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Friday, August 16, 2013

Recommended lecture of the month - August 2013 - Baxter's Law

As a person active in the area of competition, I work with both the laws made by man (the legislation) and with the economic laws – the theories summarizing the reactions and the effects induced by certain market conditions, which the man can only ascertain and, sometimes, may try to influence, but it cannot repeal.  
One of these laws, perhaps less famous, is the Baxter's law, an economic theory formulated by a law professor (!).  The theory expressed by Professor William Baxter explains how the effects of a regulated monopoly  may spill-over into non-regulated industries. William Francis Baxter Jr., who gave his name to this law was professor of antitrust law at Stanford University and also served as Assistant Attorney General for antitrust matters. Among his activities, he contributed to the break-up of the giant AT&T, the largest in the history of the Sherman Antitrust Act, dividing AT&T up into seven regional phone companies in 1982 (the "Baby Bells", named after the most famous brand of the old AT&T). Most of these companies raised, later on, back to the status of giants – Verizon and the current AT&T.
Baxter's law is applied to the industries where the incumbent is a monopolist (regulated) on the upstream market and is active also in the downstream but not regulated markets.  In the upstream market the monopolist will be forced to capped prices, in a way or another.
The basic economic theory known as ICE (Internalizing Complementary Externalities) states that when a monopolist wants to expand its monopoly power into other markets, downstream, such an expansion should be regarded rather as pro-competitive, because the monopolist would not do that unless it is able to compete – it is at least as efficient or more efficient than the competitors. The monopolist will can extract its monopoly rent by increasing the prices in the market in which is a monopolist but not in the other markets.
Baxter's Law is an exception to the ICE theory. Professor Baxter argued that monopolies which are regulated (with capped prices) cannot fully extract their monopoly rent and will attempt to monopolize related markets in which their monopolized service/product is a necessary input. Baxter's law thus explains that the monopolist is able to use its monopoly in the upstream market in order to capture a monopoly rent at another level, where it is no longer limited by the regulation. An unregulated monopolist could suffer losses in the market in which is a monopolist, that could offset the gains in the unregulated market but a regulated monopolist will suffer smaller losses because its price is already capped.  The upstream monopolist will still have full gains in the unregulated market and therefore will seek to expand its monopoly.
An example of Baxter's law works is the market for internet access, before the broadband age. If the regulator capped the price for the switched circuits offered by the telephone companies (the land lines), those companies cannot extract monopoly rents from the access network. Responding to this constraint, the phone companies who have a monopoly but this is regulated extend their business and service to unregulated markets, such as those for applications. The point is that, compared to rivals in these market, monopolies were able to offer lower rates (based on costs) for the same service because of their vertical integration. Such revenues from the unregulated markets can offset the loss due to regulation in monopoly market and increase overall profits.

The point is that monopolists which prices are capped by regulation have all the incentives and should extend in the connected markets in order to offset the result of the capped prices and optimize their overall incomes. A corollary to this theory could be that if the monopolists subject to the price regulation do not extend in the unregulated markets, this might be a sign that the price regulation is too lax – the prices set by the regulator are too high and thus they succeed in capturing the monopoly rent or at least a significant part of it, for the monopolist.