Chapter 16 - Government regulation of business. In this chapter we showed you why economists and policymakers believe well-functioning competitive markets can lead to economically efficient levels of production and consumption in equilibrium. Society’s well-being, as measured by the social surplus generated through trade between buyers and sellers, is maximized when markets operate in an economically efficient manner.
Managerial Economics ninth edition Thomas Maurice Chapter 16 Government Regulation of Business McGrawHill/Irwin McGrawHill/Irwin Managerial Economics, 9e Managerial Economics, 9e Copyright © 2008 by the McGrawHill Companies, Inc. All rights reserved Managerial Economics 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 162 Productive efficiency Allocative efficiency Managerial Economics 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 163 Managerial Economics 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 (marginalcostpricing) 164 Managerial Economics 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 marketclearing price, buyers & sellers engage in voluntary exchange that maximizes social surplus 165 Managerial Economics Efficiency in Perfect Competition (Figure 16.1) 166 Managerial Economics 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 167 Managerial Economics 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 168 Managerial Economics Market Failure & the Case for Government Intervention • Absent market failure, no efficiency argument can be made for government intervention in competitive markets 169 Managerial Economics 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 profitmaximizing price does not result in marginalcostpricing 16 At the profitmaximizing point, MB > MC Resources are underallocated to the industry Managerial Economics Regulating Price Under Natural Monopoly (Figure 16.4) 16 Managerial Economics Natural Monopoly & Market Failure • With economies of scale, marginalcost-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 16 Managerial Economics 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 16 Managerial Economics 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 16 Managerial Economics The Problem of Negative Externality • Managers rationally ignore external costs when making profitmaximizing production decisions • Social cost of production: Social cost = Private cost + External cost Or Social cost – Private cost = External cost 16 Managerial Economics Negative Externality & Allocative Inefficiency (Figure 16.5) 16 Managerial Economics Pollution as a Negative Externality (Figure 16.6) 16 Managerial Economics Finding the Optimal Level of Pollution (Figure 16.7) 16 Managerial Economics Optimal Emission Taxation (Figure 16.8) 16 Managerial Economics Nonexcludability • Two kinds of market failure caused by nonexcludability: • Common property resources • Public goods 16 Managerial Economics 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 16 Managerial Economics 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 16 Managerial Economics 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 16 Managerial Economics Information & Market Failure • Consumers may over- or underestimate quality of goods & services • If they overvalue quality, they will demand too much product relative to the allocatively efficient amount • If they undervalue quality, they will demand too little 16 Managerial Economics Imperfect Information on Product Quality (Figure 16.9) 16 ... Social cost – Private cost = External cost 16 Managerial Economics Negative Externality & Allocative Inefficiency (Figure 16.5) 16 Managerial Economics Pollution as a Negative Externality (Figure 16.6) 16 Managerial Economics. .. At the profitmaximizing point, MB > MC Resources are underallocated to the industry Managerial Economics Louisiana White Shrimp Market (Figure 16.2) 16 Managerial Economics Market Power & Public Policy • When the degree... industry output • Longrun costs are subadditive 16 Managerial Economics Subadditive Costs & Natural Monopoly (Figure 16.3) 16 Managerial Economics Natural Monopoly & Market Failure • Breaking