1. Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Managerial Economics & Business Strategy Chapter 14 A Manager’s Guide to Government in the Marketplace

2. 14-2 Government Regulations  Government regulations affect most decisions that consumers and firms make.  Legitimate reasons for government intervention:  Market Power  Externalities  Public Goods  Asymmetric Information

3. 14-3 Government Regulations Government Policy and International Markets –Quotas –Tariffs

4. 14-4 Market Power  Firm produces a level of output less than is socially efficient and charges a price higher than marginal cost.  Net gain to society if more output were produced.  Government can intervene to increase social welfare.

5. 14-5 Market Power  Market power is the ability of a firm to set P > MC.  Firms with market power produce socially inefficient output levels. –Too little output –Price exceeds MC –Deadweight loss Dollar value of society’s welfare loss MR PMPM QMQM MC D Q P PCPC QCQC Deadweight Loss

6. 14-6 Antitrust Policies  Administered by the DOJ and FTC  Goals: –To eliminate deadweight loss of monopoly and promote social welfare. –Make it illegal for managers to pursue strategies that foster monopoly power.

7. 14-7 Sherman Act (1890)  Sections 1 and 2 prohibits price-fixing, market sharing and other collusive practices designed to “monopolize, or attempt to monopolize” a market.

8. 14-8 United States v. Standard Oil of New Jersey (1911)  Charged with attempting to fix prices of petroleum products. Methods used to enhance market power: –Physical threats to shippers and other producers. –Setting up artificial companies. –Espionage and bribing tactics. –Engaging in restraint of trade. –Attempting to monopolize the oil industry.

9. 14-9 United States v. Standard Oil of New Jersey (1911)  Result 1: Standard Oil dissolved into 33 subsidiaries.  Result 2: New Supreme Court Ruling the rule of reason. –Stipulates that not all trade restraints are illegal, only those that are unreasonable are prohibited.  Based on the Sherman Act and the rule of reason, how do firms know a priori whether a particular pricing strategy is illegal?  Clayton Act (1911) and Robinson-Patman (1936)

10. 14-10 Clayton Act (1914)  Makes hidden kickbacks (brokerage fees) and hidden rebates illegal.  Section 3 Prohibits exclusive dealing and tying arrangements where the effect may be to “substantially lessen competition.”

11. 14-11 Cellar-Kefauver Act (1950)  Amends Section 7 of Clayton Act.  Strengthens merger and acquisition policies.  Horizontal Merger Guidelines –Market Concentration Herfindahl-Hirschman Index: HHI = 10,000  w i 2 Industries in which the HHI exceed 1800 are generally deemed “highly concentrated”. The DOJ or FTC may, in this case, attempt to block a merger if it would increase the HHI by more than 100.

12. 14-12 DOJ Flexibility  Mergers are often allowed even when HHI is large provided there is likelihood of entry of domestic or foreign firms, increased efficiency, or a firm has financial problems.

13. 14-13 Regulating Monopolies  When large economies of scale exist it may be that one firm can more efficiently service the market.  Government can sanction the monopoly but will regulate prices to reduce deadweight loss.

14. 14-14 Regulating Monopolies: Marginal-Cost Pricing P Q PMPM PCPC QCQC QMQM Effective Demand MR MC

15. 14-15 Problem 1 with Marginal-Cost Pricing: Possibility of ATC > P C P Q PCPC QCQC QMQM MR MC ATC PMPM

16. 14-16 Price Regulation  If regulated price is set at too low a level then the social cost of regulation is greater then the social cost of allowing the firm to price as a monopoly.  Next graph indicates this scenario.

17. 14-17 Problem 2 with Marginal-Cost Pricing: Requires Knowledge of MC P Q PMPM Q Reg QMQM MR MC Q*Q* Shortage Deadweight loss prior to regulation Deadweight loss after regulation P Reg Effective Demand

18. 14-18 Externalities  A negative externality is a cost borne by people who neither produce nor consume the good.  Example: Pollution –Caused by the absence of well-defined property rights.  Government regulations may induce the socially efficient level of output by forcing firms to internalize pollution costs –The Clean Air Act of 1970.

19. 14-19 Methods for Dealing with Negative Externalities  Command and Control methods  Market based alternatives –Pigouvian Tax –Pollution Permit System (cap and trade) –Coase

20. 14-20 Socially Efficient Equilibrium: Internal and External Costs Q P D MC external MC internal MC external + internal QCQC PCPC Q SE P SE Socially efficient equilibrium Competitive equilibrium

21. 14-21 Public Goods  A good that is non-rival and non-exclusionary (excludable) in consumption. –Non-rival: A good which when consumed by one person does not preclude other people from also consuming the good. Example: Radio signals, national defense –Non-exclusionary (excludable): No one is excluded from consuming the good once it is provided. Clean air National defense Street lights

22. 14-22 Public Goods  “Free Rider” Problem –Individuals have little incentive to buy a public good because of their non-rival & non- exclusionary nature. –The market has no incentive to provide public goods because of potential free riders. –Government provides the public good from tax monies collected from everyone.

23. 14-23 Public Goods  Benefit-cost analysis is used to determine whether and how much of a public good to provide.  Costs are straightforward  Determining benefits poses a problem

24. 14-24 Incomplete Information  Participants in a market that have incomplete information about prices, quality, technology, or risks may be inefficient.  The Government serves as a provider of information to combat the inefficiencies caused by incomplete and/or asymmetric information.

25. 14-25 Government Policies Designed to Mitigate Incomplete Information  OSHA – full info to workers  SEC – insider trading; 2009 crisis  Certification – minimum standards; certified charities; schools

26. 14-26 Government Policies Designed to Mitigate Incomplete Information  Truth in lending –creating more symmetric information between borrowers and lenders  Truth in advertising – treble damages under the Lanham and Clayton Acts  Contract enforcement – deterring opportunistic behavior.

27. 14-27 Rent Seeking  Government policies will generally benefit some parties at the expense of others.  Lobbyists spend large sums of money in an attempt to affect these policies.  This process is known as rent-seeking – selfishly motivated efforts to influence another party’s decision.

28. 14-28 An Example: Seeking Monopoly Rights  Firm’s monetary incentive to lobby for monopoly rights: A  Consumers’ monetary incentive to lobby against monopoly: A+B.  Firm’s incentive is smaller than consumers’ incentives.  But, consumers’ incentives are spread among many different individuals.  As a result, firms often succeed in their lobbying efforts. QMQM QCQC PMPM PCPC P Q MC D MR Consumer Surplus AB A = Monopoly Profits B = Deadweight Loss

29. 14-29 Quotas and Tariffs  Quota –Limit on the number of units of a product that a foreign competitor can bring into the country. Reduces competition, thus resulting in higher prices, lower consumer surplus, and higher profits for domestic firms.  Tariffs –Lump sum tariff: a fixed fee paid by foreign firms to enter the domestic market. –Excise tariff: a per unit fee on each imported product. Causes a shift in the MC curve by the amount of the tariff which in turn decreases the supply of all foreign firms.

30. 14-30 $30 Analysis of a Tariff on Cotton Shirts free trade CS = A + B + C + D + E + F PS = G Total surplus = A + B + C + D + E + F + G tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B + C + E + G P Q D S $20 25 Cotton shirts 40 A B D E G F C 70 80 deadweight loss = D + F

31. 14-31 Figure 7 The Effects of an Import Quota Copyright © 2004 South-Western Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand Isolandian price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S

32. 14-32 Conclusion  Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace.  Government’s presence creates rent- seeking incentives, which may undermine its ability to improve matters.