Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 21: Understanding the Business Environment: The Economics of Regulation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc All Rights Reserved Managerial Economics and Organizational Architecture, 5e Examples of Government Regulation • Antitrust legislation • Environmental protection laws • Financial disclosure for publicly traded stock • Intellectual property, labor, and safety laws • Utilities regulation • Financial services regulation • Transportation industry regulation 21-2 Managerial Economics and Organizational Architecture, 5e Economic Motives for Government Intervention • Provide laws and legal institutions that define and enforce property rights • Seek to correct market failure – Externalities – Public good – Monopolies – Asymmetric information 21-3 Managerial Economics and Organizational Architecture, 5e Defining and Enforcing Property Rights • Enforceable property rights increase incentive to invest and trade – patents, copyrights, trademarks • Enforceable contracts reduce transactions costs – greater gains from trade, more wealth – Lower transactions costs of contracting 21-4 Managerial Economics and Organizational Architecture, 5e Redressing Market Failures • Externalities – costs or benefits imposed on involuntary parties – pollution • Public goods – nonrival consumption – nonexcludable – free riders 21-5 Managerial Economics and Organizational Architecture, 5e Redressing Market Failures • Monopoly – antitrust laws – potential for regulators to be “captured” by the industry • Informational failures 21-6 Managerial Economics and Organizational Architecture, 5e Redistributing Wealth • Individuals have incentives to use regulatory powers to their advantage • Lobbying for wealth transfers yields no productive benefits for society • Taxi quotas raise the price above equilibrium reducing consumer surplus • Taxi companies are willing to spend up to the increase in their profits to lobby 21-7 Managerial Economics and Organizational Architecture, 5e Wealth Transfers via Government Quotas on the Number of Taxis Government intervention yields higher price (P’) and lower output (Q’), reduces consumer surplus (shaded area) and transfers wealth to cab companies (π) $ Lost potential gains from trade P’ P* π S D Q’ Q* Q 21-8 Managerial Economics and Organizational Architecture, 5e Economic Theory of Regulation • Special interests express demand for regulation or other favorable laws • Politicians (self-interested) supply regulation and other laws • Incentives to free ride and form coalitions – political power depends no ability to deliver votes and contributions – special interests are costly to form 21-9 Managerial Economics and Organizational Architecture, 5e Market for Regulation • In competitive and unregulated industry, Pc=MC • Collusion among firms could yield monopoly price, Pm>Pc • This will maximize profits in the industry • If the industry is regulated, the firms will want Pm and consumers will want Pc 21-10 Managerial Economics and Organizational Architecture, 5e Industry Profits in Competitive and Monopolized Markets $ Price (in dollars) $ P0 P0 Pm Pm Pc MC D MR Qm Pc Q Πm Qc Quantity Profit 21-11 Managerial Economics and Organizational Architecture, 5e Regulatory Behavior • Regulator seeks to maximize political support from constituents – businesses prefer higher profits – consumers prefer lower prices • Political support functions illustrate tradeoff between prices and profits that yield the same political support 21-12 Managerial Economics and Organizational Architecture, 5e Political Support Functions Increasing political support Price (in dollars) $ PS1 Pz Py PS2 Px Πx Πy p Profit 21-13 Managerial Economics and Organizational Architecture, 5e Regulatory Market Equilibrium • Regulators choose the price and profit level that maximizes their political support • Regulated price is determined by tangency between monopoly profit function and political support function • Regulated price is Pr*, Pc