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Role of Government in the Economy

Government is an institution which plays an important role in all types of economic

The role of government in all types of economic system is very essential in present
situation. By using its power, government can enact the law to regulate different
economic activities. The Government intervenes, the activities of private firm by
using various specific policies, such as industrial policy, commercial policy, labour
policy, environment policy etc.

In primitive societies, the government role was neglected. They believed that the
government is best which governed least. They preferred the minimum role of
government. Their economic ideas were based on laissez-fair doctrine, which
means the system of economic liberty. In nineteen century in England "that
government was considered the best which does the least". Due to this
government control and the role in the economy had declined.

In laissez-fair economy there was rapid economic growth and on the other the
evils, such as unequal distribution of income and wealth, monopolistic exploitation,
exploitation of unskilled labour. Consequently, the role of government again began
to increase all over the world. After World War I, Russian revolution which lead to
the abolition most private property and put state in control through central planning
of all economic activities. During the period of 1929 – 33, there occurred Great
Depression in the capitalist countries which caused huge unemployment of labour
and other resources in those countries and as a result level of national income fell
down. Due to depression many factories were closed and factories which were
working were also not being used to their full productive capacity. As a result,
unemployment, low income, low production was created. Since World War II most
of the economists had taken increasing public sector as the natural and essential
factor of development. The objectives like economic efficiency, growth,
macroeconomic stability, poverty alleviation, equal distribution of income, provision
of public of goods cannot be achieved only through private agencies. During the
period of 1967s there was re-emergence of private interest views in public sector.
In this way controversy about the role of government has not subsided. Many
research has been made regarding government involvement has hindered or
facilitate in economic sector.

The Government, Culture and Geography, Environment and Natural Resources are
taken as the basic pillars of economic growth. Economists point out the need for
government’s role mainly due to the market failure. It is therefore government’s role
is important in the economy mainly because of the following reasons:

a) Providing public goods such as rule of law, effective regulation and

development of physical infrastructure.
b) Managing positive externalities such as those emanating from the
investment in education, health, and research, and the negative ones such
as the effect of the pollution.
c) Controlling and monitoring monopoly, and
d) Managing the coordination failure occurring in the private sector
A number of world economies that were at the same level with their neighbouring
economies in terms of education, health, per capita income and natural resources
some five decades ago, have been successful in attaining significantly higher level
of economic development because of the government’s role. Countries like Sri
Lanka, Botswana, China, and South Africa have proved that significant progress
could be achieved even in a short period mainly due to the qualitative
improvements in and effectiveness of the government's role. The Human
Development Report 2003 highlights that Sri Lanka had increased life expectancy
of her people from 46 years to 58 years during 1946 to 1953. Botswana was able
to increase the primary school enrolment rate from 46 percent to 89 percent during
1970 through 1985. China successfully reduced the poverty rate from 33 percent to
18 percent in the decade of 1990s. And South Africa was able to reduce the
number of people lacking access to clean drinking water from 15 million to 7 million
only in a period of 4 years during 1997 through 2001. In the background of these
theories and instances, Nepal’s need of the hour is to develop a far-sighted vision
to ensure an effective state mechanism, even taking into account the experiences
of other economies, that facilitates in attaining higher level of economic growth.
Source: David N. Weil, Economic Growth (2005) and UNDP Human Development Report (2003)

According to World Bank Report, 1988, government was involvement mainly on

public goods, defence, diplomacy, macroeconomic management, justice, legal
matters and infrastructure like social, physical, education, health, transportation,
and environment protection.

Regulatory and Promotional Role of the Government

Any country's the prosperity and obstacles of economic growth results from
activities of government. That means, government plays important role in economic
activities. In free market economies government plays important activities. It has to
perform role to prevent market failure. As we know that market does not yield
economically efficient outcome every time as the result market fails to operate. In
free market economy government has designed activities to stimulate and assist
private enterprise and to regulate or control business practices so that their
operations are consistent with the public interest. There are various forms of
government regulation especially to regulate the activities of private firms.

a) Industrial products are subject to operating regulations, governing plant and

pollutant emission, product packaging and labelling, worker safety and health

b) Financial Regulations; Banks and Financial Institutions are subject to both the
government as well as the control made by the Central Bank for financial
A. Rational for Regulation

1) Economic Consideration; and

2) Political Consideration

1. Economic Consideration

Economic consideration is related to the cost and efficiency implications of various

regulatory methods. From economic view point a given mode of regulation or
change in regulatory policy is desirable to the extent that benefit exceeds the cost.
Political consideration relate to equity rather than efficiency.

Economic consideration has an important role in formulating regulatory policy. In

fact, it is due to market imperfection that need of regulation in production and
marketing activities was felt. If unregulated, the market activities itself creates
inefficiency or waste and market failure.

Market failure is mainly two types

a) Failure by market structure

In order to achieve the economically efficient outcome there must be many

producers and consumers within each market. This condition is unfulfilled in some
market such as water power, telecommunication etc. If these sectors are allowed
for private sectors natural monopoly situation come to exist. They may exploit the
consumers by charging higher prices and reduces the volume of output and earn
excessive profit. Under such situation market does not yield economically efficient
outcomes and creates the situation of market failure.

b) Failure by incentive

Second kind of market failure is due to lack of incentive. The market failure due to
presence of externalities is known as incentive failure. Production of the firms and
consumption of individuals are interdependent of each other. Differences between
social and private costs or benefit are called externality. Pollution caused in the
water supply in the lower part of the city by the carpet factory situated in the upper
part of the city and Plantation of trees in the certain part of the community benefits
the community as a whole are the examples of negative and positive externalities.

2. Political Consideration

In formulating regulatory policy, political manifesto of the ruling party and the
opposition parties needs to be taken into consideration for political consensus and
commitments. From political viewpoint there are two reasons for regulation:
a) Preservation of consumer sovereignty

The preservation of consumer's choice or consumer sovereignty is an inherent

aspect of democracy. Consumers have free to decision regarding to their
consumption. This is possible only in the competitive market. In competitive market
price is set at minimum point of LAC curve in the long run. Therefore monopoly
market regulatory policy can be valuable tool to restore control over the price and
quality decision making process to the public.

b) Limit concentration of economic and political power

In a democratic society it is not desirable to have economic and political power

concentrated in limited group. It is regarded that the economic and political power
remains linked with one another. Economically active power oriented persons
usually are seen interfering in political activities as well. Therefore, the
development of large structures is prevented through regulatory policy. The aim of
the government is equitable distribution of wealth and income. For the purpose
government should interfere in the market.

B. Promotional Role

In the free enterprises economy, the major role of government is to promote private
sector participation. To promote private sector, government has to develop physical
infrastructure such as transport, energy, development of irrigation, telecom
networking. The social and economic overheads created by the government help
private business at least in two ways:

a) Economic growth

The building of economic and social overhead accelerates the pace of economic
growth. Economic growth enlarges the size of market to the advantage of private
business through a sustained increase aggregate demand.

b) External economies

The adequate supply of economic and social overhead creates external economies
which reduces the private cost of production. The social, economic overhead
created by the government helps the growth of private business, facilitating
acquisition of inputs such as labour, raw material, skilled labour.


Market failure refers to a market that fails to provide efficient outcomes for the
society. In other words, market works efficiently only when there exist perfect
competition or when exclusion principle could be applied in the free market.

Exclusion principle requires that, those who do not pay for as goods should be
excluded from its consumption and those who derive any benefit from goods
should bear its cost. According to Pappas and Herschey "market failure can be
described as the failure of a system of market institutions to sustain socially
desirable activities or to eliminate undesirable ones."

In free market economy the main responsibility of the government is to prevent the
market from failure. Market failure can be summarized in two ways:

1) Market failures due to incentive or incentive failure

2) Market failures due to structure or structure failure

1) Market failure due to incentive or incentive failure

The market failure due to the presence of externalities is known as incentive

failure. The free market mechanism does not function effectively when exclusion
principle is not applicable. Exclusion principle requires that, those who do not pay
for as goods should be excluded from its consumption and those who derive any
benefit from goods should bear its cost.

But in the complex world there are many such goods and services where even
people do not use goods and services are bearing cost in terms of loss of welfare,
and even though people do not pay for the goods they are benefited by the goods
and services. Such situations are called externalities.

The market mechanism does not compensate or charge those who are affected by
externalities. Thus, collective action is needed by the government to charge those
benefit from and compensate those who suffer from externalities. In order to
prevent the market from failure, government response to incentive failure in two

A) Consumption externality; and

B) Production externality

A) Consumption externality
In traditional economics, consumption is supposed to be independent, but in reality,
consumption of an individual is not independent. It is affected by external
environment. For Example: those who smoke in a bus reduce the utility of those
who do not smoke. Externalities may arise from either consumption or production

Consumption externalities are of two kinds:

a) Positive externality in consumption; and
b) Negative externality in consumption.

a) Positive externality in Consumption

The consumption externality occurs if the welfare of the person is affected by the
consumption pattern of other person. In other words, if an individual gets
satisfaction with out incurring any cost. It is the case of positive externality. For
example when individual paint his house, it increases the beauty of the whole
society. Consumption decision of one, others receive value without paying

b) Negative externality in consumption

An external diseconomy of consumption arises when the purchase and

consumption of goods or services results in disutility for people not involved in the
transaction. For example, when an individual use loud speaker to listen the radio, it
adversely affects the students who is planned to appear an examination.

In both cases, there is difference between social cost and private cost. In case of
positive externality in consumption social value is grater than private values. In
case of negative externality in consumption social cost is greater than private cost.
The environment pollution is the glaring example of negative externality. If firm
discharge polluted water in the river, swimming fishing comes to a halt. If the firm
pulls water from the river is not available to others. People bear the cost in terms of
social welfare without using the product or service. In this sense, government
charges compensate made to firm.

B) Production externalities
Production externality is also divided in the following two parts.

a) Positive externality in production; and

b) Negative externality in production.

a) Positive externality in production

Fig: This Resort is a positive externality

An external economy of production arises when an increase in the firm's production

results in some benefit to society or another firm. As for example construction of
high way reduces the transportation cost of the firm, the research conducted by
government benefit all the firms etc, are the positive externality in production. Other
examples of positive externalities in production are:
i) Training program of on firm increases the supply of skilled labour for all the
ii) If a person increases the apple trees the output of honey producers
automatically increases.

Fig: This Park is a positive externality which provides people with a place to relax without paying the construction cost for it.

If we introduce the external economy, it reduces the cost of production, In this time,
quality production id OQ1 is greater than OQ, the output without external economy.
b) Negative externality in production

Negative externality in production arises when expansion of the firm's production

results in adverse effects (social cost) that are not paid for by the firm and are
therefore not reflected in the prices of its production. For example:

Fig: Effects of Negative Externalities

i) The water pollution created by carpet industry cost on society

ii) Factory vehicles produces air pollution and imposes cost in the society
iii) The factory car, plane, pollutes air by discharging smoke and create noise
pollution by creating loud noise

When there are negative externalities PMC curve lies below SMC curve. i.e. social
cost is greater than private cost.
Government Responses in incentive failure

In order to prevent the market form failure, positive externalities should be

increased. Market does not have any mechanism to encourage such activities.
Government should take the following steps to prevent market failure:
• Grant patents; and
• Provide operating subsidies

• Patent

Patents are a government grant of exclusive right to produce, use or sell and
inventions or ideas for a specified period of time. They are essentially a limited
grant of legal monopoly power designed to encourage inventions and innovation.
Patents arose response to the fact that a firm which develops an important
technological breakthrough cannot begin to reap the full benefits of its efforts if
other firms can freely begin making the new product or using the new production
process without having to compensate the originator. Without patent rights and
protection, few firms would devote resources to research, and the economy would
obtain few of the benefits which flow from such research efforts.

i) Patent is necessary incentive to induce the business firms to work more and
invest in new and creative projects.
ii) The inventions are disclosed soon due to the patent act. Consequently, since
there is sooner dissemination of information, it facilitates other inventions.

i) There are some perversions of the patent law that directly effects competition.
Controlling output, dividing markets, fixing prices are some perversions due to
patent right.
ii) Since patent system enables the inventors to get a great part of the social
benefit from their innovation although patent system is ineffective. Thus it
encourages imitations.

Government apathy leads to flower patent theft

More than 342 species of indigenous flowering plants grow in Nepal, according to a
survey made by Ministry of Forest and Land Conservation but the government has
not taken any initiative to register the patents of these plants. The result is people
from other countries come here and take away Nepal’s plants and register those
under their own countries’ patents.

Floriculture Association of Nepal (FAN) president Ghacchadar Karki said there are
more than 342 species identified but as they are yet to be registered at the
international level it is boosting patent theft.

“We recently heard one of our local plants known as Jamuney Mandro has got its
patent registered by Japan. Actually, it is a rare plant grown in Kathmandu Valley,”
said Karki.
“It is useless to identify our local species if we fail to protect their identity in our

He added that if the authorised bodies were active for patent registration of plants
available in our country, the floriculture business would have bloomed to
phenomenal proportions. “The plants available in our forests can be used through
tissue culture for higher production. This can increase the export of Nepal’s
flowers,” said Karki.

Though the country is rich in bio-diversity, the lack of government initiative force
FAN to import flowering and non-flowering plants from other countries.

“Huge quantities of flowering and non-flowering plants are imported from

Kalimpong and Kolkata while more than Rs. 1 million is spent on buying mother-
plants of certain flowers from abroad,” Karki said.

According to him, for festivals huge quantities of cut flowers are imported from
India during winter seasons while mother-plants are imported mainly from

Investigations are still on about the number of species of flowering plants and non-
flowering plants available at high altitudes, according to the Ministry of Forest and
Land Conservation.

“We need special package programmes such as priority for investments to

encourage the floriculture business in Nepal,” and Karki.

Currently, there a number of nurseries involved in selling flowers that are imported
from other countries but not those which are available in the country’s forests.

“Exports of foreign plants cannot make us feel proud, at least not until we are able
to sell our own floral products in the international market,” said Karki.

There is also a number of non-flowering plants which if recognized can be brought

for business in the local market. According to Karki, about 75 percent of plants both
flowering and non-flowering plants are imported from foreign countries.

There are around 500 registered floriculturists under FAN but only 350 are
participating actively. There are around 600 flower farms and nurseries in 35

Around 4000 people are directly involved in floriculture while the number of
temporary workers getting employed during peak seasons is double that.
• Subsidies

Government also responds to external economies of production by providing

subsidies to private business firms. These subsides can be indirect, as in the case
of government construction and maintenance of highways used by the trucking
industry. They can also take the form of such direct payments as special tax
treatments and government–provided low-cost financing.

Investments tax credits allowed for certain types of business investments and the
depletion allowances provided to promote resources extraction industries are
examples of tax subsides given in recognition of production externalities which
provide benefits to society. The external economies associated with locating a
major manufacturing facility in an industrial park have given rise to local
government financing of such facilities. The low-cost financing is thought to provide
compensation for the external benefits provided.

Often market creates negative externalities. Government use taxes along with
direct operating requirement and controls to correct for the external diseconomies
in the market place.

• Operating control

Just as government attempts to correct for the market failures associated with
external economies, it also works to remedy problems associated with external dis-
economies. One of the primary tools of government policy in this area is the
imposition of operating controls that limit the activities of firms.

What kind of operating controls are imposed on business firms? Controls over
environmental pollution immediately come to mind, but businesses are also subject
to many other kinds of constraints. For example:

Federal legislation sets limits for automobiles safety standards; and firms handling
food products, drugs and other substances that could harm consumers are
constrained under various labour laws and health regulations: Included are
provisions related to noise levels, noxious gases and chemicals, and safety

Anti-discrimination laws designed to protect minority groups and women also cause
some firms to modify their hiring and promotional policies.

Wage and price controls, imposed at various times in the past in attempts to
reduce high rates of inflation, restrict the freedom of firms in setting prices and
affect the usage of resources throughout the economic system.
Numerous other constraints have been imposed on firms. Rather than attempt to
enumerate all of them, it will prove more useful to specify the value of economic
analysis in determining the impact of direct controls over the activities of firms.

• Operating right grant

Government exercises the following measures as operating right grant:

a) Government controls media such as radio, television broadcasting right to

provide quality services to the public.
b) Government through central bank control banking and financial institutions.
c) In order to get the operating right for higher secondary school and college, firm
must fulfil certain conditions such as minimum amount of deposits, qualified
faculty number physical facilities etc.

• Tax policies

Taxes are used to control the negative externalities created by market. Tax policies
are designed to limit the undesirable activities of private firm. Pollution taxes,
effluent charges, fines etc are common examples of tax policies. For example
government fines to those who do not fallow the traffic rules such as wearing of
helmet wearing of safety belt etc.


Competitive market benefits society by reducing the price and improving the
efficiency of resource allocation, thus, government's priority action should be to
enhance competition. There should be enough sellers and buyers in the market to
get the beneficial effect of competition or there should be at least the possibility of
the easy entry of new firms. If such condition is not fulfilled, it is considered as the
market failure due the market structure. Depending on the nature of a particular
industry, for example: market of water, electricity, telephone, a monopoly or
oligopoly may develop, possibly resulting in too little production and excess profits.
Such condition is considered natural monopoly.

Natural Monopoly

In some industries, economies of scale operate (i.e. the long run average cost
curve may fall) continuously as output expands, so that a single firm could supply
the entire market more efficiently than any number of smaller firms. Such large firm
supplying the entire market is called natural monopoly. Examples of natural
monopolies are public utilities like electricity, gas, water, local transportation
companies etc. The characteristic of natural monopoly is:
― that the firms' long-run average cost curve is still declining even the firm
supplies the entire market.

The monopoly is that, the natural result of such firm will have lower cost per unit
than other smaller firms. This will give the firm, market power to drive the smaller
firms out of the business.

To avoid this, governments usually exercises two methods for controlling

monopolistic situation:
a) Control over market structure
b) Direct control

a) Control over market structure

Anti-trust laws are design to decrease industrial concentration and to prevent

collusion among oligopolistic firms.

Antitrust Law

In the late nineteenth century a movement toward industrial consolidation

developed in the United States. Industrial growth was rapid, and because of
economies of scale, an oligopolistic structure emerged in certain industries. Pricing
reactions became apparent to industry leaders, who concluded that higher profits
could be attained through cooperation rather than through competition. As a result,
voting trusts were formed, whereby the voting rights to the stocks of the various
firms in an industry were turned over to a trust, which then managed the firm and
sought to reach a monopoly price/output solution. The oil and the tobacco trusts of
the 1880s are well-known examples.
Although profitable to the firms, the trusts were socially undesirable, and public
indignation resulted in the passage of the first significant antitrust measure in 1890,
the Sherman Act. Other important legislation subsequently passed includes the
Clayton Act (1914) and the Federal Trade Commission Act (1914), the Robinson-
Patman Act (1936), and the Celler Anti-Merger Act (1950). Each of these acts was
designed to prevent anticompetitive actions, actions whose impact is more likely to
reduce competition than it is to lower costs by increasing operating efficiency. IN
this section we present a brief chronology of major antitrust legislation.

Sherman Act

The Sherman Act of 1890 was the first federal antitrust legislation. In substance, it
was brief and to the point. Section 1 forbade contracts, combinations, or
conspiracies in restraint of trade (then an offence at common law), and Section 2
forbids monopolization. Both sections could be enforced by civil courts decrees or
by criminal proceedings, with the guilty liable to fines or jail sentences.

Despite some landmark decisions against the tobacco, powder, and Standard Oil
trusts, enforcement proved to be sporadic. Moreover, the Sherman Act was alleged
to be too vague. On the one hand, business people claimed not to know what was
illegal; on the other, it was widely felt that the Justice Department was ignorant of
monopoly-creating practices and did not bring suit against them until it was too late
and monopoly was a fait accompli.

In 1974 the Sherman Act was amended to make violations felonies rather than
misdemeanours. That statue also increased the maximum penalties that could be
levied. Instead of $50,000 against a corporation and $50,000 and one year in
prison against an individual, the act now provides for $1,000,000 maximum fines
against corporations and up to $1,000,000 fines and three years imprisonment for
individuals. In addition to the criminal fines and prison sentences, firms and
individuals violating the Sherman Act face the possibility of triple-damage civil suits
from those injured by the antitrust violation.

Despite its shortcomings, the Sherman Act remains one of the government's main
weapons against anticompetitive behaviour. IN February of 1978 a federal judge
imposed some of the stiffest penalties in the history of U.S. anti trust actions o eight
firms and eleven of their officers who were convicted of violating the Sherman Act.
These convictions for price fixing in the electrical wiring devices industries resulted
in fines totalling nearly $900,000 and jail terms for nine of the eleven officers

Clayton Act and Federal Trade Commission Act

Congress passed two measures in 1974 that were designed to further overcome
weakness in the Sherman Act – the Clayton Act and the Federal Trade
Commission (FTC) Act. The principal features of these are summarized below.

Enforcement The Federal Trade Commission Act established and funded the
FTC for the expressed purpose of initiating actions to prevent and punish antitrust

Mergers Voting trusts that lessened competition were prohibited by the

Sherman Act, but interpretation of the act did not always prevent on corporation
form acquiring the stock of other, competing firms and then merging them into
itself. Section 7 of the Clayton Act prohibited such mergers if they were found to
reduce competition. Either the Anti-trust Division of the Justice Department or the
FTC can bring suit under Section 7, or mergers can be prevented. IF they have
been consummated prior to the suit, divestment can be ordered.

Interlocking Directorates The Clayton Act also prevented individuals form

serving on the boards of directors of two competing companies. Two so-called
competitors having common directors would obviously not compete very hard.

Price Discrimination The Clayton Act made it illegal for a seller to

discriminate prices between its customers (1) unless cost differentials in serving
the various customers justified the price differentials or (2) unless the lower prices
charged in certain markets were offered to meet competition in the area. The
primary concern was that a strong regional or nation firm might employ selective
price cuts in local markets to eliminate weak firms. Once the competitors in one
market were eliminated, monopoly prices would be charged in the area and the
excessive profits could be used to subsidize cut throat competition in other areas.

Typing Contracts and Related Arrangements A firm, particularly one with

the patent on a vital process or a monopoly on a natural resource, con use
licensing or other arrangements to restrict competition. One such procedure is the
typing contract, through which a firm ties the acquisition of one item to an
agreement to purchase other items. For example, the International Business
Machines Corporation for many years refused to sell its business machines. If
rented these machines to customers who were required to buy IBM punch cards
and related materials as well as machines maintenance from the company. This
clearly had the effect of reducing competition in the maintenance and service
industry, as well as in the punch card and related products industry. After the IBM
lease agreement was declared illegal under the Clayton Act, the company was
forced to offer its machines for sale and to cease leasing arrangements that tied
firms to agreements to purchase other IBM materials and services.

IBM Case Study

In 1969, the Justice Department filed suit against IMB under section 2 of the
Sherman Act for monopolizing the computer market, for using exclusive and trying
contracts, and for selling new equipments at below costs. The government sought
the dissolution of IBM. After 13 years of litigation, more than 104,000 trials
transcript pages, $26 million cost to the government cost to the government (and
$300 million incurred by IBM to defend itself), however, the Justice Department
dropped its suit against IBM in 1982. The reason that the government decided to
drop its case against IBM was that rapid technological change, increased
competition in the field of computers, and changed marketing methods since the
filing of the suit had so weakened the government's case that the Justice
Department felt it could not win. IN 1995, IBM was a struggling giant in a highly
competitive market rather than the near monopolist it had been accused of being in
1969. It was only in the second half of the 1990s that IBM seemed to find its way

The Microsoft Antitrust Case

In fall 1998, the U.S. Justice Department sued Microsoft, the world's largest
software company, accusing it of illegally using its Window operating system near
monopoly to overwhelm rivals and hurt consumers. Specifically, the government
accused Microsoft of merging its Web browser into its Windows operating system
in order to crush Netscape Communication Corporation, its chief competitor in the
browser business. By bundling the browser with Windows and using exclusionary
contracts to prevent personal computer makers form hiding or removing the
Microsoft browser, Microsoft prevented consumers from using rival browsers
(particularly Netscape's) and also discouraged systems other than Windows.
Furthermore, the government accused Microsoft of conducting a campaign to
curtail other potential threats form Intel, Sun Micro system, Apple Computer, and
IBM that enabled Microsoft to extend its power to other areas, such as computer
servers and Internet protocols, thus causing substantial and far-reaching harm to
consumers by stifling competition and innovation in the software industry. The
accusation were backed in court by oral testimonies of 26 witnesses, as well as
thousands of exhibits, including numerous e-mail messages and other internal
corporate records form the previous five years.

Microsoft's response was that the government's case was based on fiction and
fantasy. Microsoft said that no company could have a monopoly in the fast –
moving, intensely competitive PC and Internet business and that it faces many
competitive threats from the market place. According to Microsoft, bundling its Web
browser in Windows improved the operating system and lowered prices to
consumers and, in any event, consumers had ample choices, not least of all from
Netscape, which distributed millions of copies of its browser Navigator during 1998.
According to Microsoft, America Online's purchase of Netscape in early 1999 could
restore Netscape to a leading position in the browser business. The government
responds that Microsoft's illegal actions shattered Netscape's browser business
and that AOL had acquired Netscape mostly for its Internet "portal" site and its
server and e-business products.

On April 4, 2000, the federal district judge trying the case ruled that Microsoft had
violated antitrust laws with predatory behaviour and would impose penalties and
remedial action. There are three possible courses of remedial action if the judges
find Microsoft guilty. The weakest punishment would be simply to forbid Microsoft
from engaging in the future in exclusive dealings with providers of services on the
Internet, and nothing more. This is possible in view of the fact that Professor
Stanley Fisher, the government's leading economic expert form MIT, stated in court
that consumers "had not suffered any harm form Microsoft's actions to date." The
second option would be to force Microsoft to license Windows to other companies,
which could develop it and sell it in competition with Microsoft. The most drastic
remedy would be to break up Microsoft into two companies (along the lines of the
AT&T decision of 1982), with a company controlling Windows and another selling
its applications products, including the popular Microsoft Office suite of business
software. The Windows Company could develop its own applications business, and
the applications company could join a rival operating software company and pose a
much stronger challenge to Windows than existing competitors can

b) Direct control

Public utility regulation, which fixes prices at levels designed to prevent firms from
earning monopolistic profit.

Public Utility regulation

According to Lewis and Peterson public utility seems to have two general features:

i) The industry provides a product or service of particular importance either the

day to day livelihood or the future growth.

ii) The nature of the production process is such that competition is seem as
yielding undesirable result such as duplication of facilities.
The most common method of monopoly regulation is through price
control/regulation. The regulated price is such that monopoly recovers its fixed and
variable cost plus an allowed return on investment. The government exercises
price control mechanism for the following results:

― Sales volume of the product would increase compare to unrestricted

monopoly condition.
― Reduction of the profit of the firm
― Level of rate of return on owner's investment will reduce.

The actual output, however, will be determined by the actual demand at the price
set by the regulatory commission.

In order to restrict the firm to operate in an unconstrained monopolist condition,

government/policy maker can exercise several alternatives. Some alternatives are
discussed below:

a) Price at marginal cost;

b) Compromise solution; and
c) Undue price discrimination

Price at marginal cost

One of the measures to control monopoly price is by fixing the price of the product.
In this method, policy makers’ lets the firms maintain the existing monopoly position
and make them fix price equal to marginal cost. But, for retaining price level at
marginal cost for long time government should either compensate for loss or
provide subsidy to the firm. This situation can be explained with the help of figure

The existence of natural monopoly poses something of a dilemma fro public policy.
One alternative is to let the firm operate as a monopoly. If the firm faced the
demand curve DD, as shown in the Figure, the monopoly price would be PM and
the quantity, QM. The firm would then earn economic profit, as indicated by the
area of the rectangle PMABC. Compared to marginal cost pricing (i.e., setting the
price equal to marginal cost), the monopoly-pricing scheme would result in a
deadweight loss and also transfer of consumer surplus form consumers to

If the firm is allow maintaining its monopoly position but regulated to set the price at
marginal cost, it would result in a price of PC and a quantity of QC. At this level of
production there is no deadweight loss because production is increased until the
cost of producing the last unit is equal to the value of that unit. There is also no
transfer of surplus form consumers to producers. In fact, the problem is quite the
reverse. Because the monopolist is producing in a region of decreasing cost, its
marginal cost is less than its average cost. Being required at marginal cost, the
monopolist is unable to earn a normal return on capital. This is easily seen by
observing that at the output rate QC, the average revenue as shown by the demand
curve is less than the average cost.

Compromise Solution

The most common method for pricing the products of a natural monopoly is the
compromise solution. The nature of the compromise is depicted by the above
figure. A simple description of public utility price regulation is that price is set equal
to average cost. That is, the firm is allowed to charge a price that allows it to earn
no more than a normal return on its capital. This is shown in the figure by the price,
PR, and the quantity, QR. The regulatory approach is compromise because the
price is less than if the firm were allowed to act as a monopolist. Because the firm
earns a normal profit, there is no need for the subsidy that would be required with
marginal cost pricing. Thus, this mechanism achieves some of the gains form
marginal cost pricing without requiring a subsidy.

Undue Price discrimination

Price discrimination occurs when consumers are charged different prices for a
product and the differences in price cannot be accounted for by cost differentials.
The three requirements for successful price discrimination are:
― that consumers have different demand elasticity,
― that markets be separable, and
― that the firm has some power over price.

The telephone industry provides an example of successful price discrimination

policies by a public utility. Rates for basic telephone services are higher for
business users than they are for residential users. There is no particular reason to
assume that the cost of installing and maintaining a phone in an office is different
form putting one in a kitchen. There are, however, possible differences in demand
elasticity for business versus home phone customers. Consider the case of a
stockbroker. The vast majority of orders for the purchase or sale of stock come to
the broker by phone. There is no way the business could be conducted without a
phone. In contrast, if there is a neighbour's phone that can be used in an
emergency, it is quite possible to get along without a telephone in one's home. In
economic terms, the stockbroker is said to have more inelastic demand for
telephone service than does the residential customer.

The other conditions for price discrimination are also met in the telephone industry.
Because there is a physical connection between the customer and the phone
company, there is no way low-cost home telephone service can be resold to a
business customer. Also, is the stockbroker does not interconnect with the local
phone company; there is no practical way to have access to customers calling in

The consequence of price discrimination provides an argument for regulation.

Perhaps government should intervene to protect the commercial user from an
unfair situation. The issue is not one of efficiency, but of fairness. The presumption
is that the monopolist should not be allowed to use its power to unduly discriminate
against some consumers. Although some discrimination may be acceptable,
government intervention may be necessary when that discrimination becomes
excessive. There is no clear definition of the distinction between due and undue
discrimination. In the end, undue price discrimination is whatever the regulatory
commissions or the courts determine it to be.

Problems of Direct Regulation

a) Uncertainty
Although the concept of price regulation is simple, serious problem exist in its
application to actual regulation of public utilities. First, it is impossible to determine
exactly the cost and the demand scheduled, as well as the asset base necessary
to support a specified level of output. Utilities also serve several classes of
customers, which means that a number of different demand scheduled with varying
price elasticity are involved; therefore, any number of different rate schedules can
be used to produce the desired profit level. If telephone company profits are too
low, should rates be raised on local calls or on long distance calls? If electric
utilities need more profits, should industrial, commercial, or residential users bear
the burden? An appeal to cost considerations for a solution to this problem of no
avail, because all the services mentioned are joined products, a factor that makes it
extremely difficult, if not impossible, to separate costs and allocate them to specific
classes of customers.

b) Optimal Output
A second problem with price regulation is that regulators can make mistakes with
regards to the optimal output, growth, and service levels. For example, a telephone
utility is permitted to charge excessively high rates, more funds will be allocated to
system expansion, and communication services will grow at a faster than optimal
rate. Similarly, if prices allowed to natural gas producers are too low, consumers
will be encouraged to use gas at a high rate, producers will not seek new gas
supplies, and a shortage of gas will occur. Too low price structure for electricity will
likewise encourage the use of power but discourage the additional of new
generating equipment.
c) Inefficiency
Price regulation can also lead to inefficiency. If the regulated companies are
guaranteed a minimum return on their invested capital, then, provided demand
conditions permit, operating inefficiencies can be offset by higher prices. This is
illustrated in the figure below:

A regulated utility faces the demand curve AR and the marginal revenue curve MR.
If the utility operates at peak efficiency, the average cost curves AC1 will apply. At a
regulated price P1, Q1 units will be demanded; cost per unit will be C1; and profits
equal to the rectangle P1P1'C1'C1 will be earned. These profits are, lets us assume,
just sufficient to provide a reasonable return on invested capital.

Now assume that another company, one with less capable managers, is operating
under similar conditions. Because this management is less efficient than that of the
first company, its cost curve is represented by AC2. If its price is set at P1, it too will
sell Q1 units, but its average cost will be C2; its profits will be only P1P1'C2'C2; and
the company will be earning less than a reasonable rate of return. In the absence
of regulation, inefficiency and low profits go together, but under regulation the
inefficient company can request - and probably be granted - a rate increase to P2.
Here it can sell Q2 units of output, incur an average cost of C3 per unit, and earn
profits of P2P2'C3'C3, resulting in a rate of return on investment approximately equal
to that of the efficient company. We see, then, that regulation can reduce if not
eliminate the profit incentive for efficiency.

Investment Levels

A fourth problem with regulation is that it can lead to over investment or under
investment in fixed assets. The allowed profits are calculated as a percentage of
the rate base, which is approximately equal to fixed assets. If the allowed rate of
return exceeds the cost of capital, it will benefit the firm to expand fixed assets and
to shift to capital – intensive methods of production. Conversely, if the allowed rate
of return is less than the cost of capital; the firm will not expand capacity rapidly
enough and will produce by methods that require relatively little capital. This is
related to the issue of determining the optimal output, growth, and service levels
discussed above.

Regulatory Lag and Political Problems

A related problem is that of regulatory lag, which is defined as the period between
the times it is recognized that a price increases (or decrease) is appropriate and
the effective date of the price change. Because of the often lengthy legal
proceedings involved in these price change decisions, long periods can pass
between the times when they are implemented.

The problem of regulatory lag is particularly acute during periods of rapidly rising
prices. During the late 1960s and the 1970s, for example, inflationary pressures
exerted a constant upward thrust on coasts. If normal profits and a fair rate of
return on capital are to be maintained in such a time, expeditious price increases
have to be implemented.

However, public utility commissioners are either political appointees or elected

officials, and either those who appoint them or the commissioners themselves must
periodically stand for election. Further, most voters are consumers of utility
services and naturally dislike price increases, whether these increases are justified
or not. Unlike consumers of unregulated goods and services, however, utility
customers can do exert great pressure on public utility commissioners to deny or at
least delay rate increases.

Cost of Regulation

By this time the sixth problem with price regulation should be obvious. A great deal
of careful and costly analysis must be conducted before regulatory decisions can
be made. Maintaining public utility commission staffs is expensive, but an even
more important cost element – maintaining required records and processing rate
cases – is borne directly by the company. Ultimately activities are borne by

It should be pointed out that we emphatically favour utility regulation. Indeed, we

can see no other reasonable alternative to such regulation for electric, gas
telephone, and private water companies. If is clear, however, that serious problems
arise form efforts to regulate industry through price determination. The market
system, if competition is present, is a much more efficient allocator of goods and
services, and it is for this reason that efforts are made to maintain a workable level
of competition in the economy.
Regulation of Environmental Pollution

Having argued in general that there is a role for government when externalities
distort the workings of competitive markets, we now turn to the most persuasive
example-the problem of what to do in the face of environment pollution.

Many of our streams and lakes

have historically served as
depositories of chemical waste
generated by industrial plants and
mines. Some are cleaner now, but
many still suffer damage form
earlier discharges of chemicals,
like PCBs whose "half-lives" are
measured in hundreds of years.
Many pesticides, fertilizers, and
detergents used by farms and
homes find their way into our
lakes and waterways, where they
have damaged commercial and
recreational fishing. Automobiles
are primary source of many air
pollutants. The residue of their
emission can foul both the air that
we breathe and the land located
close to the road that we drive on.
Factories generate particles of
various kinds, often through the
combustion of fossil fuels; these
pollute the air and fall onto the
ground-both near and far. Some
of our pollution has even been
Fig: Waste dumped into water source shown to cause damage on a global scale. The
production and emission of chlorofluorocarbons
has damaged the ozone layer and exposed much of the planet to increased
ultraviolet (UV-B) radiation from the sun; the emission of carbon dioxide and other
greenhouse gases has begun to warm the planet at rates that many find alarming.

Why does our economy tolerate any pollution of the environment? We now know
that an externality occurs when one person (or firm's) use or abuse of a resource
damages other people who cannot obtain proper compensation. When this occurs,
a competitive economy is unlikely to function properly. For market prices to
produce an efficient allocation of resources, it is necessary that the full cost of
using each resource be borne by the person or a firm that uses it. If this is not the
case, so that the user bears only part of the full costs, then the resource is not
likely to be directed by the price system into the socially optimal use. And why do
people use resources like the environment? This is because; pollution is a by-
product of activities that add to their welfare. These activities bring economic gain
to producers and utility gain to consumers. We do not pollute the planet just for fun;
we do it as part of activities that improve our welfare. The economist's view of this
is that pollution creates another trade-off of cost and benefit that must be weighed
on a case by case basis.

Resources are used most efficiently in a perfectly competitive economy because

they are allocated to the people and firms that find it worthwhile to bid the most for
them. Underlying this scheme is the notion that the resulting prices of all resources
would reflect their true social costs. Suppose, however, that the presence of
external diseconomies made it possible that people and firms did not pay the true
social cost for certain resources. Suppose that some firms or people were using
water or air for free even though other firms or people were incurring some cost
from this use. Suppose, to be quite specific, that some firms were polluting the air
or water and those others were suffering economic losses as a result. In this case,
the private costs of using air and water would vary form the social costs. The prices
paid by the user of water and air would be guided in their decisions by the private
costs of water and air-costs that would be reflected by the prices that they had to
pay. Faced with this difference between private and social cost, these firms would
"use" too much air and water form society point of view, because the prices that
they would pay for air and water would be too low.

Note that the divergence between private and social costs occurs if and only if the
use of water or air by one firm or person imposes costs on other firms or other
people. A paper mill that uses water and then restores it to its original quality would
not be responsible for creating a divergence between private and social costs; it
would be paying the full social cost of using the water in the (presumably minimum)
cost of running the restoration process. But if the same mill dumped untreated
wastes into a stream so that firms and towns downstream had to pay to restore the
quality of the water, then it would be responsible for creating a divergence between
private and social costs. The same is true of air pollution. If an electric power plant
used the atmosphere as a cheap and convenient place to dispose of waste but
people living and working nearby incurred some cost (including poorer health and
the more frequent need to paint their houses) as a result, then there would be a
divergence between private and social costs.

Fig: Smoke coming out from a factory

Efficient Pollution Control

Any industry should, in general, be able to vary the amount of pollution that it
generates at each level of output, especially in the long run. A representative firm
may, for example, install pollution control devices like scrubbers or electrostatic
precipitators to reduce the amount of pollution that it generates at each level of

The figure below shows why, untreated waste of the industry dumps into the
environment increase the level of total social costs. The figure also shows the costs
of pollution control at each level of discharge of the industry's wastes. Just as
clearly, the more the industry cuts down on the amount of wastes it discharges, the
higher are its costs of pollution control. In addition, the figure shows the sum of
these two costs-the cost of pollution and the cost of pollution control-at each level
of discharge of the industry's wastes.

Figure A

Form the point of view of society as a whole, the industry should reduce its
discharge of pollution to the point where the sum of these costs is minimized.
Specifically, the efficient level of pollution in the industry is R in the Figure A Why?
Because increasing pollution from a level lower than R would improve social
welfare. Discharging one more unit of pollution would increase the cost of pollution,
but it would reduce the cost of pollution control by more. Reducing pollution from a
level higher than R would also improve welfare. In this case, discharge one fewer
unit of pollution would increase the cost of pollution control, but it would reduce the
cost of pollution by more.
To make this more evident, curve AA' in Figure B shows the marginal cost of an
extra unit of discharge of waste at each level. Curve BB' in Figure B also shows the
marginal cost of reducing the industry's discharge of waste by 1 unit. The
economically efficient level of pollution for the industry occurs at the point where
the two curves intersect. At this point, the cost of an extra unit of pollution would
just equal the extra cost of reducing pollution by an extra unit. Regardless of
whether we look at Figure A or Figure B, the answer is the same: R is the
economically efficient level of pollution.

Figure B

Earlier we observed that the efficient level of pollution is generally not zero. It
should now be clear why this is true. The costs of reducing pollution can exceed
the associated benefits if control is pushed beyond a certain point. In Figures A and
B, this point is reached when pollution is limited to R. But, could the efficient level
of pollution be zero? Sure. Zero would be the right answer if the pollutant were so
damaging that the marginal cost of even the first unit released into the environment
exceeded the marginal cost of not allowing its release. Graphically, zero could be
efficient in Figure B if marginal-cost curve AA' started form a point on the vertical
axis that was higher than S (indicating that the cost of pollution would increase
faster form zero that the cost of pollution control would fall).
Direct Regulation, Effluent Fees, and Transferable Emission

Left to its own devices, the industry in Figure B would not necessarily reduce its
pollution level to R. Why? This is because; it would not necessarily pay all of the
social costs of its pollution. Indeed, if the industry paid no private cost for its
pollution, then it would emit T units-the quantity for which the marginal cost of
control would equal zero. This, of course, is the heart of the problem. How can the
government establish incentives that would lead industries to choose the efficient
amount of pollution control in their own best interest, even if they do not face all the
social costs of residual emissions?

Direct regulation of polluting activity (i.e., setting a legal limit for pollution)
frequently comes to mind. The government could, for example, simply limit the
industry's pollution to R units by decree. Direct regulation of this sort was popular in
the United States shortly after the passage of the first Clean Air Act in the 1970s.
The decree were generally associated with definitions of the "best available
technologies" for pollution control, but they were criticized frequently for being too
rigid to accommodate efficiently the changing landscape of modern industry and
the diversity of the suppliers of modern markets.

Effluent fees offer governments a second approach to pollution control. An effluent

fee is a unit price that a polluter must pay to the government for discharging waste.
The idea behind the imposition is that they can bring the marginal private cost of
polluting faced by firms closer to the true marginal social cost of their emissions. In
Figure B, for example, an effluent fee of E per unit of pollution discharge might be
charged. If it were, then the (private) marginal cost of an additional unit of pollution
discharge to the industry would be E, and so the industry would cut back its
pollution so long as the marginal cost of reducing pollution by a unit were less than
E. As you can see form Figure B, marginal cost falls short of E as long as the
pollution discharge exceeds R. To maximize their profits, therefore, the firms in the
industry would reduce pollution to R units.

Effluent fees often have one major advantage over direct regulation. It is, of course,
socially desirable to use the cheapest way to achieve any given reduction in
pollution, and a system of effluent fees is more likely to accomplish this result than
direct regulation. To see why, first consider a particular polluter facing an effluent
charge. It would find it profitable to reduce its discharge of waste to the point where
the (marginal) cost of reducing its emissions by 1 unit equalled the fee. The effluent
fee would be the same for all polluters. And it is a simple matter to show that the
total cost of achieving the corresponding reduction in total emissions across all of
the polluters would thereby be minimized. To that end, suppose that the cost of
reduction waste discharges by an additional unit were not the same for all polluters
(as might be the case if they were given individual quantity limits). The cost of
achieving the same amount of total pollution control could then be reduced by
allowing polluters whose marginal control costs were high to increase their
emissions (and lower their marginal control costs) while encouraging polluters
whose marginal control costs were low to reduce theirs (by and equal amount).
Effluent fees do not however, guarantee the same constant level of total emissions
that could be expected if a set of individual quantity limits were issued. Why not?
Because firms will pay for the right to more or less pollution as they increase or
decrease their outputs. So, although direct regulation would restrict total emissions
regardless of business conditions, and equivalent effluent fee could, at best,
guarantee that the expected value of equivalent effluent fee could, at best,
guarantee that the expected value of total emission s over along period of time
would correspond to the same total. Variation in the level of total pollution can be
harmful in some cases, and not in others. The point here is that preference for
effluent fees is not quite so clear-cut when the reality of uncertainty is brought to
bear on the discussions.

Governments have recently learned that they can work the trade-off between the
certainty of direct regulation and the efficiency of effluent charges by issuing a
fixed number of transferable emission permits-permits that allow the holder to
generate a certain amount of pollution. The total number of permits can be
limited, so that total pollution can be held below any targeted level. The
economically efficient amount might be the pollution target, but there could be
others (especially if it was difficult to collect the information necessary to identify
the efficient level or if there were an emissions threshold beyond which damage
would be severe). In any case, allowing permits to be bought and sold would
mean that firms whose marginal control costs were high would probably try to buy
some (so that they could increase their emissions) and firms whose marginal
control costs were low would try to sell some (and make money even though they
would have to reduce their emissions). In fact, the market would work to bring the
marginal cost of pollution control at each firm equal to the market price of permits,
and so to would bring the marginal cost of pollution control at every firm in line
with the marginal cost at every other firm. Notice that this is exactly the condition
for minimizing the cost of holding total emissions to a particular level.

Transferable Emission Permits

Government have recently learned that they can work the trade-off between the
certainty of direct regulation and the efficiency of effluent charges by issuing a fixed
number of transferable emissions permits – permits that allow the holder to
generate a certain amount of pollution. The total number of permits can be limited,
so that total pollution can be held below any targeted level. The economically
efficient amount might be the pollution target, but there could be others (especially
if it were difficult to collect the information necessary to identify the efficient level or
it there were an emissions threshold beyond which damage would be severe). In
any case, allowing permits to be bought and sold would mean that firms whose
marginal control costs were high would probably try to but some (so that they could
their emissions) and firms whose marginal control costs were low would try to sell
some (and make money even thought they would have to reduce their emissions).
In fact, the market would work to bring the marginal cost of pollution control at each
firm equal to the market price of permits, and so it would bring the marginal cost of
pollution control at every form in line with the marginal cost at every other firm.
Notice that this is exactly the condition for minimizing the cost of holding total
emissions to a particular level.