Sherman Antitrust Act

Trusts were finally limited by the Sherman Act of 1890

  • Main provisions of the Sherman Act are contained in the first two sections:
    • Section 1: forming a trust, or attempting to form a trust between firms is illegal
    • Section 2: forming or attempting to form a monopoly is illegal

Taken together, this outlawed specific firm behavior

  • Cartels were explicitly banned
  • Mergers that increased efficiency were allowed, while mergers that increased market power were not – hence, a natural monopoly does not violate the Sherman Act

Issues with the Sherman Act

  • The Sherman Act is (intentionally?) vague
    • What constitutes a contract or conspiracy “in restraint of trade”?
    • How can one determine if a firm is acting as a monopoly or attempting to monopolize
    • When is it a conspiracy?
  • Regulators face a difficult job of detecting and punishing monopolistic behavior
    • Are firms exhibiting non-competitive activities, or are they just more efficient than their competition?
    • Is the monopoly using their market power to discourage competition, or are they merely a natural monopoly?
    • Will regulation disincentivize competition?

Penalties and Sanctions

  • Enforcing the Sherman Act was difficult
    • Enforcement was deferred to the courts
    • They created guidelines for determining whether firms are in violation of the act
  • Initially, the penalty for a violation was a maximum of $100M for firms for each offense, and up to 10 years in prison and $1M in fines for individuals for each offense
  • What if a firm can make an extra $100M by acting as a monopoly?
  • In order to incentivize legal firm behavior, Congress passed the Criminal Fines Improvement Act, allowing regulators to fine offenders up to twice the value of the firm’s pecuniary gains
  • However, firms know that they will not always be caught…

Sanctions Example

  • Let’s consider an example where a firm is trying to decide whether to act competitively or behave as a monopoly
    • Suppose that if a firm acts as a monopoly, it can earn $60M in profit
    • The firm believes there is a 40% chance that it will get caught (violating the Sherman Act)
    • If found guilty, the firm will have to pay $3M in legal fees and the CEO will go to jail for 10 years, which she values at $12M
  • What is the firm’s expected profit by acting as a monopoly?

\[ \begin{aligned} E(\Pi) &=P(\text{not caught})\cdot \Pi_{monopoly} + P(\text{caught})\cdot (\Pi_{monopoly}-\text{fines})\\ &=0.6(\$60\text{m}) + 0.4(\$60\text{m}-\$120\text{m} - \$3\text{m} - \$12\text{m}) \\ &=\$36\text{m} - \$30\text{m} \\ &=\$6\text{m} \end{aligned} \]

  • Notice the firm expects to make more profit if they act as a monopolist, relative to competitively (zero profit condition)
  • Recall that firms are self-interested and profit maximizing → The firm will illegally act as a monopoly
  • In this case the conduct is unlikely to be deterred
  • The intent of the Sherman Act was to deter monopoly behavior, not punish it

Legislative Intent of the Sherman Act

  • Diving deeper into the intent of the Sherman Act, we will look at two influential interpretations:
    • Robert Bork: The intent of the Sherman Act was to promote consumer welfare through allocative efficiency
    • Robert Lande: The intent of the Sherman Act was to prevent firms with market power from unfairly transferring wealth from consumers to themselves

Bork Interpretation

  • Sherman’s main concern was with behavior that prevents “full and free competition” and raises prices for consumers
    • Bork discussed the closure of fish, deli, and produce markets in favor of supermarkets
    • Supermarkets would not be a violation of the Sherman Act, since although supermarkets may force out smaller, specialized markets, they increase efficiency in a way that benefits consumers (i.e. cost savings can, in theory, be passed on to consumers)

Lande Interpretation

  • Lande believed the intent of the Sherman Act was to prevent unfair wealth transfers from consumers to producers
    • As in, the writers of the act did not care about economic efficiency but rather wanted a law that favored consumers over producers.
    • This interpretation argues that, in addition to preventing unfair wealth transfers, Congress wanted to limit the social and political power of large firms.

Consequences of Varying Interpretations

  • A firm monopolizes a market through unfair predatory business practicies, both Borke and Lande believed the firm activity violated the Sherman Act
    • This is not always the case
  • Consider a profit maximizing natural monopoly
    • Recall that natural monopolies occur because they are more efficient than many smaller, competitive firms
    • Due to the market power of monopoly, the firm can price as a monopolist and extract more wealth from consumers (relative to the competitive alternative)
  • Bork believed this natural monopoly is legal, since it’s more efficient than competition
  • Lande believed this natural monopoly is illegal, since it’s still transferring wealth from consumers to the firm

Early Enforcement

Early enforcement: Peckham Rule

  • Between 1897-1899, Supreme Court Justice Rufus Peckham wrote five opinions in antitrust cases. In the course of these decisions emerged the Peckham Rule in antitrust cases
    • The rule stated that any business practices designed to restrict output were illegal.
    • This rule is consistent with legislative aim of promoting consumer welfare.

Early enforcement: Issues

  • Early enforcement of the Sherman Act had many problems
    • Many businesses did not know if they were at risk of prosecution due to the vagueness of the law
    • Enforcement was often left to the judge’s discretion
    • Firms could work around the Sherman Act by finding ways to mask anticompetitive behavior/effects.
  • The Sherman Act was almost immediately identified as flawed
  • Teddy Roosevelt who read the Sherman Act to forbid all combinations regardless of their economic effect opposed the legislation.
  • Roosevelt proposed his own solution:
    • Create a list of all impermissible business practices
    • Give a license to businesses to do anything not on the list

Rule of Reason

  • The Rule of Reason is a heuristic for enforcing the Sherman Act and comes from the case of Standard Oil Co. v. United States (1911)
    • Every monopolization case under the Sherman Act must be viewed independently on its own merit
    • Contracts or conduct to exclude rival firms was illegal; however, being a monopoly was not illegal per se
    • Affirmed the remedy of breaking up the firm into 34 parts
  • Despite the new heuristic for determining antitrust, the Sherman Act was still criticized
    • Viewed as giving too much power to judges
    • Viewed as an attempt at fixing monopolization, as opposed to preventing it from occurring