0. A manager’s guide to Government in the marketplace
Rules and regulations passed and enforced by government enter into every decision firms and consumers make.
As manager, it is important to understand
regulations passed by government
Why such regulations have been passed
How they affect optimal managerial decisions

1. Reasons for government involvement in market economy
Provide legal, monetary and social framework for markets to operate
Insure that markets operate in a competitive manner
Redistribute income and wealth in a more desirable (equitable) fashion
Guarantee a more efficient allocation of resources in the face of externalities
Stabilize the overall level of economic activity

2. MARKET FAILURE

3. Market Failure
Market economy may produce too much or too little of certain products
Failure to make efficient use of society’s limited resources

4. 4 reasons why free markets may fail to provide socially efficient outcomes (need for government intervention)
Market power
Externalities
Public goods
Incomplete information

5. Market Failures
Market Power:- Firms with market power tend to restrict output to force prices up. Price > MC  there may be a net gain to society if additional output is produced Government may intervene in the market to regulate actions of firms in an attempt to increase social welfare Monopolies = deadweight loss Government uses antitrust policy to enact and enforce laws that restrict the formation of monopolies

6. Outlaws price-fixing agreements and other collusive practices Competition Act 1889 (Canada) – outlaws price fixing, bid-rigging conspiracies, mergers that inhibit competition etc. Bureau of Competition- enforcer Sherman Antitrust Act 1890 (USA) Exceptions may be made if mergers will result in increase in technology or efficiency

7. Externalities
When production/consumption processes create benefits or costs for people who are not part of the production or consumption process of that good.
Failure of markets to take into account all the costs and benefits associated with production or consumption of a good or service

8. Business consider only private or internal costs – cost borne by the firm– in production decisions
Consumers tend to consider only private or internal benefits in consumption decisions
Both groups ignore external costs borne by others or benefits that may be received by others.
Ignoring external costs or benefits – Externalities– results in an inefficient use of our scarce resources
Produce too much some items because full costs are not considered or produce too little because full benefits are not considered

9. External costs
Having a quiet dinner at your favorite restaurant only to have a shrieking baby at the next table
Watching a movie at the theatre with a kid using the back of your seat as a bongo drum.
Negative= costs, positive = benefits
Negative: pollution, smoking etc.
Positive: anchor store in a mall, day care, education etc

10. Scenario: Textile firm emits pollutants, a by-product of the production process, into a river.  cost to society of dirtier water marginal cost to society increases. If firms are allowed to dump pollutants in the water for free then marginal price paid by society for textiles is greater than price paid to firms.

11. Social costs is the full cost to society of producing the textiles– private costs + external costs.
Correcting for external costs:- how do we force business and individuals to consider all the costs of their actions?
Forcing them to internalize the costs.
Cost of pollution is not internalized by those who buy and sell textiles.
Basic reason for this market failure is the lack of well defined property rights

12. Possibilities:
Government can assign property rights to un-owned resources like lakes and rivers so individuals may charge for their use.---Basic reason for this market failure is the lack of well defined property rights
2. Legislations to limit (forbid) activities that create external costs

13. Government may force firms to internalize the cost by enacting policies that shift the cost of production to where it actually equals the social cost of production. e.g. Clean Air Act : Get a permit to pollute. Pay a fee for each unit of pollutants emitted.  internalize the cost of emission Permits can be sold by one firm to another within and across industries This provides an incentive for firms to develop and innovate new technologies that produce less pollution

14. Coase Theorem: government intervention to eliminate the effect of externalities is not necessary
If property rights are well defined (by the courts)  bargaining between the parties involved would result in an optimal solution.
This works if transactions costs – costs of striking the bargain-- are relatively low and in which the number of people involved is relatively small

15. Market Failure and the provision of public goods
Markets may fail because some goods are not simply well suited to be provided by private firms.
These products must be provided by government or they won’t be provided at all.

16. 3 categories of goods & services
Pure private goods – convey their benefits only to the consumer. eg. Hamburger for lunch, jacket you are wearing etc.
Private goods that yield external benefits: - education, flu shots, driver’s training etc.
Public goods – benefits are enjoyed equally by paying and non-paying members of society.
Problem, everyone enjoys so who wants to pay for the good???

17. PUBLIC GOODS
Goods that benefit persons other than those who buy the goods Public goods are non-rival and non-exclusionary Non-rival  If one person’s increase in consumption does not reduce the quantity available to others e.g. fireworks, radio signals, lighthouse etc. Rival goods  when you consume the good another person is unable to consume it as well

18. Non-exclusionary once the good is made available, everyone gets it; no one can be excluded from enjoying the good. Most goods are exclusionary: e.g. chocolate bar

19. FREE RIDER PROBLEM
Since everyone gets to enjoy a public good once it is available, individuals have little incentive to purchase the good.
Rather, they prefer to let other people pay for it and then they can ‘free-ride” on the efforts of others
If everyone thinks this way, the good will not be available

20. Markets will not provide public goods efficiently.
Imagine, a private firm providing street lights and charging for it? Nobody will pay for it. If one person pays for it, everyone else will enjoy it (free ride).
National defense, snow warning systems, etc. cannot be offered so as to restrict their benefits to payers alone

21. Government solves the public-goods problem by forcing everyone to pay taxes and then uses to fund public projects
Not all publicly provided goods are public goods. eg. Education, public swimming pools
Government may not provide the socially efficient quantity of a public good. It may over provide

22. Firms may provide public goods to increase their profits. e. g
Firms may provide public goods to increase their profits. e.g. clean local parks, give money to PBS creates goodwill and may create brand loyalty or increase the demand for the firm’s product

23. Demand for Public a Good In Action
Market Failure
Demand for Public a Good In Action
Price
Total demand for streetlights
Individual consumer surplus = $72
Individual demand for streetlights
Quantity of
streetlights

24. Demand for Public a Good In Action
Market Failure
Demand for Public a Good In Action
Price
Price
A’s consumer
surplus from
free-riding
= $85.50
Total demand
by B and C 30
A’s demand
for streetlights
B’s and C’s
individual demand
Quantity
of streetlights 30
Quantity
of streetlights

25. INCOMPLETE INFORMATION
When participants in a market have incomplete information about things such as prices, quality, risks, etc. it may result in inefficiency in input usage and in firm’s output
Classic example: The call for restaurants to indicate the caloric input of each meal on their menu.
If individuals are not told that cigarettes are harzardous, some people would smoke out of ignorance

26. Government requires labels/warnings on products
Regulates work environment (hard hats, dangers of chemicals etc.)
Laws against insider trading
Certification
Truth in advertising

27. Rent Seeking
Government policies generally benefit some parties at the expense of others. Some people (lobbyists???) spend considerable sums in attempts to influence government policies : rent seeking Monopolist can spend money on campaign contributions, wining and dining politicians or even bribes to avoid regulation that will eat into its profits.

28. Resource Allocation and Rent Seeking
Government policies can improve the allocation of resources to alleviate market failures.
These policies, however, generally benefit some parties at the expense of others.
Implications: lobbyists spend considerable sums in attempt to influence government policy; a process known as rent seeking.

29. Incentives to Engage in Rent-Seeking Activities In Action
Price C A B
MC = AC
Demand MR
Quantity

30. Government Policy and International Markets
Quotas
A quota is a government restriction that limits the quantity of imported goods that can legally enter the country.
Implications:
Reduces competition in domestic market
Higher domestic prices
Higher profits for domestic firms
Lower consumer surplus for domestic consumers
Conclusion: Domestic producers benefit at the expense of domestic consumers and foreign producers

31. Quota In Action Government Policy and International Markets Price E M E M A K B G
Demand
Quantity in the
domestic market

32. Government Policy and International Markets
Tariffs
A tariff is designed to limit foreign competition in the domestic market to benefit domestic producers, which accrue at the expense of domestic consumers and foreign producers.
Lump-sum tariff: fixed fee that foreign firms must pay the domestic government to be able to sell in the domestic market.
Excise (per-unit) tariff: the fee an importing firm must pay to the domestic government on each unit it brings into the country.

33. Lump-Sum Tariff on a Foreign Firm In Action
Government Policy and International Markets
Lump-Sum Tariff on a Foreign Firm In Action
Price
Average cost
After lump-sum tariff
Average cost
before
lump-sum tariff
AC2 MC
AC1
Quantity of
individual
foreign firm’s
output

34. Impact of a Lump-Sum Tariff on Market Supply In Action
Government Policy and International Markets
Impact of a Lump-Sum Tariff on Market Supply In Action
Price A
Market supply curve
after lump-sum tariff
Market supply curve
before lump-sum tariff
Quantity in the
domestic market

35. Quota In Action Government Policy and International Markets Price
Price
Supply after
excise tax E C H B
Demand
Supply before
excise tax A
Quantity in the
domestic market

36. In this section we’d look for the answers to these questions:
How do wages compensate for differences in job characteristics?
Why do people with more education earn higher wages?
Why are wages sometimes above their equilibrium values?
Why is it difficult to measure discrimination?
When might the market solve the problem of discrimination? When might it not? 36

37. U.S. Median Weekly Earnings, Selected Occupations, 2006
Both sexes
Men
Women
Gender gap
Chief executives
$1,875
$1,907
$1,422
34.1%
Aircraft pilots
1,407
1,419
n.e.d.
Educ. administrators
1,125
1,275
1017
25.4%
Fire fighters
912
918
Registered nurses
978
1,074
971
10.6%
Social workers
732
749
728
2.9%
Secretaries
583
559
584
– 4.3%
Telemarketers
395
n.e.d
Waiters/waitresses
363
401
348
15.2%
Maids/housekeeping
355
404
16.1%
The last column, labeled “Gender gap,” is the percentage by which men’s earnings exceed women’s earnings.
BLS did not provide earnings figures for categories with fewer than 50,000 persons, presumably due to nondisclosure issues. In such cases, “n.e.d.” appears in the chart.
Source: Bureau of Labor Statistics,
I got these figures from a table containing data on over 800 occupations. The table also showed the number of employees in each occupation (total and by gender). The table is available at bls.gov, click on “wages by area and occupation” and then “national wage data for over 800 occupations.”
n.e.d. = not enough data for BLS disclosure requirements 37 37

38. Introduction
In competitive markets, the wages workers earn equal the value of their marginal products.
There are many factors that affect productivity and wages…
EARNINGS AND DISCRIMINATION 38

39. Compensating Differentials
Compensating differential: a difference in wages that arises to offset the nonmonetary characteristics of different jobs
These characteristics include unpleasantness, difficulty, safety. Examples:
Coal miners and fire fighters are paid more than other workers with similar education to compensate them for the extra risks.
Night shift workers paid more than day shift to compensate for the lifestyle disruption of working at night.
EARNINGS AND DISCRIMINATION 39

40. Ability, Effort, and Chance
Greater ability or effort often command higher pay. These traits increase workers’ marginal products, make them more valuable to the firm.
Wages also affected by chance
E.g., new discoveries no one could have predicted make some occupations obsolete, increase demand in others
EARNINGS AND DISCRIMINATION 40

41. Ability, Effort, and Chance
Ability, effort, and chance are difficult to measure, so it is hard to quantify their effects on wages.
They are probably important, though, since easily measurable characteristics (education, age, etc.) account for less than half of the variation in wages in our economy.
EARNINGS AND DISCRIMINATION 41

42. Case Study: The Benefits of Beauty
Research by Hamermesh and Biddle:
People deemed more attractive than average earn 5% more than people of average looks.
Average-looking people earn 5-10% more than below-average looking people.
EARNINGS AND DISCRIMINATION 42

43. Case Study: The Benefits of Beauty
Hypotheses:
1. Good looks matter for productivity
In jobs where appearance is important, attractive workers are more valuable to the firm, command higher pay.
2. Good looks indirectly related to ability
People who make an effort to project attractive appearance may be smarter or more competent in other ways.
3. Discrimination
EARNINGS AND DISCRIMINATION 43

44. The Superstar Phenomenon
Superstars like Will Smith, Bono earn many times more than average in their fields.
The best plumbers or carpenters do not.
Superstars arise in markets that have two characteristics:
Every customer in the market wants to enjoy the good supplied by the best producer.
The good is produced with a technology that allows the best producer to supply every customer at a low cost.
“Every customer in the market wants to enjoy the good supplied by the best producer.”
Example: Seeing two movies that are half as entertaining is not a good substitute for seeing one movie that’s very entertaining. Having two CDs by artists that are half as good as U2 is not a good substitute for having one CD by U2.
EARNINGS AND DISCRIMINATION 44

45. Human Capital
Human capital: the accumulation of investments in people, such as education and on-the-job training
Human capital affects productivity, and thus labor demand and wages.
EARNINGS AND DISCRIMINATION 45

46. Weekly Earnings of Full-Time Employed Persons Age 25+ by Education, 2007:Q4
Educational attainment
Median weekly earnings
Less than H.S.
$ 424
H.S. diploma
610
Some college or Associate degree
697
Bachelor’s degree
994
Advanced degree
1,259
This table should provide good motivation for our students to stay in school and get their degree.
Source: Bureau of Labor Statistics,
Look for “usual weekly earnings of wage and salary workers.” 46 46

47. The Increasing Value of Skills
The earnings gap between college-educated and non-college-educated workers has widened in recent decades.
Percentage difference in annual earnings for college graduates vs. high school diploma
This table should provide even more motivation for students to complete their degree programs.
Source: See textbook, table 1 of this chapter.
35%
44%
1980
72%
87%
2005
Men
Women
EARNINGS AND DISCRIMINATION 47

48. The Increasing Value of Skills
Two hypotheses:
1. International trade Rising exports of goods made with skilled labor, rising imports of goods made with unskilled labor.
2. Skill-biased technological change New technologies have increased demand for skilled workers, reduced demand for unskilled workers.
Difficult to determine which hypothesis better explains the widening earnings gap; probably both are important.
EARNINGS AND DISCRIMINATION 48

49. The Signaling Theory of Education
An alternative view of education:
Firms use education level to sort between high-ability and low-ability workers.
The difficulty of earning a college degree demonstrates to prospective employers that college graduates are highly capable.
Yet, the education itself has no impact on productivity or skills.
Policy implication: Increasing general educational attainment would not affect wages.
EARNINGS AND DISCRIMINATION 49

50. Reasons for Above-Equilibrium Wages
1. Minimum wage laws
The minimum wage may exceed the eq’m wage of the least-skilled and experienced workers
2. Unions
Union: a worker association that bargains with employers over wages and working conditions
Unions use their market power to obtain higher wages; most union workers earn 10-20% more than similar nonunion workers.
EARNINGS AND DISCRIMINATION 50

51. Reasons for Above-Equilibrium Wages
3. Efficiency wages
Efficiency wages: above-equilibrium wages paid by firms to increase worker productivity
Firms may pay higher wages to reduce turnover, increase worker effort, or attract higher-quality job applicants.
Efficiency wage theory may help explain why some workers are paid more than others.
One version of efficiency wage theory says that firms will pay workers above-equilibrium wages when firms cannot perfectly monitor workers’ effort. Workers prefer shirking to working, and know they can probably get away with a little shirking now and then. Firms fire workers caught shirking. But the prospect of losing one’s job may not be sufficient incentive to prevent shirking – if the labor market is in equilibrium, then there are plenty of other jobs at the going wage. If firms pay above-market wages, then employees have a stronger incentive not to shirk, for if they are caught and fired, they lose a particularly good job.
Now, compare two workers of equal education, ability, etc. One works in an occupation where firms can easily monitor his or her effort. The other works in an occupation where it is difficult for firms to monitor employee effort. The latter employee may earn more than the former.
Another textbook (which shall remain nameless) provides a specific example: It is very hard for parents to monitor the child care workers they hire. When parents are at work, the worker can often get away with shirking (e.g., have his/her girlfriend/boyfriend over, lock the kids up in the basement, go to the mall and leave the kids alone, etc). Hence, the parents may pay more than the going wage for child care workers to give the worker an incentive not to shirk.
EARNINGS AND DISCRIMINATION 51

52. A C T I V E L E A R N I N G 2 Explaining wage differentials
In each case, identify which worker would earn more and explain why.
A. The best physical therapist on the planet or the best writer on the planet
B. A trucker that hauls produce or a trucker that hauls hazardous waste from nuclear power plants
C. A graduate of an Ivy League college or an equally intelligent & capable graduate of a state university
D. Someone who graduated from a state university with a 3.7 GPA, or someone who graduated from the same university with a 2.4 GPA
Let’s break up the lecture for a few minutes and see if students can apply the material from the first part of this chapter. 52

53. The Economics of Discrimination
Discrimination: the offering of different opportunities to similar individuals who differ only by race, ethnicity, gender, or other personal characteristics
EARNINGS AND DISCRIMINATION 53

54. Measuring Labor-Market Discrimination
Median earnings of full-time U.S. workers, 2007:
White males earn 21% more than white females.
White males earn 24% more than black males.
Taken at face value, these differences look like evidence that employers discriminate.
But there are many possible explanations for wage differences besides discrimination; the data above do not control for differences in other factors that affect wages.
Source of data:
I obtained the data from this URL:
I selected median weekly earnings of full-time, year-round adult (16 yrs + up) workers – white men, white women, black men, black women.
EARNINGS AND DISCRIMINATION 54

55. Measuring Labor-Market Discrimination
Differences in human capital among groups:
White males 75% more likely to have college degree than black males
White males 11% more likely to have graduate degree than white females
Women have less on-the-job experience than men
Public schools in many predominantly black areas are of lower quality (e.g., funding, class sizes)
There may well be discrimination in access to education, but this problem occurs long before workers enter the labor force.
Source of data: Same as textbook.
EARNINGS AND DISCRIMINATION 55

56. Measuring Labor-Market Discrimination
Recent study by Bertrand and Mullainathan finds evidence of labor-market discrimination:
5000 fake résumés sent in response to “help wanted” ads.
Half had names more common among blacks, like Lakisha Washington or Jamal Jones. The other half had names common among whites, like Emily Walsh or Greg Baker.
Otherwise, the résumés were the same.
The white names received 50% more calls from interested employers than the black names.
This case study is based on an article in the September 2004 American Economic Review.
The last chapter of Freakonomics by Levitt and Dubner explores this issue in more detail. (Much more detail.)
EARNINGS AND DISCRIMINATION 56

57. Discrimination by Employers
Competitive markets provide a natural remedy for employer discrimination:
The profit motive…
The non-discriminating firms can hire females for a lower wage, giving them a cost advantage and economic profits, which attract entry of other non-discriminating firms.
Suppose some firms discriminate against female workers. They will hire fewer females, more males.
Result: A wage differential.
EARNINGS AND DISCRIMINATION 57

58. Discrimination by Employers
The discriminating firms will begin to lose money and be driven out of the market. Result: Demand for female workers increases, demand for male workers falls until wages are equalized
Female workers
Male workers WF LF WM LM SF SM DM DF DF WM DM DM DF
Don’t worry that the text looks garbled – it will look fine in presentation mode.
Alan Greenspan provides an excellent example of the profit motive correcting a discrimination problem. See #8 in the Problems and Applications at the end of this chapter in the textbook. WF WM WF
EARNINGS AND DISCRIMINATION 58

59. Discrimination by Consumers
Discrimination by consumers may result in discriminatory wage differentials.
Suppose firms care only about maximizing profits, but customers prefer being served by whites.
Then firms have an incentive to hire white workers, even if non-whites are willing to work for lower wages.
EARNINGS AND DISCRIMINATION 59

60. Discrimination by Governments
Some government policies mandate discriminatory practices.
apartheid in South Africa before 1994
early 20th century U.S. laws requiring segregation in buses and streetcars
Such policies prevent the market from correcting discriminatory wage differentials.
EARNINGS AND DISCRIMINATION 60

61. CONCLUSION
In competitive markets, workers are paid a wage that equals the value of their marginal products.
Many factors affect the value of marginal products and equilibrium wages.
The profit motive can correct discrimination by employers, but not discrimination by customers or discriminatory policies of governments.
Even without discrimination, the distribution of income may not be equitable or desirable – a topic we explore in the following chapter.
EARNINGS AND DISCRIMINATION 61