Instead of aiming for a variety of – partially incompatible – goals as “Harvard” had done, “Chicago” radically reduced complexity by focusing on one single goal, efficiency. Market structure did not play any role – as long as outcomes were efficient. Monopoly was, in fact, radically re-interpreted: if a firm has been able to establish a monopoly position, this was taken as an indicator that it must be the most efficient firm in the market (the so-called “survival of the fittest” or “survivor test”). Reasons for firms being able to establish monopoly positions could, e.g., lie in their achieving economies of scale or cost savings as an effect of learning by doing. According to Chicago, it would be foolish to prohibit firms from achieving efficiencies because these mean cost-savings and, in the end, higher consumer surplus.
Chicago economists distinguish between three kinds of competitive constraints, namely (1) natural, (2) artificial and (3) state-created ones. Natural constraints to competition are not created by men, they just exist as such (e.g., if there is just one river that can be used for shipping or just one deposit of bauxite). Even if they have an influence on competitive results, trying to fight them would be pointless because they are not wilful creations of men. The artificial creation of constraints to competition by competitors is deemed to be “foolish and self-defeating behaviour”. Since erecting such constraints is not in the rational self-interest of firms, their appearance is supposed to be highly unlikely. Hence, competition authorities should not be preoccupied with them.
State-created competitive constraints are, however, a different story. These include a host of regulations. A good example is tariff and non-tariff trade barriers to trade that protect domestic firms from having to compete on an equal footing with foreign firms. Such trade barriers will result in a loss of consumer surplus, and thus efficiency. Some of these constraints are very dangerous: take import caps as an example. For a long time, Italian regulations prohibited the import of more than 3,500 Japanese-made cars into Italy on an annual basis. No matter how good, cheap or efficient Japanese cars were, Japanese carmakers were completely barred access to the Italian markets beyond the threshold of 3,500 cars. Such policies can obviously entail heavy costs for consumers. Ultimately, they will also hurt the producers as they will be (partially) exempt from competition. In the long run, their competitiveness will decrease and their business prospects worsen.
In 1968, Oliver E. Williamson published the so-called trade-off model in which potential costs of a horizontal merger are weighted against its potential benefits. At the time, Williamson was often considered to belong to the Chicago School. In the meantime, he has, of course, been central in the development of Transaction Cost Economics to which we turn later in this chapter. The trade-off model is, however, still an important and central model and thus deserves to be shortly presented here.
This model entails a worst-case scenario: suppose that a merger changes outcomes from the perfectly competitive case (hence price equals marginal cost) to the monopoly case (in which marginal returns equal marginal costs). In that case, the welfare losses of the merger can be depicted as the triangle ADH in figure 5. These are the costs, and the possibility of this triangle is the main reason why many mergers have not been passed. But Williamson does not stop there. He stresses that there are potential benefits that should be taken into consideration, namely benefits based on lower cost curves. There are, of course, a variety of reasons why costs could be
lower subsequent to a merger, lower input prices being the most obvious one. The pre-merger cost curve is depicted by MC1, the post-merger cost curve by MC2.
The gains of the merger in terms of saved resources are the difference in cost curves (i.e., MC1 – MC2) times the quantity produced and they are depicted as the rectangle which is called “cost savings”. In this case, cost-savings are expected to outweigh the deadweight loss. From an efficiency point of view, the merger should thus pass although the merged entity might decide to increase prices.
This is, however, only correct if the decisive criterion used to decide merger cases is overall welfare, which can be decomposed into consumer rent and producer rent. The pre-merger consumer rent is depicted by the triangle abc, the producer rent is zero. Post-merger, things have changed: The consumer rent has been reduced to cde, while there now exists a positive producer rent depicted by the rectangle defg. The triangle adh is nobody’s gain, that is why it is called deadweight loss. We thus observe a redistribution of rents from the consumers to the producers. Most members of the Chicago School now argue that producer rent is also part of overall welfare and does not constitute a problem as such. Others argue that the decisive criterion should not be overall welfare, but only consumer rents. They are thus ready to forego efficiencies in production.
It is one of the important achievements of the Chicago approach to have pointed to the detrimental effects of state-mandated constraints with regard to the functioning of competition. An important task of competition policy would thus be the undoing of state-created competitive constraints that inhibit the realisation of efficiencies.
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