BSA CORE 1

MANAGERIAL ECONOMICS

MODULE 12
Wednesday

MARKET FAILURES

Patent system
 Patent law grants the holder exclusive rights to an invention for 20 years.
o An invention must take the form of a product or process. Intangible
knowledge (say, a mathematical theorem) is not patentable.
 Moreover, the invention must contain a minimum degree of novelty.
o Their most important role is to provide incentives for firms (and individuals)
to pursue inventions and innovations.
 Without patent protection, a firm that creates an invention would be
able to claim only a small portion of the profit generated by the
invention.
 Patent protection encourages the process of invention by allowing
the inventor to capture a greater portion of the benefits created.
o Patent laws represent a trade-off. On one hand, they provide strong
incentives for research and invention in the first place.
 On the other hand, the patent grants the successful inventor a
monopoly over the sale of knowledge embodied in the invention.
Copyright
 Copyright law provides protection for expressive works, such as music, drama,
literature, film, and even software.
o The Copyright Act of 1790 protected material for 14 years, renewable for
another 14 years while the author was still alive.
o By 1998, this protection had been raised to the life of the author plus 70
years.
 Media attention continues to focus on the contours of copyright law, especially in
the area of music where technological advances (video recorders, DVD
recorders, and the like) have made copying and downloading easy and
inexpensive.
o In the late 1970s, Universal Pictures and Disney sued Sony and other
makers of video recorders to prohibit the sale of the recorders, alleging
that such recording violated copyright law.

Source: Samuelson, Willian F. & Marks, Stephen G. 2012. Managerial Economics, 7th Edition. John Wiley
and Sons, Inc.
  The federal district court ruled in Sony’s favor and allowed the production of
these devices.
o On the other hand, in 2001, the Court of Appeals (Ninth Circuit) upheld an
injunction that effectively shut down Napster, a popular music and file
exchange service.
o In that case, the court objected to Napster making copyrighted songs
available from its main server.
 Although the music industry has recently begun suing individual violators, illegal
downloads continue to dominate the market.
o To further fight the downloading problem, the industry has aggressively
promoted paid download services such as iTunes, MusicMatch,
Rhapsody, and even a new paid Napster fficient regulation depends on a
careful consideration of benefits and costs.
Regulatory reforms and deregulation
 Regulatory reforms in the 1980s and 1990s have made slow but steady progress
in this direction.
 Initially, benefits were not explicitly traded off against costs.
o For example, the 1970 Clean Air Act specifically excludes a consideration
of costs in setting air-quality standards, and the Food and Drug
Administration is not obligated to use benefit-cost tests in ascertaining
product safety.
o However, over time regulatory agencies have increasingly turned to a
comparison of benefits and costs.
 One important area of reform is deregulation.
o Critics have pointed out that, by intention or not, regulation frequently
reduces true competition: Regulated rates can hold prices up as well as
down.
 Critics argue that regulators are often “captured’’ by the firms they are supposed
to regulate and that government intervention has spread into many areas that are
a far cry from natural monopolies: trucking, airlines, and banking, for example.
o Regulations that limit market entry and fix prices frequently do more harm
than good in markets where competition otherwise would be viable
 Deregulation has produced entry by no-frills airlines, greater competition along
high-traffic routes, lower average fares, greater variety and frequency of service,
and increased airline efficiency (stemming from hub-and-spoke operations and
reduced labor costs) with some reduction in service quality.
o Overall, consumers have benefited significantly from the 25 years of
airline deregulation.
Market failure due to imperfect information

Source: Samuelson, Willian F. & Marks, Stephen G. 2012. Managerial Economics, 7th Edition. John Wiley
and Sons, Inc.
  Some economic transactions involve significant uncertainties as to product
quality, reliability, or safety.
o In these cases, consumers may not have sufficient information to make
efficient choices.
 There are numerous cases of market inefficiencies due to imperfect information,
ranging from the routine to the dramatic.
o As a simple example, consider two lines of household batteries marketed
by competing firms.
 The first firm’s battery is a best seller; it is cheaper to produce and
thus carries a lower price (10 percent lower) than the competition.
 According to objective tests, however, the second firm’s battery
lasts 18 percent longer on average.
 If consumers possessed perfect information about the batteries, the
second battery brand could well be the better seller because it
delivers more power per penny.
 However, only a minority of consumers (perhaps diligent readers of
Consumer Reports) are knowledgeable about the lives of different
brands of batteries.
 Most consumers decide mainly on initial purchase price.
o Thus, in the presence of imperfect information, a free competitive market
will have no way to rid itself of the less-efficient product.

 When consumers possess imperfect information or misinformation, market

outcomes typically will fail the efficiency test.
o Government regulators, with superior information, may be able to mandate
better outcomes than would occur in an unregulated market.
o Under this rationale, the government bans some drugs, taxes alcohol and
cigarettes, mandates compulsory education up to a certain grade, and
prohibits the sale of unsafe products.
o Government can also act by requiring producers to provide certain types
of information, such as nutritional labelling on foods or warning labels on
cigarettes and wine.

 Frequently, the choice is between imperfect markets and imperfect regulation or,
sometimes, between market failure and regulatory failure.
o For instance, the automobile is probably the single most regulated product
today.
o Regulations govern general performance, reliability, safety, fuel economy,
and emissions.
o The majority of these regulations represent improvements over what
would be offered in an unregulated market.

Source: Samuelson, Willian F. & Marks, Stephen G. 2012. Managerial Economics, 7th Edition. John Wiley
and Sons, Inc.
 o But almost all these regulations are costly, and not all constitute
unambiguous improvements.

Source: Samuelson, Willian F. & Marks, Stephen G. 2012. Managerial Economics, 7th Edition. John Wiley
and Sons, Inc.