MODULE B

GOVERNMENT IN THE MARKETPLACE

Class I 21 | Group 5
Agung Nugroho 2106789265
Fandhy A B Thesia 2106670754
Guntur Prayogo 2106670861
Muhamad Gifari Rusdi 2106671233

Master of Management | University of Indonesia 2022

MODULE 5: REGULATORY CONSTRAINT ON
MARKET POWER

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 Market Power
The ability of a firm to set its price above marginal cost.

● The socially efficient price and output arise naturally if the industry is perfectly competitive. In contrast, a firm that has market
power produces less than the socially efficient level of output because it charges a price that exceeds its marginal cost of
production.
● In these instances, government may intervene in the market and regulate the actions of firms in an attempt to increase social
welfare.

Assuming that the monopolist must charge the same price to all consumers in the
market, the profit-maximizing output is QM units, and these units are sold at the
monopoly price of PM.
At this price, consumers pay more for the last unit of output than it costs the producer to
manufacture and sell it. Total social welfare under monopoly is the region labeled W in
Figure M5–1.

Deadweight loss of monopoly is the consumer and producer surplus that is lost due to
the monopolist charging a price in excess of marginal cost.

● Notice in Figure M5–1 that the area of triangle ABC is the deadweight loss of the
monopoly—welfare that would have accrued to society if the industry were
perfectly competitive but is not realized because of the market power the
monopolist enjoys.

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 Government Tools to Constrain Market Power
● The government uses antitrust policy to enact and enforce laws that restrict the formation of monopolies.
● The government attempts to reduce the deadweight loss by regulating the price charged by the monopolist.
The rationale for these policies is that by preventing monopoly power from emerging, the deadweight loss of monopoly can be avoided

Herfindahl-Hirschman index (HHI)

The sum of the squared market shares of firms in a given industry
multiplied by 10,000
Antitrust Policy
Antitrust policy attempts to eliminate the deadweight loss of
monopoly by making it illegal for managers to engage in activities
that foster monopoly power, such as price-fixing agreements and
other collusive practices.
● The rule of reason has become the code of decision making
used by the court for determining antitrust cases.
Effectively, the rule of reason stipulates that not all trade
restraints are illegal; rather, only those that are
“unreasonable” are prohibited
● The problem with the rule of reason is that it makes it
difficult for managers to know in advance whether
particular pricing strategies used to enhance profits are in
fact violations of the law
● wi represents firm i’s sales in the relevant market as a fraction of
the total sales of all firms in that market.
A merger that increases HHI by less than 100 or leads to an
unconcentrated market (post-merger HHI < 1,500) is ordinarily
allowed
● Markets in which the postmerger HHI is between 1,500 and 2,500
are considered moderately concentrated.
In moderately concentrated markets, mergers that increase HHI
by more than 100 points potentially raise antitrust concerns.
● Markets in which the postmerger HHI exceeds 2,500 are deemed
highly concentrated.
In highly concentrated markets, an increase in the HHI of between
100 and 200 points also potentially raises antitrust concerns.
● If a merger increases HHI by more than 200 and leads to a highly
concentrated market, it is presumed to be likely to enhance
market power.

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 Price Regulation
Government may allow a firm to exist as a monopoly but choose to regulate its price to reduce the deadweight loss

Regulating a Monopolost’s Price at the Socially Efficient Level

● Suppose the government imposed and enforced a regulated price of PC, which
corresponds to the price a competitive industry would charge for the product
given identical demand and cost conditions.

● The monopolist cannot legally charge a price above PC, so the maximum price it
can charge for units less than QC is PC

● As a consequence, the effective inverse demand curve of the monopolist is given

by PCBD

● To maximize profits, the regulated monopolist will produce where the marginal
revenue of the effective demand curve (PC) equals marginal cost, which in this
case is at point B. This corresponds to an output of QC

● Thus, when the monopolist’s price is regulated at PC in Figure M5–2, the firm
maximizes profits by producing Qc units and selling them at the regulated price
of PC

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 Price Regulation (cont’)
Government may allow a firm to exist as a monopoly but choose to regulate its price to reduce the deadweight loss

Regulating a Monopolost’s Price Below the Socially Efficient Level

● Suppose the government regulates the price at the level P*.

Given the regulated price, the effective demand curve for the monopolist is now
P*FD, and the corresponding marginal revenue curve for units produced below
Q* is given by line P*F

● To maximize profits, the regulated monopolist will produce where the marginal
revenue of the effective demand curve (P*) equals marginal cost, which is at
point G.
This corresponds to an output of QR, which is less than the output the
monopolist would have produced in the absence of regulation

● The quantity demanded at a price of P* is Q*, so there is a shortage of Q* − QR

units under the regulated price

● The deadweight loss under this regulated price (regions R + W) is actually larger
than the deadweight loss in the absence of regulation (region W)

● If the government lacks accurate information about demand and costs, or for
some other reason regulates the price at too low a level, it can actually reduce
social welfare and create a shortage of the good

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 Price Regulation (cont’)
Government may allow a firm to exist as a monopoly but choose to regulate its price to reduce the deadweight loss

A Case Where Price Regulation Drives the Monopolist Out of Business

● In Figure M5–4, where the monopolist is just breaking even at point A, an

unregulated monopolist would produce QM units and charge a price of PM
However, Since price is equal to the average total cost of production, this
monopolist earns zero economic profits in the absence of regulation

● Now suppose the price is regulated at PC.

Under the regulated price, average total cost lies above the regulated price, so
the monopolist would experience a loss if it produced.
Thus, in the long run the monopolist would exit the market if the price were
regulated at PC, and everyone in the market would be made worse off (there
would be no product to consume)

● To keep this from happening, the government would have to subsidize the
monopoly by agreeing to compensate it for any losses incurred. These funds
would come from taxes, and thus consumers would indirectly be paying for the
lower price through higher taxes.

● The manager of a subsidized monopoly would have no incentive to keep costs

low; any losses that resulted would be subsidized by the government.
Consequently, the manager would have an incentive to spend enormous sums
of money on plush offices, corporate jets, and the like, since losses would be
reimbursed by the government 7
Rent Seeking ● Definition
○ Selfishly motivated efforts to influence another party’s decision.
○ When, lobbyists spend considerable sums in attempts to influence government policies.

● For our illustration, suppose a politician has the power to regulate the monopoly in
Figure M5–5. The monopoly currently charges a price of PM, produces QM units of
output, and earns profits described by the shaded region A. At the monopoly price
and output, consumer surplus is given by triangle C.

● If consumers could persuade the politician to regulate the monopolist’s price at the
competitive level (PC), the result would be an output of QC. If this happened, the
monopoly would lose all of its profits (rectangle A). Consumers, on the other hand,
would end up with total consumer surplus of regions A, B, and C.

● Since the monopolist stands to lose rectangle A if the regulation is imposed, it has
an incentive to lobby very hard to prevent the regulation from being imposed.
These expenditures may be in the form of legal activities, such as campaign
contributions or wining and dining the politician.

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MODULE 6: REGULATION OF MARKETS WITH
EXTERNALITIES, PUBLIC GOODS, OR
INCOMPLETE INFORMATION

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 Negative Externalities
Externalities ●
○ Costs borne by parties who are not involved in the production or consumption of a good.

○ The most common example of a negative externality is pollution. While the firm benefits
from dumping waste into the river, it reduces the oxygen content of the water and clogs
normal waterway routes even creates reproduction problems for birds, fish, reptiles, and
aquatic animals.

● Figure M6–1 shows the negative externality is the marginal cost of pollution to
society. This represents the cost to society of dirtier water due to increases in steel
production. Production of only a little steel results in only minor damage to water,
but as increasing amounts are produced, more and more pollutants collect in the
water.

● The supply curve is based on the costs paid by the steel firms. If they are allowed to
dump pollutants into the water for free, the market equilibrium is at point B, where
the market demand and supply curves intersect.

● The socially efficient level of output, which takes into account all the costs and
benefits of producing steel, is at point C, where the marginal cost to society
intersects the market demand curve. In other words, consumers get to purchase too
much output at too low a price.

● Government can play an important role in encouraging firms to internalize the costs
of emitting pollutants by making them produce more output at lower levels of
output. In this case one of the example is The Clean Air Act.

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The Clean Air Act

● Congress passed the Clean Air Act in 1970 and a sweeping amendment in 1990. The amended Clean Air Act covers 189 toxic air
pollutants and was the most comprehensive anti-pollution act passed by any country as of 1992.

● The Clean Air Act now covers any industry that releases over 10 tons per year of any of the listed pollutants or 25 tons per year of
any combination of those pollutants.

● The Clean Air Act causes firms to internalize the cost of emitting pollutants since a fee must be paid for each unit emitted. This
raises each firm’s marginal cost and therefore induces them to produce less output.

● Under the Clean Air Act, permits can be sold by one firm to another
both within and across industries. This does two things that allow
the market to reduce pollution. First, it allows new firms to enter an
industry when demand increases. Second, it provides an incentive
for existing firms to invest in new technology.

● As a result, the market equilibrium quantity of pollution is decreased

from Q0 to Q1 and the market price is raised from P0 to P1.

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Public Goods
● Public goods that are non rival and non exclusionary in nature and therefore benefit persons other than those who buy the goods
● Public goods differ from most goods you consume, which are rivalrous in nature, that means when you consume the good,
another person is unable to consume it as well.
● Nonrival good is a good that nonrival in consumption if the consumption of the good by one person does not preclude other
people from also consuming the good.
● Non exclusionary good is a good or service that non exclusionary if, once provided, no one can be excluded from consuming it.

There are 3 People (A,B,C) that have identical inverse demand

: PA = 30 − Q, PB = 30 − Q, and PC = 30 − Q
So we get PA + PB + PC = 90 – 3Q

The socially efficient level of streetlights is at point A in Figure M6–3,

where the marginal cost of producing streetlights exactly equals the
total demand for streetlights (54 = Marginal Cost of streetlight)
PA+PB+PC = 54

54 = 90 - 3Q
Q = 12
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Public Goods

● The problem is that each individual would be better off by letting the other two install the streetlights. In particular, it is
strategically advantageous for each person to misrepresent their true personal demand function (valuation of the public good)
● If A claimed she did not want streetlights, and let the others pay for them, she would get to enjoy the lights
● This is similar to “cheating” on a cooperative agreement and is called free riding
● Government solves the public-goods problem by forcing everyone to pay taxes regardless of whether or not a given taxpayer
claims to want government services
● We conclude by pointing out that it may be advantageous for a firm to contribute to public goods in its market area.
● Another advantage is that it may put the firm on more favorable terms with politicians, who have considerable latitude in
affecting the environment in which the firm operates. 13
Incomplete Information
● When participants in the market have incomplete information about such things, the result will be inefficiencies in input usage
and in firms’ output
● One of the more severe causes of market failure is asymmetric information, a situation where some market participants have
better information than others.
● To prevent any asymmetric information, several government policies are designed to alleviate the problems

Rules against Insider Trading

● The main reason that government regulation designed to alleviate market failures due to asymmetric information is the law
against insider trading in the stock market
● To prevent insider trading from destroying the market for financial assets, the government has enacted rules such as :
1. The regulations on insider trading come from Section 16 of the Securities and Exchange Act (1934).
2. And were amended in 1990 and again in 2002.
3. Most recently, Section 16 was amended by the Sarbanes-Oxley Act of 2002, which made sweeping changes in governance
and reporting obligations
Certification
● Another policy government uses to disseminate information and reduce asymmetric information is the certification of skills
● The purpose is to assure consumers that the products or services have been certified as meeting a certain set of minimum
standards
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Incomplete Information
Truth in Lending
● Regulation Z and TLSA require that all creditors comply with the act.
● A creditor is defined as anyone who loans money subject to a finance charge, where the money is to be paid back in four or more
installments
● TLSA requires that creditors disclose certain information to debtors in writing before the consummation of loans
● The purpose of this law is to ensure that all debtors are given an opportunity to understand all aspects of
borrowing money from a specific creditor, thus creating more symmetric information between borrowers and
lenders.

Truth in Advertising
● The asymmetric information can induce consumers to ignore advertising messages altogether, out of fear that the messages are
false.
● Government often can alleviate these market failures by regulating the advertising practices of firms.
● The Lanham Act, in concert with the Clayton Act, allows someone who is harmed by false or misleading
advertising to stop the deceptive practice and receive treble damages.

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Enforcing Contracts

● Another way government solves the problems of asymmetric information is through contract enforcement.
● Problems do not arise when reputation is important or when there is the potential for repeated interaction
among the parties
● The one time gain to behaving opportunistically will be more than offset by future losses.
● In short-term relationships, however, one or more parties may take advantage of the “end period” by
behaving opportunistically.
● One solution to this problem is for government to enforce contracts.
● By enforcing contracts, government effectively solves the “end-of-period” problem by requiring dishonest
people to honor the terms of contracts.
● Government enforcement of contracts can solve market failures caused by the end-of-period problem.

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MODULE 7: GOVERNMENT POLICY AND
INTERNATIONAL MARKETS

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Quotas

● The purpose of a quota is to limit the number of units of a product that foreign competitors can bring into
the country.
● Figure M7–1, which shows the domestic market for a product.
● Before the imposition of a quota, the domestic demand curve is D, the supply curve for foreign
producers is SForeign, the supply curve for domestic producers is SDomestic, and the market
supply curve—the horizontal summation of the foreign and domestic supply curves—is SF+D.
● Equilibrium in the absence of a quota is at point K, where the equilibrium price is PF+D and
the equilibrium quantity is QF+D.
● Now suppose a quota is imposed on foreign producers that restricts them from selling more
than the quota in the domestic market.
● Under the quota, foreign supply is GASF Quota, while the supply by domestic firms remains at
SDomestic.
● Thus, market supply in the domestic market after the quota is GBC, resulting in an equilibrium
at point M.
● The quota increases the price received by domestic producers to PQuota, and domestic firms
now earn higher profits.
● The shaded triangle represents the deadweight loss due to the quota.
● Total welfare declines as a result of the quota even though domestic producers earn higher
profits.
● The reason for the decline in total welfare is that domestic consumers and foreign producers
are harmed more than domestic producers gain from the quota. Domestic producers
therefore have a strong incentive to lobby for quotas on foreign imports into their market.

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Tariff

● Designed to limit foreign competition in the domestic market to benefit domestic producers.
● The benefits to domestic producers accrue at the expense of domestic consumers and foreign producers
● The purpose of a quota is to limit the number of units of a product that foreign competitors can bring into
the country.

Lump-sum tariffs: A lump-sum tariff is a fixed fee

● Before the tariff is imposed, the supply curve for foreign
that foreign firms must pay the domestic
competitors is ESF, that for domestic producers is ESD,
government to be able to sell in the domestic and the market supply curve—the summation of
market. domestic and foreign supply—is ESD+F.
● After the lump-sum tariff is imposed, the foreign supply
curve becomes ASF because importers will not pay the
lump-sum tariff to enter the domestic market unless the
price is above P2.
● Thus, the market supply curve in the presence of a
lump-sum tariff is given by EBCSD+F.
● The overall effect of this policy is to remove foreign
competitors from the domestic market if the demand
curve crosses the domestic supply curve at a price below
P2.
● A lump-sum tariff increases the profits of domestic
producers if demand is low but has no effect on their
profits if demand is high. 19
Excise or per-unit tariffs: requires the importing firms to pay
the domestic government a fee on each unit they bring into
the country.

If an excise tariff is imposed on foreign producers instead of a

lump-sum tariff, domestic pro- ducers benefit at all levels of
demand

● SF is the supply by foreign producers before the tariff, SD is the

sup- ply by domestic producers, and ABSD+F is the market supply
curve before an excise tariff.
● Equilibrium in the absence of a tariff is at point H.
● When a tariff of T is imposed on each unit of the product, the
marginal cost curve for foreign firms shifts up by the amount of
the tariff, which in turn decreases the supply of all foreign firms to
SF+T in Figure M7–4.
● The market supply under a per-unit tariff is now ACSD+F+T, and
the resulting equilibrium is at point E.
● The tariff raises the price domestic consumers must pay for the
product, which raises the profits of domestic firms at the expense
of domestic consumers and foreign producers.

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THANK YOU