Managerial Economics & Business
Strategy
Chapter 14
A Manager’s Guide
to Government in the
Marketplace
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Government Regulations
 Government regulations affect most
decisions that consumers and firms make.
 Legitimate reasons for government
intervention:
 Market Power
 Externalities
 Public Goods
 Asymmetric Information
14-2
Government Regulations
Government Policy and International Markets
– Quotas
– Tariffs
14-3
Market Power
 Firm produces a level of output less than is
socially efficient and charges a price higher
than marginal cost.
 Net gain to society if more output were
produced.
 Government can intervene to increase
social welfare.
14-4
Market Power
 Market power is the ability
of a firm to set P > MC.
 Firms with market power
produce socially inefficient
output levels.
– Too little output
– Price exceeds MC
– Deadweight loss
P
Deadweight
Loss
MC
PM
PC
MC
• Dollar value of society’s
welfare loss
D
QM
QC
MR
Q
14-5
Antitrust Policies
 Administered by the DOJ and FTC
 Goals:
– To eliminate deadweight loss of monopoly and
promote social welfare.
– Make it illegal for managers to pursue strategies
that foster monopoly power.
14-6
Sherman Act (1890)
 Sections 1 and 2 prohibits price-fixing,
market sharing and other collusive
practices designed to “monopolize, or
attempt to monopolize” a market.
14-7
United States v. Standard Oil of New Jersey
(1911)
 Charged with attempting to fix prices of
petroleum products. Methods used to enhance
market power:
– Physical threats to shippers and other
producers.
– Setting up artificial companies.
– Espionage and bribing tactics.
– Engaging in restraint of trade.
– Attempting to monopolize the oil industry.
14-8
United States v. Standard Oil of New Jersey
(1911)
 Result 1: Standard Oil dissolved into 33
subsidiaries.
 Result 2: New Supreme Court Ruling the rule of
reason.
– Stipulates that not all trade restraints are
illegal, only those that are unreasonable are
prohibited.
 Based on the Sherman Act and the rule of
reason, how do firms know a priori whether a
particular pricing strategy is illegal?
 Clayton Act (1911) and Robinson-Patman (1936)
14-9
Clayton Act (1914)
 Makes hidden kickbacks (brokerage fees)
and hidden rebates illegal.
 Section 3 Prohibits exclusive dealing and
tying arrangements where the effect may
be to “substantially lessen competition.”
14-10
Cellar-Kefauver Act (1950)
 Amends Section 7 of Clayton Act.
 Strengthens merger and acquisition policies.
 Horizontal Merger Guidelines
– Market Concentration
• Herfindahl-Hirschman Index: HHI = 10,000 S wi2
• Industries in which the HHI exceed 1800 are
generally deemed “highly concentrated”.
• The DOJ or FTC may, in this case, attempt to
block a merger if it would increase the HHI by
more than 100.
14-11
DOJ Flexibility
 Mergers are often allowed even when HHI
is large provided there is likelihood of entry
of domestic or foreign firms, increased
efficiency, or a firm has financial problems.
14-12
Regulating Monopolies
 When large economies of scale exist it
may be that one firm can more efficiently
service the market.
 Government can sanction the monopoly
but will regulate prices to reduce
deadweight loss.
14-13
Regulating Monopolies:
Marginal-Cost Pricing
P
MC
PM
PC
Effective Demand
MR
QM
QC
Q
14-14
Problem 1 with Marginal-Cost
Pricing: Possibility of ATC > PC
P
MC
PM
ATC
PC
ATC
MR
QM
QC
Q
14-15
Price Regulation
 If regulated price is set at too low a level
then the social cost of regulation is greater
then the social cost of allowing the firm to
price as a monopoly.
 Next graph indicates this scenario.
14-16
Problem 2 with Marginal-Cost
Pricing: Requires Knowledge of
MC
P
Deadweight loss
after regulation
MC
PM
Deadweight loss
prior to regulation
PReg
Effective Demand
MR
QReg QM
Q*
Q
Shortage
14-17
Externalities
 A negative externality is a cost borne by
people who neither produce nor consume
the good.
 Example: Pollution
– Caused by the absence of well-defined
property rights.
 Government regulations may induce the
socially efficient level of output by forcing
firms to internalize pollution costs
– The Clean Air Act of 1970.
14-18
Methods for Dealing with Negative
Externalities
 Command and Control methods
 Market based alternatives
– Pigouvian Tax
– Pollution Permit System (cap and trade)
– Coase
14-19
Socially Efficient Equilibrium:
Internal and External Costs
P
Socially efficient equilibrium
MC external + internal
PSE
MC internal
PC
MC external
Competitive
equilibrium
D
QSE QC
Q
14-20
Public Goods
 A good that is non-rival and non-exclusionary
(excludable) in consumption.
– Non-rival: A good which when consumed by one
person does not preclude other people from also
consuming the good.
• Example: Radio signals, national defense
– Non-exclusionary (excludable): No one is
excluded from consuming the good once it is
provided.
• Clean air
• National defense
• Street lights
14-21
Public Goods
 “Free Rider” Problem
– Individuals have little incentive to buy a public
good because of their non-rival & nonexclusionary nature.
– The market has no incentive to provide public
goods because of potential free riders.
– Government provides the public good from tax
monies collected from everyone.
14-22
Public Goods
 Benefit-cost analysis is used to determine
whether and how much of a public good to
provide.
 Costs are straightforward
 Determining benefits poses a problem
14-23
Incomplete Information
 Participants in a market that have
incomplete information about prices,
quality, technology, or risks may be
inefficient.
 The Government serves as a provider of
information to combat the inefficiencies
caused by incomplete and/or asymmetric
information.
14-24
Government Policies Designed to Mitigate
Incomplete Information
 OSHA – full info to workers
 SEC – insider trading; 2009 crisis
 Certification – minimum standards;
certified charities; schools
14-25
Government Policies Designed to Mitigate
Incomplete Information
 Truth in lending –creating more symmetric
information between borrowers and
lenders
 Truth in advertising – treble damages
under the Lanham and Clayton Acts
 Contract enforcement – deterring
opportunistic behavior.
14-26
Rent Seeking
 Government policies will generally benefit
some parties at the expense of others.
 Lobbyists spend large sums of money in an
attempt to affect these policies.
 This process is known as rent-seeking –
selfishly motivated efforts to influence
another party’s decision.
14-27
An Example:
Seeking Monopoly Rights
 Firm’s monetary incentive to
P
lobby for monopoly rights: A
 Consumers’ monetary incentive
to lobby against monopoly:
A+B.
PM
 Firm’s incentive is smaller than
consumers’ incentives.
C
 But, consumers’ incentives are P
spread among many different
individuals.
 As a result, firms often succeed
in their lobbying efforts.
Consumer
Surplus
A = Monopoly Profits
B = Deadweight Loss
A
B
MC
D
MR
QM
QC
Q
14-28
Quotas and Tariffs
 Quota
– Limit on the number of units of a product that a foreign
competitor can bring into the country.
• Reduces competition, thus resulting in higher prices, lower
consumer surplus, and higher profits for domestic firms.
 Tariffs
– Lump sum tariff: a fixed fee paid by foreign firms to enter
the domestic market.
– Excise tariff: a per unit fee on each imported product.
• Causes a shift in the MC curve by the amount of the tariff
which in turn decreases the supply of all foreign firms.
14-29
Analysis of a Tariff on Cotton Shirts
P
free trade
CS = A + B + C
+D+E+F
PS = G
Total surplus = A + B
+C+D+E+F+G
tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B
+C+E+G
Cotton
shirts
deadweight
loss = D + F
S
A
B
$30
$20
C
D
E
F
G
25
40
70 80
D
Q
14-30
Figure 7 The Effects of an Import Quota
Price
of Steel
Domestic
supply
Equilibrium
without trade
Domestic
supply
+
Import supply
Quota
Isolandian
price with
quota
Equilibrium
with quota
Price
World
without =
price
quota
0
Imports
with quota
Q
S
Q
S
Domestic
demand
Q
Imports
without quota
D
Q
D
World
price
Quantity
of Steel
14-31
Copyright © 2004 South-Western
Conclusion
 Market power, externalities, public goods,
and incomplete information create a
potential role for government in the
marketplace.
 Government’s presence creates rentseeking incentives, which may undermine
its ability to improve matters.
14-32