The Efficiency Role of Government
• When a well-functioning, perfectly competitive market is
permitted to reach its equilibrium, the outcome is efficient
– No opportunities for mutual gain remain unexploited
– Any government intervention that changes the market quantity (say,
a price ceiling or a price floor) will create inefficiency—a welfare
loss
• But government can—and does—contribute to the
economic efficiency of markets
– Provides infrastructure that permits markets to function
• Physical infrastructure—bridges, airports, waterways, and buildings
• Institutional infrastructure—laws, courts, and regulatory agencies
– Stepping in when markets are not working properly
• When they leave Pareto improvements unexploited and therefore fail
to achieve economic efficiency
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The Institutional Infrastructure of a
Market Economy
• Americans take their institutional infrastructure almost completely for
granted
• In some countries
– Police are more likely to steal from citizens than to protect them from
thievery
– People have no effective rights to their own property
– If a person is injured by a drunk driver, there may be no system for
compensating her or punishing the drive
• In nations with highly developed and stable legal infrastructures, such
incidents are the exception
• When countries are divided into three groups, according to the quality of
their institutional infrastructure
– There is a strong relation between infrastructure and output per worker
2
Average Output per Worker
Figure 8: Government Infrastructure
and Output per Worker
$18,000
14,000
10,000
6,000
2,000
Low
Medium
High
Quality of Infrastructure
3
The Legal System: Criminal Law
• The backbone of a market economy’s institutional
infrastructure is the legal system
• Criminal law
– While criminal law has important moral and ethical
dimensions
• Central economic function is to limit exchanges to voluntary
ones
– By making most involuntary exchanges illegal, criminal
law helps to channel our energies into exchanges and
productive activities that benefit all parties involved—
Pareto improvements
• In this way, criminal law contributes to economic efficiency
4
Property Law
• Property law gives people precisely defined, enforceable
rights over things they own
• When property rights are poorly defined
– Much time and energy are wasted in disputes about ownership
• People spend time trying to capture resources from others
– Time that could have been spent producing valuable goods and services
• Property law contributes to economic efficiency by
increasing total production
– Raising total benefits that markets can provide by reducing
disputes about property
– Channeling resources into production
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Contract Law
• In countries in which contract law is less well
defined or less strictly enforced, investors would
worry that they would not be able to collect their
share
• A contract is a mutual promise
– Often one party does something first and the other
party promises to do something later
• Contracts play a special role in a market economy
– Without them, only Pareto improvements involving
simultaneous exchange could take place
• You get a bag of apples from a farmer and simultaneously hand
over some money
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Contract Law
• Contracts enable us to make exchanges that take place over time and
in which one person must act first
– In this way, contracts help society enjoy the full benefits of specialization
and exchange
• Legal enforcement of contacts is not the only force that makes people
keep promises
– Parents, religious organizations, and schools teach people that keeping
promises is a moral obligation
– A reputation for failing to keep promises would be harmful to a business or
a person
• While socialization and concern over reputation are important,
contracts and the infrastructure for enforcing them play vital role in
making economy more efficient
• Because of contract law, people are more willing to take a chance with
a new business
– Since they know that they have a law behind them if new business
reneges on a deal
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Tort Law
• Deals with interactions among strangers or people not
linked by contracts
• Specifically, a tort is a wrongful act—such as
manufacturing an unsafe product—that causes harm to
someone, and for which the injured person can seek
remedy in court
– Tort law defines types of harm for which someone can seek legal
remedy
• And what sorts of compensation the injured person can expect
• When people and business are held responsible for
injuries they cause, they act more carefully
• Also protects against fraud
– In which a seller of something—a product, a business, shares of
stock—lies to the buyer in order to make the sale
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Antitrust Law
• Designed to prevent business from making agreements or
engaging in other behavior that limits competition and
harms consumers
– Operates in three areas
• Agreements among competitors
– U.S. antitrust law—expressed in Section 1 of Sherman Act—prohibits
“contracts, combinations, or conspiracies” among competing firms that
would harm consumers by raising prices
• Monopolization
– Section 2 of Sherman Act Makes it illegal to monopolize or attempt to
monopolize a market
• Mergers
– In a merger, two firms combine to form one new firm
» The result is to increase the danger of higher prices from oligopoly or
monopoly
» Mergers of this type are often blocked by U.S. government based on
Section 7 of Clayton Act
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Regulation
• Important part of the institutional infrastructure that
supports a market economy
– Under regulation, a government agency—such as the Food and
Drug Administration (FDA), the Environmental Protection Agency
(EPA), or a state public utilities commission—has power to direct
business to take specific actions
• In addition to protecting public safety and health
– Regulation is also used to help markets function more efficiently
• Regulation differs from use of legal procedures in a
fundamental way
– Regulators reach deep into the operations of business to tell them
what to do
• While legal procedures typically result in fines or other penalties if
businesses do something wrong
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Law and Regulation in Perspective
• Invisible hand of market system cannot
operate on its own
– Legal system, along with regulatory agencies,
creates an environment in which invisible hand
can do its job
– Almost every Pareto improvement that we can
think of relies on legal and regulatory
infrastructure
• But what about cases where law and regulation don’t
seem to be working perfectly?
– Does this mean that our institutional infrastructure is failing
us?
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Law and Regulation in Perspective
• Yes…and no
– While instances like these are never welcome, society has chosen
not to eliminate them entirely
– Must balance benefits—safer products, reduced crime—against
costs
• A legal and regulatory system that ensured the complete
elimination of crime, unsafe products, and other
unwelcome activities would be less efficient than a system
that tolerated some amount of these activities
– An efficient infrastructure must consider the costs, as well as the
benefits, of achieving our legal and regulatory goals
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Market Failures
• Another vitally important role for government
– To intervene in situations of market failure
• When a market equilibrium—even with the proper institutional
support—is economically inefficient
• General types of market failures to which
economists have devoted a lot of attention
– Monopoly power
– Externalities
– Public goods
• While economists and policy-makers agree in
theory on what causes a market failure
– Dealing with real-world market failures remains one of
the most controversial aspects of government policy
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Monopoly and Monopoly Power
• A firm has monopoly power when it can influence
the price that it charges for its product
– A market with just one seller, or a few oligopolists who
cooperate and behave as a monopoly, is a more
serious market failure
• Monopoly and imperfectly competitive markets—
in which firms charge a single price greater than
marginal cost—are generally inefficient
– Price is too high, and output is too low, to maximize net
benefits in market
• What can government do to make this monopoly
market more efficient?
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Figure 9: The Welfare Loss from
Monopoly
1. A monopoly charges a higher price
than a competitive market . . .
MC
Dollars
3. The result is a welfare loss . . .
$22
$19
2. and produces a
lower quantity.
E
4. from not producing
the efficient quantity,
at point E.
MR
2,500
D
Number of Lessons per Week
4,000
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Anti-trust Law as a Remedy
• In the case of the guitar-lesson monopoly, there may be a
solution
– Since this market would function very well under competitive
conditions, the government could use anti-trust law to break the
monopoly into several competing firms
• But breaking up a monopoly would not make sense when the market
would perform even worse with more competition
• Monopolies that arise from patents and copyrights, provide
an incentive for artistic creations and scientific discovery
• Monopoly power that arises from network externalities
offers benefits that would be hard to achieve under more
competitive conditions
• When a monopoly arises as a natural monopoly
– Using anti-trust law to break it up or even to prevent its formation in
the first place is a poor remedy
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The Special Case of Natural
Monopoly
• A natural monopoly exists when, due to economies of
scale, one firm can produce for the entire market at a
lower cost per unit than can two or more firms
– If government steps aside, such a market will naturally evolve
toward monopoly
• If breaking up a natural monopoly is not advisable, what
can government do to bring us closer to economic
efficiency?
– One option is public ownership and operation
• Public takeover of private business is rare, except when certain
conditions are present
– That leaves one other option
• Regulation
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Figure 10: Regulating A Natural
Monopoly
Dollars
Unregulated monopoly
$60
A
Efficient production
(requires subsidy)
C
$29
$15
"Fair rate of return"
production
F
MR
50,000
B
LRATC
MC
D
100,000
85,000
Number of
Households
Served
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Regulation of Natural Monopoly
• Under regulation, a government agency digs deep
into the operations of a business and takes some
of the firm’s decisions under its own control
– In the case of a natural monopoly, regulators are
interested in achieving economic efficiency, which they
do by telling the firm what price it can charge
• At first glance, you might think that natural
monopoly regulators have an easy job
• Unfortunately, it’s not that easy
– There is the matter of information
• Regulators must be able to trace out firm’s MC curve as well as
market demand curve
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Regulation of Natural Monopoly
• Even with perfect information about
monopolist’s cost and demand curves,
regulators have a serious problem
– Look again at Figure 7—notice that MC curve
lies everywhere below LRATC curve
– Problem for regulators
• If they set the efficient price of $15 so that buyers
demand efficient quantity of 100,000, firm’s cost per
unit is greater than $15
– Firm will suffer a loss
– In long-run, it will go out of business
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Regulation of Natural Monopoly
• Leaves regulatory agency with two alternatives
– Set prices to MC and subsidize the monopoly from the general
budget, to make up for the loss
• In practice, however, regulators in market economies
around the world have usually chosen a different solution
– Regulators determine a price that gives owners a “fair rate of return”
for funds they’ve put into the monopoly
– Should give monopoly what economists call normal profit
• Profit just high enough to cover all of the owners’ opportunity costs,
including the foregone interest of their own funds
• What price will accomplish this?
– A fair rate of return is already built into LRATC curve
– This strategy—called average cost pricing—is the most common
solution chosen by regulators of natural monopolies
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Regulation of Natural Monopoly
• With average cost pricing, regulators strive to set price
equal to cost per unit where LRATC curve crosses
demand curve
– At this price, the natural monopoly makes zero economic profit
• Which provides its owners with a fair rate of return, and keeps the
monopoly in business
• Average cost pricing is not a perfect solution
– Does not quite make the market efficient
– Provides little or no incentive for the natural monopoly to
economize on capital
• Tendency of regulated natural monopolies to overinvest in capital is
known as the Averch-Johnson effect, after the two economists who
first explained it
• Averch-Johnson effect is a specific example of a more general idea
– When a firm is not striving to maximize profit (in this case, because the
government is guaranteeing a specific rate of return)
» Firm need not economize on costs
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