Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 Economic Efficiency and Public Policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Describe the distinction between productive and allocative efficiency. 4. Describe the goals and results of U.S. antitrust policy. 3. List the alternative methods for regulating a natural monopoly. 2. Explain why perfect competition is allocatively efficient, whereas monopoly is allocatively inefficient.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Full employment of resources does not guarantee efficiency: 1. firms may not use least-cost methods of production 2. marginal costs may not be equated across firms in an industry 3. too much of one product and too little of another product may be produced. Productive and Allocative Efficiency

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 12.1 Review of Four Market Structures

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Productive Efficiency Productive efficiency for a firm requires costs to be minimized for any given level of output (recall chapter 8). Productive efficiency for an industry requires the MC to be the same for every firm. If all industries are productively efficient, then the economy is on the production possibilities boundary.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.1 Productive Efficiency for the Industry

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.2 Productive Efficiency and the Production Possibilities Boundary

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.3 Allocative Efficiency and the Production Possibilities Boundary

Copyright © 2008 Pearson Addison-Wesley. All rights reserved What is the Amount of Steel and Wheat to Produce?

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Which Market Structures Are Efficient? Profit-maximizing, competitive firms are productively efficient. If they interact in competitive markets, the outcome will be allocatively efficient (p = MC). On the other hand, monopoly is productively efficient, but allocatively inefficient (since p > MC).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.4 Consumer and Producer Surplus in a Competitive Market

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.5 The Allocative Efficiency of Perfect Competition

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.6 The Deadweight Loss of Monopoly The deadweight loss is shown by area = A monopolist generates a deadweight loss by restricting output below the competitive level.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Allocative Efficiency and Market Failure Market failures: when the free market fails to generate allocative efficiency several causes — discussed in Chapter 16 public policies — discussed in Chapters 17 and 18 Under some circumstances government action can “correct” the market failure and improve the efficiency of market outcomes.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Economic Regulation to Promote Efficiency Regulation of Natural Monopolies Natural monopoly: a situation where costs decline over the whole range of market output.  room for only one firm to achieve MES Two policy responses: - public ownership - regulation

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Three Approaches to Regulating Natural Monopolies 1. Marginal-cost pricing (set p = p 1 ) D MC ATC Q2Q2 Q1Q1 c1c1 p1p1 p2p2 Output Price Costs Marginal-cost pricing is allocatively efficient, but the firm will incur losses.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 12.7 Pricing Policies for Natural Monopolies with Falling Costs

Copyright © 2008 Pearson Addison-Wesley. All rights reserved A two-part tariff can be used to cover costs. –fixed monthly charge –charge that varies with the actual amount consumed This policy allows customers pay one price to gain access to the product and a second price for each unit consumed: For example: Electric bill Tariff

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Average-cost pricing (set p = p 2 ) D MC ATC Q2Q2 Q1Q1 c1c1 p1p1 p2p2 Output Price Costs Average-cost pricing results in zero profits, but it is allocatively inefficient because p > MC. Average-Cost Pricing

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The allocatively efficient pricing system would determine output by setting prices equal to MC in the short run. It would also adjust capacity in the long run until the long-run MC is equal to the price. (Average-cost pricing generally leads to inefficient long-run investment decisions.) In the very long run, technological changes may create or destroy natural monopolies. Long Run Adjustment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Regulation of Oligopolies There is growing skepticism about regulators’ ability to improve the behaviour of oligopolistic industries. Regulation often reduced competition Public ownership was not clearly more efficient Globalization led to more international competition - reduced need for regulation? Advanced industrial countries pushed toward deregulation and privatization when it was realized that:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved U.S. Antitrust Policy The Framework of Antitrust Policy The antitrust law prohibits: collusive behavior mergers that reduce competition Monopolization of an industry Sherman Act of 1890, Section 1: illegal to restrain trade Sherman Act of 1980, Section 2: illegal to monopolize Clayton Act of 1914: prohibited other anticompetitive practices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved APPLYING ECONOMIC CONCEPTS 12.1 Does Nineteenth Antitrust Policy Still Work in the Twenty-First Century? Antitrust Policy in the 21th Century

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Evolution of Antitrust Policy and Recent Developments Over time, there has been considerable variation in the aggressiveness of antitrust enforcement and in the interpretation of exactly what type of behavior is illegal. U.S. v. Socony-Vacuum Oil Co. (1940): price fixing was found illegal regardless of the consequences ALCOA (1945): company was ruled an illegal monopoly despite no evidence of “unreasonable behavior” Be the mid-1970s, a more balanced antitrust approach was adopted, particularly in merger policy.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Looking Forward History suggests that U.S. antitrust policy will continue to change. –technological changes –Globalization Factors that will affect antitrust issues include: