W014 - Government Regulation of Business-FJO

Creating the great business leaders
Managerial Economics
By
Team Teaching FEB
Chapter 16 - Government Regulation of Business
Christopher Thomas, S. Charles Maurice
2020
Fakultas Ekonomi dan Bisnis
School of Economic and Business Learning Objectives
Telkom University
After reading this chapter, you will be able to:
16.1 Define social economic efficiency and explain why well-functioning competitive
markets achieve social economic efficiency without government regulation.
16.2 Explain the concept of market failure and explain why it provides an economic
justification for government intervention in markets.
16.3 Identify deadweight loss associated with market power and discuss ways antitrust
policy, second-best pricing, and two-part pricing can reduce the cost of market
power.
16.4 Discuss pollution as a negative externality and show how government regulation
can create incentives for firms to choose the optimal level of pollution.
16.5 Explain why common property resources and public goods are underproduced and
how government can reduce market failure created by nonexcludability.
16.6 Discuss why imperfect information about product price and quality can lead to
market failure.

School of Economic and Business
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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

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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

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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)

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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

Efficiency in Perfect Competition (Figure 16.1)

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Market Failure & the Case for Government Intervention

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■ 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


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■ Six forms of market failure can undermine economic efficiency:

● Monopoly power
● Natural monopoly
● Negative (& positive) externalities
● Common property resources
● Public goods
● Information problems


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■ Absent market failure, no efficiency argument can be made for

government intervention in competitive markets

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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

Louisiana White Shrimp Market (Figure 16.2)

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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

Promoting Competition Through Antitrust Policy

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■ 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

Promoting Competition Through Antitrust Policy

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■ 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

Natural Monopoly & Market Failure

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■ 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

Subadditive Costs & Natural Monopoly (Figure 16.3)

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■ 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

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Regulating Price Under Natural Monopoly (Figure 16.4)

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■ 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

The Problem of Negative Externality

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■ 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


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■ 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


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■ 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

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Negative Externality & Allocative Inefficiency (Figure 16.5)

Pollution as a Negative Externality (Figure 16.6)

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Finding the Optimal Level of Pollution (Figure 16.7)

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Optimal Emission Taxation (Figure 16.8)

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Nonexcludability
■ Two kinds of market failure caused by nonexcludability:

● Common property resources
● Public goods

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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

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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

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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

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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

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Imperfect Information on Product Quality (Figure 16.9)

School Economics and Business
TERIMA KASIH….
34 Creating the great business leaders

W014 - Government Regulation of Business-FJO

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Creating the great business leaders

Creating the great business leaders

Creating the great business leaders

■ Exists when suppliers produce goods & services at the lowest

Creating the great business leaders

■ Requires businesses to supply optimal amounts of all goods &

Creating the great business leaders

■ Achieved by markets in perfectly competitive equilibrium

Creating the great business leaders

Efficiency in Perfect Competition (Figure 16.1)

Creating the great business leaders

Market Failure & the Case for Government Intervention

■ Competitive markets can achieve social economic efficiency without

Creating the great business leaders

Market Failure & the Case for Government Intervention

■ Six forms of market failure can undermine economic efficiency:

Creating the great business leaders

Market Failure & the Case for Government Intervention

■ Absent market failure, no efficiency argument can be made for

Creating the great business leaders

■ Firms with market power must price above marginal cost to

Creating the great business leaders

Louisiana White Shrimp Market (Figure 16.2)

Creating the great business leaders

■ When the degree of market power grows high enough, antitrust

Creating the great business leaders

Promoting Competition Through Antitrust Policy

■ A high degree of market power (or monopoly power) can arise in

Creating the great business leaders

Promoting Competition Through Antitrust Policy

■ Firms may be found guilty of actual monopolization only if both of

Creating the great business leaders

Natural Monopoly & Market Failure

Creating the great business leaders

Subadditive Costs & Natural Monopoly (Figure 16.3)

Creating the great business leaders

Creating the great business leaders

Creating the great business leaders

Creating the great business leaders

The Problem of Negative Externality

Creating the great business leaders

The Problem of Negative Externality

■ Externalities undermine allocative efficiency

Creating the great business leaders

The Problem of Negative Externality

■ Managers rationally ignore external costs when making profit-

Creating the great business leaders

Creating the great business leaders

Pollution as a Negative Externality (Figure 16.6)

Creating the great business leaders

Finding the Optimal Level of Pollution (Figure 16.7)

Creating the great business leaders

Optimal Emission Taxation (Figure 16.8)

Creating the great business leaders

■ Two kinds of market failure caused by nonexcludability:

Creating the great business leaders

■ Resources for which property rights are absent or poorly defined

Creating the great business leaders

■ A public good is nonexcludable & nondepletable

Creating the great business leaders

■ Market failure may also occur because consumers lack perfect

Creating the great business leaders

■ Consumers may over- or under-estimate quality of goods & services