Managerial economics strategy by m perloff and brander chapter 16 government and business

– One important rationale for government policy is to reduce or eliminate market failure deadweight loss, but some may win and others lose.. • The Pareto Principle – Pareto Principle: ch

Chapter 16

Government and

Business

Table of Contents

• 16.1 Market Failure & Government Policy

• 16.2 Regulation of Imperfectly Competitive Markets

• 16.3 Antitrust Law & Competition Policy

• 16.4 Externalities

• 16.5 Open-Access, Club, & Public Goods

• 16.6 Intellectual Property

– Governments also respond to externalities, a market failure due to incomplete

property rights (open-access, club, public goods, patents, and copyrights).

16.1 Market Failure &

Government Policy

• Economic Efficiency and Government Policy

– Perfectly competitive markets achieve economic efficiency: total surplus is maximized However, most markets exhibit a significant market failure, which substantially reduce economic efficiency and result in deadweight losses

– One important rationale for government policy is to reduce or eliminate market failure (deadweight loss), but some may win and others lose

– Economists evaluate the desirability of government policy with two lenses: the Pareto Principle and Cost-Benefit Analysis

• The Pareto Principle

– Pareto Principle: change that benefits some people without harming

anyone else– A government policy that eliminates a market failure is a Pareto

improvement if the reallocation of goods or productive inputs helps at least one person without harming anyone else

– The outcome is Pareto efficient once all possible Pareto improvements

have occurred So, any additional change would harm at least one person

16.1 Market Failure &

• Pareto and Cost-Benefit Compared

– Any policy that generates a Pareto improvement satisfies the cost-benefit principle If some people gain from a policy and no one suffers a loss, then the aggregate benefit is positive However, the converse is not true – In practice, policies that have large net benefits and small distributional effects tend to generate broad support But, policies with small net

benefits and large distributional effects are likely to be more contentious, especially if the distributional effect is regressive (worse income

distribution)

16.2 Regulation of Imperfectly Competitive Markets

• First Approach to Eliminate Market Failure

– A government can eliminate imperfectly competitive pricing by a

monopolist with a direct approach: own the monopoly and set relatively low prices

– Example: many governments own and operate electric power and water utilities

• Second Approach to Eliminate Market Failure

– A government can change the market structure using antitrust or

competition laws

– Example: the U.S government increased the number of aluminum

manufacturers during World War II, ending Alcoa’s monopoly

• Third Approach to Eliminate Market Failure

– A government can regulate the industry to prevent firms from setting excessively high prices

– We will focus on this third approach next

16.2 Regulation of Imperfectly Competitive Markets

• Optimal Price Regulation: Cap Price

– A government can eliminate the deadweight loss of monopoly by imposing

a price cap equal to the price that would prevail in a competitive market.– Example: Price cap regulation is used for telecommunications monopolies

in 33 U.S states, and many countries including Australia, Canada, Denmark, France, Germany, Mexico, Sweden, and the U.K

• Efficient Cap Price Regulation: Graph Analysis

– In Figure 16.1, an unregulated monopoly maximizes its profit at e m, where

MR = MC The monopoly sells 6 units at a price of $18 per unit, and

society suffers a deadweight loss, –C – E.

– The government sets a price cap at $16 (horizontal demand for the

monopolist) and the regulated monopolist maximizes profit at e o, where

MR r = MC The monopolist sells 8 units at the maximum price allowed of

$16

– This is an optimal price cap because it gives a competitive price and the

16.2 Regulation of Imperfectly Competitive Markets

Figure 16.1

Optimal Price

Regulation

16.2 Regulation of Imperfectly Competitive Markets

• Non Optimal Price Regulation Due to Poor Information

– Well-intentioned government regulators often fail to regulate monopolies optimally because of limited information about the monopoly’s demand and cost curves

– If regulators rely on the monopoly or on industry experts for information, they may be misled, and the price cap may be above or below the

efficient level resulting in a deadweight loss

• Non Optimal Price Regulation Due to Inability to Subsidize

– If a monopolist exhibits economies of scale, a price cap regulation based

on MC may force the monopolist to shutdown because MC < AC, unless it gets a subsidy.

– Given that subsidizing a monopolist may not be politically viable, a better regulation is to set the price cap equal to the average cost so that firm continues to operate (Pareto improvement over marginal cost pricing)

16.2 Regulation of Imperfectly Competitive Markets

• Regulatory Capture

– Some regulators may be captured so that they regulate in the manner

that the industry wants (the interests of the industry ahead of the public interest)

– Firms engage in rent seeking practices (devote effort and expenditures to gain a rent of profit from government actions) to capture some regulators – A captured regulator’s objective might be to keep prices high rather than low, so they may impose entry restrictions to keep potential competitors out

• Applying the Cost-Benefit Principle to Regulation

– Regulating all markets where P > MC (market failure) will not increase

total surplus because many regulations would not pass a cost-benefit test – Regulation has its own costs: costs of gathering information, costs of

honest mistakes, costs of captured regulators, costs of rent seeking

– Price regulation passes a cost-benefit test only when the market failure is large enough that the benefits from significantly reducing it exceed the cost associated with regulation

16.3 Antitrust Law & Competition Policy

• Antitrust Laws in the U.S.

– In the late nineteenth century, cartels or trusts, were legal and were common

in the United States Oil, railroad, sugar, and tobacco trusts raised prices

substantially above competitive levels.

– The U.S Congress passed the Sherman Antitrust Act in 1890 and the Federal Trade Commission Act of 1914, which prohibited firms from explicitly agreeing

to take actions that reduce competition So, price fixing is a per se violation: It

is strictly against the law and firms have no possible mitigating justifications – The two governmental agencies responsible for U.S antitrust policy are the

Antitrust Division of the Department of Justice (DOJ) and the Federal Trade

Commission (FTC).

• Why do Cartels Persist Despite Antitrust Laws?

– First, international cartels and cartels within certain countries operate legally – Second, some illegal cartels operate believing that they can avoid detection or that the punishment will be insignificant.

– Third, some firms are able to coordinate their activities without explicitly

colluding and thereby running afoul of competition laws.

16.3 Antitrust Law & Competition Policy

• Mergers

– To prevent firms from forming a monopoly, most antitrust and

competition laws restrict the ability of firms to merge if the net effect is to harm society

– Whether a merger helps or harms society depends on which of its two

offsetting effects—reducing competition and increasing efficiency—is larger

– Proposed U.S mergers beyond a certain size must be reported and

evaluated by either the DOJ or the FTC These agencies block mergers that they believe harm society But, firms can appeal this decision to the federal courts

• Predatory Actions

– Antitrust policy also prevents predatory pricing: a firm charges a price

below MC or AC to drive its rivals out of business and then raise its price.

– It is difficult for the DOJ to demonstrate predatory pricing because the

firm does not benefit from predating if its rivals or other firms reenter the market as soon as it raises its price

16.3 Antitrust Law & Competition Policy

• Regulation of Vertical Relationships

– Antitrust policy also addresses vertical interactions between a firm and its customers or suppliers

– Vertical actions that competition authorities investigate include resale

price maintenance, refusal to deal, exclusive dealing, and price discrimination

• Resale Price Maintenance

– A manufacturer engages in resale price maintenance (RPM) if it requires the retailers that sell its product to charge a price no lower than a price it specifies

– In the U.S., RPM was per se illegal However, since 2007, it is a rule of

reason or cost-benefit: RPM is illegal only if it has a net negative effect on competition

– Today, restrictions on dealers’ prices or other activities are usually legal if the manufacturer acts unilaterally

16.3 Antitrust Law & Competition Policy

• Exclusive Dealing

– Exclusive dealing arises when a firm sells its product only to customers who agree to buy from that firm and not from its rivals, or when a firm is forced to sell to only one buyer and not to the buyer’s rivals.

– Exclusive contracts are legal if it promotes efficiency and competition in the market

by guaranteeing a source of supply, lowering transaction costs, or creating dealer loyalty However, they are illegal if new firms cannot enter the market.

• Price Discrimination

– Price discrimination is legal unless it harms competition (Robinson-Patman Act of

1936).

16.4 Externalities

• Effects of Actions that Occur Outside Markets

– When a person’s well-being or a firm’s production capability is directly

affected by the actions of other consumers or firms rather than indirectly through changes in prices, it is called externality (the effect occurs outside

market transactions)

• Negative and Positive Externalities

– Negative Externality: A chemical plant that dumps its waste into a lake, reducing the profits of a firm that rents boats and the utility of visitors to the lake Because the chemical plant does not pay for the harm caused to the other firm and visitors, it dumps too much

– Positive Externality: A homeowner that plants nice trees in his property increases the value of the neighbor’s homes too Because this homeowner

is not compensated for the benefits she gives to the community, too little

of such externality is produced

16.4 Externalities

• Negative Externality: Paper Industry and Air and Water Pollution

– We examine a competitive market in which firms produce paper and emit by-products of the production process—such as air and water pollution—that harm people who live near paper mills

– Paper firms do not pay for the harm from the pollution they cause Each

firm’s private cost includes its direct costs (labor, energy, and wood pulp),

but not the indirect costs of the harm from the externality The true social

cost for society includes private costs and indirect costs.

• Market Graphical Analysis

– In Figure 16.2, the competitive equilibrium, e c, is determined by the

intersection of the demand curve and the private marginal cost curve, MC p

Too much paper is produced (Q c = 105 tons) and sold at low prices (p c =

$240 per ton) because the firm ignores the cost of pollution E represents

the deadweight loss

– The social optimum, e s, is at the intersection of the demand curve and the

social marginal cost curve, MC s = MC p + MC x , where MC x is the marginal cost

of the pollution There is no deadweight, Q s = 84 and p s = $282 per ton

16.4 Externalities

• Regulation to Reduce Externalities

– If a government has sufficient knowledge about pollution damage, the

demand curve, costs, and the production technology, it can force a competitive market to produce the social optimum

– The government can control pollution directly or indirectly It can control pollution directly by setting emissions standards or taxing pollution with emission fees or effluent charges It can do it indirectly by limiting outputs

or inputs

– Direct pollution regulation encourages firms to adopt efficient new

technologies

• Another Approach to Reduce Externalities: Property Rights

– Government agencies or courts could clearly assign property rights giving one party the right to pollute or the other party the right to be free from pollution

– If clear property rights can be established, pollution can be priced and the externality problem can be reduced or eliminated

16.4 Externalities

• Emissions Standards

– In Figure 16.2, the government can maximize total surplus by enacting an emission standard that prohibits paper mills to produce more than 84

units of paper per day (pollution is directly related to paper output)

– Limitations: the government may not have full information to set the

correct emission standard, or may have limited monitoring and enforcing resources

• Emission Fees

– In the paper mill case, if the government knows the marginal cost of the

emissions, MC x , it can set the output tax, t(Q), which varies with output,

Q, equal to this marginal cost curve: t(Q) = MC x.– Usually, the government sets a specific tax rather than a tax that varies with the amount of pollution

16.4 Externalities

• Property Rights and the Coase Theorem

– Coase Theorem (Coase, 1960): a polluter and its victim can achieve the optimal levels of pollution if property rights are clearly defined and they can bargain effectively

– The Coase Theorem demonstrates that unclear property rights is the root

of the externality problem However, it may not be practical for most cases

• Secret Garden Tea House & Fixit Car-body Shop Case

– Fixit causes noise pollution, which hurts business at the Secret Garden – As Table 16.1 shows, if Fixit works on more cars per hour, its profit

increases, but the resulting extra noise reduces the tea house’s profit The last column shows the total profit of the two firms Having the auto body shop work on one car at a time maximizes their joint profit Anything else

is inefficient

16.4 Externalities

Table 16.1 Daily Profits Vary with Production and Noise

16.4 Externalities

• Unclear Property Rights for Fixit and Secret Garden

– Initially, because property rights are not clearly defined, Fixit won’t

negotiate with the Secret Garden After all, why would Fixit reduce its output and the associated noise, if the Secret Garden has no legal right to

be free of noise?

– So, Fixit works on two cars per hour and maximizes its profit at 400

(Table 16.1) The excessive noise drives the Secret Garden out of business; joint profit is 400

• Defining Clear Property Rights for Fixit & Secret Garden

– Suppose the Secret Garden gets the right to silence If it forces Fixit to shut down, the Secret Garden makes 400 and their joint profit is 400 However, if Fixit works on one car, its gain is 300, while the Secret Garden loses only 200

– The firms should be able to reach an agreement where Fixit pays the tea house between 200 and 300 for the right to work on one car Under such

an agreement, their joint profit is maximized at 500

– If Fixit gets the right to noise, a similar beneficial outcome is produced