Government Regulation for Business Efficiency

1. Chapter 16 Government Regulation of Business

2. Market Competition & Social Economic Efficiency • 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

3. 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

4. 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)

5. 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

6. Efficiency in Perfect Competition (Figure 16.1)

7. 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

8. 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

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

10. 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

11. Louisiana White Shrimp Market (Figure 16.2)

12. 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

13. 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

14. 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

15. Natural Monopoly & Market Failure • Natural monopoly • 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

16. Subadditive Costs & Natural Monopoly (Figure 16.3)

17. 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

18. Regulating Price Under Natural Monopoly (Figure 16.4)

19. 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

20. 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

21. 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

22. 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

23. Negative Externality & Allocative Inefficiency (Figure 16.5)

24. Pollution as a Negative Externality (Figure 16.6)

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

26. Optimal Emission Taxation (Figure 16.8)

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

28. 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

29. 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

30. 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

31. 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

32. Imperfect Information on Product Quality (Figure 16.9)