1. Chapter 16 Government Regulation of Business

2. Learning Objectives
Define social economic efficiency and explain why well‐functioning competitive markets achieve social economic efficiency without government regulation
Explain the concept of market failure why it provides economic justification for government intervention
Identify deadweight loss associated with market power and discuss ways antitrust policy, second‐best pricing, and two‐part pricing can reduce the cost of market power
Discuss pollution as a negative externality and show how government regulation can create incentives for firms to choose the optimal level of pollution

3. Learning Objectives
Explain why common property resources and public goods are underproduced and how government can reduce market failure created by nonexcludability
Discuss why imperfect information about product price and quality can lead to market failure

4. 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

5. 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

6. 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)

7. 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

8. Efficiency in Perfect Competition (Figure 16.1)

9. 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

10. 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

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

12. 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

13. Louisiana White Shrimp Market (Figure 16.2)

14. 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

15. 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

16. 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

17. 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

18. Subadditive Costs & Natural Monopoly (Figure 16.3)

19. 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

20. Regulating Price Under Natural Monopoly (Figure 16.4)

21. 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

22. 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

23. 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

24. 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

25. Negative Externality & Allocative Inefficiency (Figure 16.5)

26. Pollution as a Negative Externality (Figure 16.6)

27. Finding the Optimal Level of Pollution (Figure 16.7)

28. Optimal Emission Taxation (Figure 16.8)

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

30. 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

31. 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

32. 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

33. 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

34. Imperfect Information on Product Quality (Figure 16.9)

35. Summary
Social economic efficiency occurs when two efficiency conditions are fulfilled: productive efficiency and allocative efficiency
At the competitive market-clearing price, buyers and sellers engage in voluntary exchange that maximizes social surplus
Market failure occurs when a market fails to achieve social economic efficiency
Absent market failure, no efficiency argument can be made for government intervention in competitive markets
The problem with market power is the loss of allocative efficiency
Most industrialized nations rely on antitrust laws to reduce the social cost of market power

36. Summary
An important cause of market failure arises when actions taken by market participants create benefits or costs that spillover to other members of society
When spillover effects are beneficial to society, they are referred to as positive externalities, and when they are costly to society, they are called negative externalities
When access to a good or a scarce resource cannot be excluded, market failure usually results
Two kinds of market failure caused by lack of excludability are common property resources and public goods
Market power can also emerge in competitive markets because imperfectly informed consumers do not have complete knowledge of all producers and prices