THE COSTS OF MARKET POWER 66

APPLICATION 3.3 Monopoly Rent-Seeking in the Pharmaceutical Industry 67

3.4.2 CAUTIONS 68

3.5 Present Value and Discounting 70

3.6 Antitrust Policy Toward Monopolization 723.6.1 EARLY CASES 72

APPLICATION 3.4 American Tobacco's "Attempt to Monopolize" 73

3.6.2 THE ALCOA ERA 74

3.6.3 MORE RECENT TRENDS IN SECTION 2 CASES 76

3.6.4 SECTION 2 IN THE TWENTY-FIRST CENTURY 79

SUMMARY 80

CONTENTS Xi

CHAPTER' Market Structure 87

4.1 Concentration in Individual Markets 884.1.1 STRUCTURE-BASED MEASURES 88

APPLICATION 4.1 Aggregate Concentration Within the United States andGlobally 89

4.1.2 DEFINITION OF THE RELEVANT MARKET 93

4.2 Entry and Exit 95

4.2.1 PATTERNS OF ENTRY AND EXIT 95

4.2.2 ENTRY 96

4.2.3 STATIC OR STRUCTURAL BARRIERS TO ENTRY 97

APPLICATION 4.2 How Do Economists Estimate Economies of Scale? 99

APPLICATION 4.3 What Does the Evidence Say About Barriers to Entry? 108

4.2.4 INCENTIVES TO ENTER 109

4.2.5 EXIT 110

4.2.6 THE INTERACTION OF ENTRY AND EXIT 111

4.3 Mergers 112 I4.3.1 MERGER HISTORY 113

4.3.2 MOTIVES FOR MERGER 115

APPLICATION 4.4 What's Brewing in'the Beer Industry? 118

4.3.3 THE EFFECTS OF HORIZONTAL MERGERS ON COMPETITION AND

WELFARE 119

4.3.4 EMPIRICAL EVIDENCE ON THE EFFECTS OF MERGERS 122

4.3.5 PUBLIC POLICY TOWARD HORIZONTAL MERGERS 123

4.3.6 MERGER GUIDELINES AND THE HART-SCOTT-RODINO ACT 127

SUMMARY 130

CHAPTER, Monopoly Practices 138

5.1 Dominant-Firm Price Leadership Model 138

5.1.1 SOURCES OF DOMINANCE 139

5.1.2 PRICING BY A DOMINANT FIRM 139

APPLICATION 5.1 Banks and Credit Unions: Dominant Firms and FringeSuppliers? 144

5.1.3 EMPIRICAL EVIDENCE OF THE DECLINE OF DOMINANT-FIRM PRICE

LEADERS 144

5.2 Contestable Markets: A Check on Market Power? 145

5.3 Network Economics 148

5.3.1 COMPLEMENTARITY, COMPATIBILITY, AND STANDARDS 149

5.3.2 EXTERNALITIES 150

Xil CONTENTS

CHAPTER I

5.3.3 SWITCHING COSTS AND LOCK-IN 151

5.3.4 SIGNIFICANT ECONOMIES OF SCALE 151

5.3.5 MATH OF NETWORK EXTERNALITIES 151

5.3.6 SUMMARY OF NETWORK EFFECTS 154

APPLICATION 5.2 Microsoft and Network Effects 154SUMMARY 155

Empirical Industrial Organization 160

6.1 Structure-Conduct-Performance 160

6.2 Statistical Tools Used to Test the SCP Paradigm 1616.2.1 EXOGENOUS AND ENDOGENOUS VARIABLES 166

6.3 Measurement Issues 1666.3.1 MEASURES OF PERFORMANCE 166

6.3.2 SUMMARY OF MEASURES OF PROFITABILITY 168

6.4 Measures of Market Structure 1696.4.1 MEASURES OF CONCENTRATION 169

6.4.2 BARRIERS TO ENTRY 169

6.4.3 OTHER VARIABLES 170

6.5 Early Structure-Conduct-Performance Studies 170

6.6 Econometric Studies 1716.6.1 CONCENTRATION AND PROFITABILITY: EVIDENCE FROM

INDUSTRY-LEVEL>STUDIES 172

6.6.2 SUMMARY OF INDUSTRY-LEVEL RESULTS 173

6.7 Conceptual Problems with SCP Studies 173 ;6.7.1 COLLUSION VERSUS EFFICIENCY 173

6.7.2 ASSUMPTION OF LINEARITY 175

6.7.3 VARIATIONS OVER TIME 176

6.7.4 ENDOGENEITY PROBLEM 177

6.8 Prices and Concentration 178

6.9 An Alternative Approach: Sunk Costs and Market Concentration 1796.9.1 MARKETS WITH EXOGENOUS SUNK COSTS 180

6.9.2 MARKETS WITH ENDOGENOUS SUNK COSTS 180

6.9.3 SUTTON'S EMPIRICAL TESTS 181

APPLICATION 6.1 Applying Sutton's Theory in the Supermarket Industry 182

6.10 The New Empirical Industrial Organization 1846.10.1 STRUCTURAL MODELS THAT ESTIMATE THE DEMAND CURVE AND THE

SUPPLY RELATIONSHIP IN A MARKET 185

6.10.2 ADDITIONAL APPROACHES TO THE NEW EMPIRICAL INDUSTRIAL

ORGANIZATION 191

CONTENTS xiii

6.10.3 SUMMARY OF NEW EMPIRICAL INDUSTRIAL ORGANIZATION

EVIDENCE 192

APPLICATION 6.2 Price-Cost Margins in the RTE Cereal Industry 193

SUMMARY 194

PART II MODERN INDUSTRIAL ORGANIZATION: GAME THEORY ANDSTRATEGIC BEHAVIOR

Game Theory: A Framework for UnderstandingOligopolistic Behavior 201

7.1 What Is Game Theory? 201

7.1.1 THE INFORMATION STRUCTURE OF GAMES 202

7.2 Simple Zero-Sum Games 203 _

APPLICATION 7.1 University Rankings and Merit-Based Financial Aid as aZero-Sum Game 205

7.3 Prisoner's Dilemma Games 206

APPLICATION 7.2 A Prisoner's Dilemma—Doctors and HMOs 208

7.4 Repeated Games 209

7.5 Games of Mixed Strategies 210

7.6 Sequential Games 213

7.6.1 CREDIBLE VERSUS NONCREDIBLE THREATS AND SUBGAME

PERFECT NASH EQUILIBRIA 215

APPLICATION 7.3 Dr. Strangelove and Credible Threats Gone Wrong 216

SUMMARY 217

CHAPTER 8 The Development of Theory 225

8.1 Models Based on Quantity Determination 2258.1.1 THE COURNOT MODEL 225

8.1.2 THE COURNOT-NASH EQUILIBRIUM 230

8.1.3 COURNOT-NASH MODEL WITH MORE THAN TWO FIRMS 234

8.1.4 Examples of Cournot-Nash Pricing in Real Markets 235

APPLICATION 8.1 Empirical Evidence of Cournot-Nash Behavior—Experimental

Games with Varying Numbers of Players 238

APPLICATION 8.2 The Paradox of Mergers in a Cournot-Nash Market 240

CONTENTS

CHAPTER

8.2 The Stackelberg Model 240

8.2.1 FIRMS WITH IDENTICAL COSTS AND DEMAND 241

8.2.2 THE STACKELBERG MODEL: FIRMS WITH DIFFERENT COSTS 243

APPLICATION 8.3 Empirical Examples of Stackelberg Equilibrium 245

8.3 The Bertrand Model 247

APPLICATION 8.4 Brazil and Columbia in the Coffee Export Market 250

APPLICATION 8.5 Bounded Rationality, Sluggish Consumers, Internet Pricing,

and the Failure to Achieve Bertrand Equilibrium 2518.3.1 THE BERTRAND-EDGEWORTH MODEL WITH CAPACITY

CONSTRAINTS 252

SUMMARY 255

9 Collusion: The Great Prisoner's Dilemma 259

9.1 The Prisoner's Dilemma Revisited 259APPLICATION 9.1 Tit-for-Tat in Baseball 261

APPLICATION 9.2 A Real-World Example of "Nice" Behavior in Response toRandom or "Accidental" Defections Automobiles 266

9.2 Another Strategy for Maintaining Effective Collusion: Trigger Price

Strategies 267

9.2.1 TRIGGER PRICES IN GAMES WITH UNCERTAINTY 268

9.2.2 TRIGGER PRICES IN GAMES WITH UNCERTAIN DEMAND 272

9.2.3 TRIGGER PRICES WITH OBSERVABLE RANDOM CHANGES

IN DEMAND 274 ,:

APPLICATION 9.3 The United Kingdom Salt Duopoly 276

9.3 Collusive Agreements as Viewed by One Firm in a Cartel 278

9.4 Factors Affecting the Ease or Difficulty of Effective Collusion 285

9.4.1 THE EXISTENCE OF MARKET POWER 285

9.4.2 'THE COSTS OF REACHING AND MAINTAINING AN

AGREEMENT 286

APPLICATION 9.4 Factors Facilitating Global Cartels: Evidence from Lysine,Citric Acid, and Vitamins A and E 289

9.5 Antitrust Policy Toward Collusion 291

9.5.1 PUBLIC POLICY TOWARD DIRECT PRICE-FIXING AGREEMENTS 293

9.5.2 PRICE-EXCHANGE AGREEMENTS 294

9.5.3 OLIGOPOLISTIC BEHAVIOR—CONSCIOUS PARALLELISM 295

9.5.4 TRADE ASSOCIATIONS 297

9.5.5 NONPROFIT ORGANIZATIONS: CASES INVOLVING COLLEGES AND

UNIVERSITIES 298

SUMMARY 300

CONTENTS XV

CHAPTER Cartels in Action 307

10.1 Attempted Methods of Achieving Effective Collusion 307

10.1.1 DOMINANT-FIRM PRICE LEADER AND BENEFACTOR 307

10.1.2 PRICE LEADERSHIP 310

APPLICATION 10.1 A Sweet Case of Price Leadership: Dole and Del Monte in theCanned Pineapple Industry 315

10.1.3 MOST FAVORED CUSTOMER CLAUSES AND "LOW-PRICE" GUARANTEES 316

APPLICATION 10.2 Most Favored Customer Clauses for Medicaid, But What About

Everyone Else? 318

10.1.4 BASING POINT PRICING SYSTEMS 319

10.1.5 TRADE AND PROFESSIONAL ASSOCIATIONS 321

APPLICATION 10.3 "Something Is Rotten in the State of Denmark: The DanishGovernment Promotes Tacit Price Fixing 323

10.1.6 SCHEMES TO DIVIDE MARKETS 325

10.1.7 PATENT CARTELS 327

10.2 How Successful Are the Solutions? 329

10.2.1 EXCESS CAPACITY PROBLEMS" 329

10.2.2 ENCROACHMENT OF SUBSTITUTE PRODUCTS 330

10.2.3 MORE EFFECTIVE ANTITRUST STRATEGIES: THE DEPARTMENT OF JUSTICE

CORPORATE LENIENCY PROGRAM 330

SUMMARY 333

CHAPTER. Oligopoly Behavior: Entry and Pricing Strategiesto Deter Entry 339

11.1 Limit Pricing 339

11.1.1 LIMIT PRICING WITH A COST ADVANTAGE FOR THE MONOPOLIST FIRM 339

11.1.2 LIMIT PRICING IN THE ABSENCE OF A COST ADVANTAGE FOR THE

MONOPOLIST FIRM 342

11.1.3 THE CRITIQUE OF GAME THEORISTS 343

11.1.4 LIMIT PRICING WITH ASYMMETRIC INFORMATION 348

11.1.5 EMPIRICAL EVIDENCE OF LIMIT PRICING 351

APPLICATION 11.1 Limit Pricing in the Antihistamine Market 354

11.2 Predatory Pricing 355

11.2.1 PREDATORY PRICING WITH PERFECT, CERTAIN, COMPLETE, AND SYMMETRIC

INFORMATION 356

11.2.2 PREDATORY PRICING WITH IMPERFECT, CERTAIN, INCOMPLETE, AND

ASYMMETRIC INFORMATION 357

11.2.3 THE KREPS AND WILSON PREDATORY PRICING GAME 358

11.2.4 EMPIRICAL EVIDENCE: PREDATORY PRICING AND BUILDING A TOUGH

REPUTATION 359

XVI CONTENTS

APPLICATION 11.2 Does Wal-Mart Use Predatory Pricing? 361

APPLICATION 11.3 Don't Mess with Bill: Netscape Versus Microsoft in the Internet

Browser Market 363

SUMMARY 365

APPENDIX: DETAILS OF THE KREPS AND WILSON PREDATORY PRICING MODEL 370

! CHAPTER 12 j Oligopoly Behavior: Entry and Nonpricing Strategies toj I Deter Entry 375

12.1 Excess Capacity 375

12.1.1 INVESTING IN RESEARCH AND DEVELOPMENT TO LOWER COSTS 379

12.1.2 EMPIRICAL EVIDENCE 379

12.2 Raising Rivals'Costs 381 •

12.2.1 LOBBYING TO INCREASE BARRIERS TO ENTRY 383

12.2.2 INCREASING ADVERTISING 383

12.2.3 PROVIDING COMPLEMENTARY GOODS AND SERVICES 384

12.2.4 SABOTAGING CORPORATE COMPETITORS 384

12.2.5 EMPIRICAL EVIDENCE ON RAISING RIVALS' COSTS 384

APPLICATION 12.1'. Detergent Wars and the Battle of Good Versus Evil:Amway v. Procter & Gamble 387

12.3 Learning by Doing 389

12.3.1 EMPIRICAL EVIDENCE ON LEARNING BY DOING 390

APPLICATION 12.2 Qualitative Learning by Doing in the Motion Picture Industry:

The Case of the "Talkies" 394

12.4 Product Proliferation 395

12.4.1 EMPIRICAL EVIDENCE ON THE USE OF PRODUCT PROLIFERATION 396

12.5 Empirical Evidence on the Use of Price and Nonprice Strategies to DeterEntry 401

SUMMARY 403

APPENDIX: PRODUCT PROLIFERATION REVISITED 410

PART III BUSINESS PRACTICES

CHAPTER 13 Product Differentiation 418

13.1 Forms of Product Differentiation 418

13.2 Theoretical Analysis of Product Differentiation 419

13.2.1 PRODUCT DIFFERENTIATION IN SPATIAL MODELS 420

CONTENTS XVU

13.3 The Bertrand Model with Product Differentiation 428

13.4 The Economics of Monopolistic Competition and the Optimal Amount ofVariety 430

13.4.1 THE WELFARE BENEFITS OF VARIETY WITH MONOPOLISTIC

COMPETITION 432

APPLICATION 13.1 "It's Not Delivery. It's DiGiorno": Monopolistic Competition inthe Frozen Pizza Market 436

13.5 Product Differentiation with Asymmetric Information 437

13.5.1 THE LEMONS MODEL 437

13.5.2 ADVERSE SELECTION 440

13.5.3 DEALING WITH THE PROBLEMS ASSOCIATED WITH PRODUCT DIFFERENTIA-

TION, ASYMMETRIC INFORMATION, AND ADVERSE SELECTION 441

APPLICATION 13.2 What Do the Markets for Thoroughbred Racehorses andBaseball Players Have in Common? Product Differentiation, Asymmetric Information,and Adverse Selection 442

APPLICATION 13.3 Adverse Selection in Internet Dating, or So, If He's/She's SoGreat, Why Is He/She Using eHarmony to Get a Date? 444

13.6 The Product Differentiation Advantages of First Movers 445

SUMMARY 450

CHAPTER 1 4 Advertising 455

14.1 The Social Benefits of Advertising 455

14.2 The Social Costs of Advertising 457

14.2.1 ADVERTISING AND QUALITY 459

14.3 Advertising and Market Structure 462

14.3.1 WELFARE EFFECTS OF ADVERTISING 462

14.3.2 THE DORFMAN-STEINER MODEL 464

i 14.3.3 ADVERTISING AND OLIGOPOLY BEHAVIOR 466

APPLICATION 14.1 The Variability of the Advertising-to-Sales Ratios AcrossIndustries 470

14.4 Advertising as a Barrier to Entry 473

14.5 Strategic Advantages of Heavily Advertised Brands 475

14.6 Product Differentiation and Increased Competition 475

14.7 Empirical Evidence 476

14.7.1 TRADITIONAL STUDIES OF THE RELATIONSHIP BETWEEN ADVERTISING

AND PERFORMANCE ACROSS INDUSTRIES 476

14.7.2 NEW EMPIRICAL INDUSTRIAL ORGANIZATION STUDIES 479

SUMMARY 481

XV111 CONTENTS

CHAPTER 15 Technological Change and Research and Development 486

15.1 Schumpeter and the Process of "Creative Destruction" 486

APPLICATION 15.1 Examples of Creative Destruction 488

15.2 The Process of Technological Change 488

15.3 The Relationship Between Market Structure, Firm Size, and Technological

Advance 489

15.3.1 THE IMPACT OF OLIGOPOLY 491

15.3.2 DOMINANT FIRMS AS FAST-SECOND INNOVATORS 496

15.3.3 A CONTRIBUTION OF GAME THEORY 498

15.3.4 THE THEORETICAL IMPACT OF A PATENT SYSTEM 500

15.4 The Impact of Firm Size 503

15.5 Empirical Evidence 50515.5.1 MEASUREMENT ISSUES 505

15.5.2 TESTING SCHUMPETER'S HYPOTHESES 507

15.6 The Economics of the Patent System 512

15.6.1 EMPIRICAL EVIDENCE ON THE IMPACT OF PATENTS 515

15.6.2 INTELLECTUAL PROPERTY RIGHTS AND COPYRIGHTS 518

APPLICATION 15.2 Why Bother with Intellectual Property Rights? The Case of

China 518

15.7 Patents, Intellectual Property Rights, and the Law 520

SUMMARY 522

APPENDIX: GAME THEORY AND PATENT RACES 529

CHAPTER Price Discrimination 532

16.1 Types of Price Discrimination 532

16.1.1 FIRST-DEGREE PRICE DISCRIMINATION 533

APPLICATION 16.1 Microsoft's Attempt to Use First-Degree PriceDiscrimination 534

16.1.2 SECOND-DEGREE PRICE DISCRIMINATION 535

APPLICATION 16.2 The Use of Coupons and Second-Degree Price

Discrimination 537

16.1.3 THE WELFARE EFFECTS OF SECOND-DEGREE PRICE DISCRIMINATION 539

16.1.4 THIRD-DEGREE PRICE DISCRIMINATION 540

16.1.5 WELFARE IMPLICATIONS OF THIRD-DEGREE PRICE DISCRIMINATION 540

APPLICATION 16.3 Third-Degree Price Discrimination at Disney World 544

APPLICATION 16.4 Combining Second-Degree and Third-Degree PriceDiscrimination in Broadway Theater Tickets 545

16.2 Two-Part Tariffs, Tying, and Bundling 547

CONTENTS XIX

16.2.1 TWO-PART TARIFFS 547

16.2.2 THE WELFARE EFFECTS OF A TWO-PART TARIFF 549

APPLICATION 16.5 Changing Pricing Strategies at Disneyland and Disney

World 551

16.2.3 BUNDLING 551

16.2.4 MIXED BUNDLING 552

APPLICATION 16.6 Mixed Bundling in Over-the-Counter Cold Remedies 557

16.2.5 REQUIREMENTS TIE-IN SALES 558

16.3 Distribution Effects of Price Discrimination 559

16.4 Effect on Competition "~ 560

16.5 Antitrust: Price Discrimination and the Robinson-Patman Act 56216.5.1 SECONDARY-LINE CASES 563

16.5.2 PRIMARY-LINE CASES 568

16.5.3 ILLEGALLY INDUCED PRICE DISCRIMINATION 571

SUMMARY 572

APPENDIX: THE WELFARE IMPLICATIONS OF PRICE DISCRIMINATION WITH NONLINEARDEMAND 580

CHAPTER 17 Vertical Integration and Vertical Relationships 582

17.1 Vertical Relationships as a Solution to Economic Problems 582

17.1.1 THE PROBLEM OF DOUBLE MARGINALIZATION 584

17.2 Alternative Methods of Achieving Joint Profit Maximization 586

17.2.1 THE PROBLEM OF INSUFFICIENT PROMOTIONAL SERVICES 586

APPLICATION 17.1 Vertical Integration, Exclusive Dealing, and the Value of an

Upscale Pub's Amenities in Australia 590

APPLICATION 17.2 The Welfare Effects of Exclusive Dealing in the U.S. Beer

Industry 592

, 17.2.2 SOLVING THE PROBLEM OF INPUT SUBSTITUTION 593

17.3 * The Competitive Effects of Vertical Relationships 594

17.3.1 RESALE PRICE MAINTENANCE AGREEMENTS 594

APPLICATION 17.3 Toys "R" Us as the Facilitator of Toy Manufacturer

Collusion 596

APPLICATION 17.4 Free Riding and the Internet 598

17.3.2 STRATEGIC USES OF VERTICAL RESTRAINTS AND INTEGRATION 601

17.3.3 RAISING THE CAPITAL BARRIER TO ENTRY 602

17.3.4 COLLUSION AND VERTICAL INTEGRATION 603

APPLICATION 17.5 The Possible Negative Welfare Impacts of Increasing VerticalIntegration: The Case of the Southern California Gasoline Retailing Market 604

17.3.5 FORECLOSURE 605

XX CONTENTS

17.4 Antitrust: Public Policy Toward Vertical Restraints of Trade 606

17.4.1 TYING AGREEMENTS 606

17.4.2 CASES DEALING WITH FRANCHISING AGREEMENTS 609

17.4.3 EXCLUSIVE DEALING AGREEMENTS 610

17.4.4 TERRITORIAL AND CUSTOMER RESTRICTIONS 612

17.4.5 RESALE PRICE MAINTENANCE AGREEMENTS 614

SUMMARY 618

APPENDIX: THE PROBLEM OF INPUT SUBSTITUTION 624

CHAPTER 18 Regulation and Deregulation 628

18.1 The Rationale for Economic Regulation: Traditional Public UtilityRegulation 628

18.2 The Workings of American Regulation 630

18.2.1 SETTING THE PERMITTED RATE OF RETURN 631

18.3 Efficiency Problems Associated with Rate of Return Regulation 633

18.3.1 X-lNEFFICIENCY 633

18.3.2 THE AVERCH-JOHNSON EFFECT 633-

18.3.3 SETTING THE PRICE STRUCTURE WITH DECREASING COSTS 635

18.3.4 SETTING THE PRICE STRUCTURE WITH INCREASING COSTS 636

18.4 The Spread of Regulation into Other Markets 637

18.4.1 THE CAPTURE THEORY OF REGULATION 637

APPLICATION 18.1 It's More Than Peanuts 638

18.5 The Movement from Regulation to Deregulation 640 :

18.5.1 SURFACE TRANSPORTATION 640

18.5.2 AIRLINE REGULATION AND DEREGULATION 641

APPLICATION 18.2 Airline Regulation: Where Did All the Profits Go? 642

18.5.3 ELECTRICITY 645

APPLICATION 18.3 Electricity Restructuring: Lights Out in California? 646

18.5.4 NATURAL GAS INDUSTRY 647

18.5.5 FINANCIAL MARKETS 648

SUMMARY 653

GLOSSARY 659

ANSWERS TO ODD-NUMBERED PROBLEMS 668

INDEX 697

CREDITS 731