Chapter 16: Government Regulation of Business McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Market Competition & Social Economic Efficiency Exists when the goods & services that society desires are produced & consumed with no waste from inefficiency Two efficiency conditions must be met Productive efficiency Allocative efficiency

Productive Efficiency Exists when suppliers produce goods & services at the lowest possible total cost to society Occurs when firms operate along their expansion paths in both the short-run & long-run

Allocative Efficiency Requires businesses to supply optimal amounts of all goods & services demanded by society And these units must be rationed to individuals who place the highest value on consuming them Optimal level of output is reached when the MB of another unit to consumers just equals the MC to society of producing another unit Where P = MC (marginal-cost-pricing)

Social Economic Efficiency Achieved by markets in perfectly competitive equilibrium At the intersection of demand & supply, conditions for productive & allocative efficiency are met At the market-clearing price, buyers & sellers engage in voluntary exchange that maximizes social surplus

Efficiency in Perfect Competition (Figure 16.1)

Market Failure & the Case for Government Intervention Competitive markets can achieve social economic efficiency without government regulation But, not all markets are competitive, and even competitive markets can sometimes fail to achieve maximum social surplus Market failure When a market fails to achieve social economic efficiency and, consequently, fails to maximize social surplus

Market Failure & the Case for Government Intervention Six forms of market failure can undermine economic efficiency: Monopoly power Natural monopoly Negative (& positive) externalities Common property resources Public goods Information problems

Market Failure & the Case for Government Intervention Absent market failure, no efficiency argument can be made for government intervention in competitive markets

Market Power & Public Policy Firms with market power must price above marginal cost to maximize profit (P > MC) These firms fail to achieve allocative efficiency, which reduces social surplus Lost surplus is a deadweight loss Allocative efficiency is lost because the profit-maximizing price does not result in marginal-cost-pricing At the profit-maximizing point, MB > MC Resources are underallocated to the industry

Louisiana White Shrimp Market (Figure 16.2)

Market Power & Public Policy When the degree of market power grows high enough, antitrust officials refer to it legally as monopoly power No clear legal threshold has been established to determine when market power becomes monopoly power

Promoting Competition Through Antitrust Policy A high degree of market power (or monopoly power) can arise in three ways: Actual or attempted monopolization Price-fixing cartels Mergers among horizontal competitors

Promoting Competition Through Antitrust Policy Firms may be found guilty of actual monopolization only if both of the following conditions are met: Behavior is judged to be undertaken for the sole purpose of creating monopoly power Firm successfully achieves high degree of market power Firms can also be guilty of attempted monopolization

Natural Monopoly & Market Failure When a single firm can produce total consumer demand for a good or service at a lower long-run total cost than if two or more firms produce total industry output Long-run costs are subadditive

Subadditive Costs & Natural Monopoly (Figure 16.3)

Natural Monopoly & Market Failure Breaking up a natural monopoly is undesirable Increasing number of firms drives up total cost & undermines productive efficiency Under natural monopoly, no single price can establish social economic efficiency

Regulating Price Under Natural Monopoly (Figure 16.4)

Natural Monopoly & Market Failure With economies of scale, marginal-cost-pricing results in a regulated natural monopoly earning negative economic profit Two-part pricing is a solution that can meet both efficiency conditions & maximize social surplus

The Problem of Negative Externality Externalities When actions taken by market participants create either benefits or costs that spill over to other members of society Positive externalities occur when spillover effects are beneficial to society Negative externalities occur when spillover effects are costly to society

The Problem of Negative Externality Externalities undermine allocative efficiency Market participants rationally choose to ignore the benefits & costs of their actions that spill over to others Competitive market prices do not capture social benefits or costs that spill over to society

The Problem of Negative Externality Managers rationally ignore external costs when making profit-maximizing production decisions Social cost of production: Social cost = Private cost + External cost or Social cost – Private cost = External cost

Negative Externality & Allocative Inefficiency (Figure 16.5)

Pollution as a Negative Externality (Figure 16.6)

Finding the Optimal Level of Pollution (Figure 16.7)

Optimal Emission Taxation (Figure 16.8)

Nonexcludability Two kinds of market failure caused by nonexcludability: Common property resources Public goods

Common Property Resources Resources for which property rights are absent or poorly defined No one can effectively be excluded from such resources Without government intervention, these resources are generally overexploited & undersupplied

Public Goods A public good is nonexcludable & nondepletable The inability to exclude nonpayers creates a free-rider problem for the private provision of public goods Even when private firms supply public goods, a deadweight loss can be avoided only if the price of the good is zero

Information & Market Failure Market failure may also occur because consumers lack perfect knowledge Perfect knowledge includes knowledge about product prices, qualities, and any hazards Market power can emerge because of imperfectly informed consumers

Information & Market Failure Consumers may over- or under-estimate quality of goods & services If they over-value quality, they will demand too much product relative to the allocatively efficient amount If they under-value quality, they will demand too little

Imperfect Information on Product Quality (Figure 16.9)