Chapter 7
GOVERNMENT MARKETS
Chapter in a Nutshell
1. In some cases, unregulated markets may not provide the best answers to the fundamental
economic questions of society. Whenever that occurs, government intervention is needed to
temper the market’s operation and make it conform to the interests of society.
2. Some markets fail to allocate resources efficiently, a situation called market failure. The
main sources of market failure include: (1) monopoly power, (2) spillovers or externalities,
(3) public goods, (4) inadequate information and (5) economic inequality.
3. Antitrust policy is the attempt to curb anti-competitive behavior and foster a market
environment that will lead to increased competition. The Sherman Act of 1890 and the
Clayton Act of 1914 are the foundations of federal antitrust policy.
4. Besides using antitrust laws to regulate business behavior, the federal government sometimes
enacts economic regulation to control the prices, wages, conditions of entry, and standards of
service of an industry. Industries made subject to economic regulation have included airlines,
trucking, railroads, banking, communications, and energy. By the late 1970s, however, it was
generally agreed that many economic regulations were no longer suited to prevailing
economic conditions. As a result, the federal government initiated steps to dismantle many
economic regulations, a process known as deregulation.
5. Public utilities have traditionally been subject to economic regulation on the grounds that
they are natural monopolies. In return for being granted an exclusive franchise to serve a
local market, the utility is subject to price regulation according to the fair-return principle.
Although fair-return pricing allows a utility to realize a price that covers average total cost, it
does not provide the incentive for a utility to minimize its costs.
6. A spillover is a cost or benefit imposed on people other than the producers and consumers of
a good or service. When the production of some good results in spillover costs, too much of
it is produced and there is an over allocation of resources to its use. Conversely,
underproduction and under allocation of resources arise from spillover benefits.
7. Social regulation attempts to correct a variety of undesirable side effects in a market economy
that relate to health, safety, and the environment—effects that markets, left to themselves,
often ignore. Among the federal government agencies involved in social regulation are the
Environmental Protection Agency, the Consumer Product Safety Commission, the Food and
Drug Administration, and the Occupational Safety and Health Administration.
8. Public goods, such as national defense, are indivisible and are not subject to the exclusion
principle. As a result, the market system fails to efficiently supply public goods.
9. Without adequate information, markets may give false signals, incentives may get distorted,
and sometimes markets may simply not exist. In such cases, government may decide to step
in the correct the market failure.
66
Chapter 7: Government Markets
67
10. Because an unregulated market may fail to provide a fair distribution of income and output
for society, government modifies the distribution of income through taxation and transfer
payment programs.
Chapter Objectives
After reading this chapter, you should be able to:
1. Explain why markets sometimes fail to allocate resources efficiently.
2. Describe the nature and operation of antitrust policy.
3. Assess the advantages and disadvantages of economic regulation versus social regulation.
4. Explain why public utilities, such as electricity and cable television, have traditionally been
provided an exclusive franchise to serve a local community.
5. Identify the factors that contribute to the failure of the market system.
Knowledge Check
Key Concept Quiz
1. market failure
_____ a. goods subject to the exclusion principle
2. antitrust policy
_____ b. goods that are indivisible
3. fair return price
_____ c. is designed to correct undesirable side effects of a
market economy in areas of health, safety and the
environment
4. spillover effect
5. incentive-based
regulation
6. social regulation
7. private goods
8. public goods
9. manufacturer’s suggested
retail price (MSRP)
10. invoice cost
_____ d. when a firm can charge a price only high enough to
cover average total cost
_____ e. flexible methods of reducing spillover costs
_____ f. an attempt to curb anti-competitive behavior
_____ g. also known as the window sticker price
_____ h. can take the form of either cash or low-rate financing
offers
11. rebates
_____ i. a payment made by manufacturers to dealerships to
finance its inventory of cars
12. holdback
_____ j. when markets do not allocate resources efficiently
_____ k. is a cost or a benefit and is a reason for market failure
_____ l what the dealer paid for the car
Multiple Choice Questions
1. All of the following are sources of market failure except
a. monopoly power
68
Chapter 7: Government Markets
b. public goods
c. spillovers
d. production of output, where MR = P = ATC
2. Unlike a competitive market, a monopoly imposes a “tax” on consumers because it
a.
b.
c.
d.
charges a higher price
produces a smaller quantity
earns economic profits
all of the above
3. A monopoly
a.
b.
c.
d.
earns normal profits
produces more than a competitive firm
is an example of market failure
produces less than a competitive firm
4. Antitrust policy is designed to do all of the following except
a.
b.
c.
d.
limit the scope of regulation
prevent unfair business practices
prevent price fixing conspiracies
foil predatory activity by firms to achieve monopoly power
5. The passage of the Sherman Act of 1890 allowed the federal government to
a.
b.
c.
d.
protect consumers from firms changing unfair prices
prevent collusive agreements among firms attempting to control markets
take legal action against firms engaging in illegal monopoly behavior
all of the above
6. The Clayton Act of 1914 made explicit the intent of the Sherman Act by outlawing all of the
following business practices except
a.
b.
c.
d.
price discrimination not justified by cost differences
mergers that lessen competition
interlocking directorates
earning economic profits
7. The antitrust laws are applicable to all of the following types of business enterprises except
a.
b.
c.
d.
natural monopolies
manufacturing firms
marketing firms
transportation companies
8. A paint producer dumps effluents into an adjacent stream. These effluents reduce the fish
harvest of the hatchery downstream. This is an example of a (an)
a.
b.
c.
d.
externality
spillover cost
overallocation of resources
all of the above
Chapter 7: Government Markets
69
9. Social regulation is designed to correct undesirable side effects of markets in all of these
areas except
a.
b.
c.
d.
health
safety
the environment
social attitudes
10. Private goods are
a.
b.
c.
d.
divisible
subject to the exclusion principle
characterized by the principle of rival consumption
all of the above
11. Public goods are
a.
b.
c.
d.
indivisible
consumed only by those who are willing to pay for them
always bought and sold in a competitive market
all of the above
12. Public goods are
a.
b.
c.
d.
under produced by the competitive market
not subject to the exclusion principle
have a high likelihood of being prey to the free-rider problem
all of the above
13. When the insurance industry follows a uniform pricing policy, it may result in
a.
b.
c.
d.
people with more health risks buying insurance
higher insurance premiums
less coverage
all of the above
14. All of the following are examples of transfer payments except
a.
b.
c.
d.
unemployment compensation
Medicare
business subsidies
taxes paid by polluters
15. The polluter-pays principle is supposed to
a. provide polluters with incentives to develop more efficient pollution control techniques
b. incorporate the cost of pollution prevention into the prices of goods and services that
cause pollution
c. all of the above
d. punish all polluters
16. The approach that the U.S. government has generally used to force companies to reduce their
pollution is
a. fair-return regulation
b. command-and-control regulation
c. incentive-based regulation
70
Chapter 7: Government Markets
d. antitrust regulation
17. Critics of fair-return regulation maintain that it may result in
a.
b.
c.
d.
economic losses incurred by the regulated firm
excessive costs incurred by the regulated firm
interlocking directorates among the board of directors of competing firms
tying contracts between the regulated firm and its customers
18. With pollution, market failure occurs because a firm does not take into account spillover
costs. As a result
a.
b.
c.
d.
too much output will be produced at too low a price
too much output will be produced at too high a price
too little output will be produced at too low a price
too little output will be produced at too high a price
19. Which antitrust law proclaimed that contracts and conspiracies in restraint of trade,
monopolies, attempts to monopolize, and conspiracies to monopolize are illegal?
a.
b.
c.
d.
Clayton Act
Celler-Kefauver Act
Robinson-Patman Act
Sherman Act
20. If Microsoft is a natural monopoly, antitrust policies that break it up would
e.
f.
g.
h.
enhance its ability to compete with foreign rivals
limit the benefits that may be acquired from economies of scale
enhance the ability of the separate firms to realize economies of scale
make it harder for the firm to prevent diseconomies of scale
21. The United Auto Workers (UAW) provides an example of a (an)
a.
b.
c.
d.
industrial union
craft union
exclusive union
public employee union
22. The United Steel Workers (USW) attempts to raise wages for its members by
a.
b.
c.
d.
decreasing the demand for steel workers
reducing tariffs and quotas on steel imports
imposing an above-equilibrium floor on wages
reducing productivity of steel workers
23. About _______ of the American labor force currently belongs to labor unions
a.
b.
c.
d.
86 percent
54 percent
38 percent
14 percent
Chapter 7: Government Markets
71
24. Empirical research has found that increases in the minimum wage cause
a.
b.
c.
d.
rising employment, especially among elderly workers
rising unemployment, especially among teenagers
sharp reductions in the productivity of workers
many large corporations to become bankrupt
25. The minimum wage is essentially a
a.
b.
c.
d.
price floor
price ceiling
tax on labor
subsidy to employers
26. If the federal government imposes a minimum wage that is above the market equilibrium
wage, we can expect
a.
b.
c.
d.
a leftward shift in the supply curve of labor
a leftward shift in the demand curve for labor
a decrease in the quantity supplied of labor
a decrease in the quantity demanded of labor
True-False Questions
1.
T
F
Unregulated markets may fail to provide a fair distribution of income and
output.
2.
T
F
When externalities exist, market failures ensue.
3.
T
F
Antitrust policy is designed to curb the powers of natural monopolies.
4.
T
F
Regulation of public utilities provides incentives for cost minimization.
5.
T
F
Public goods are subject to the exclusion principle.
6.
T
F
Private goods are rival in consumption.
7.
T
F
Monopolies typically produce more than competitive markets.
8.
T
F
A regulated firm can change a fair-return price and thus earn an
economic profit.
9.
T
F
An unregulated monopolist typically maximizes profits using the
MC = MR rule.
10.
T
F
Spillovers are always costly.
11.
T
F
Spillover costs lead to overallocation of resources.
12.
T
F
The Clayton Act outlawed tying contracts.
13.
T
F
Banking is an unregulated industry.
14.
T
F
Command-and-control regulations do not specify the price a polluting
company may charge for its product.
15.
T
F
The most widely used method of controlling pollution in the U.S. is
incentive-based regulations.
72
Chapter 7: Government Markets
16.
T
F
Social regulation typically controls social attitudes towards products.
17.
T
F
The international environmental policy of the United States is founded
on the polluter-pays principle.
18.
T
F
The polluter-pays principle pays subsidies to non-polluters.
19.
T
F
Public goods are indivisible.
20.
T
F
Private goods are subject to the free-rider problem.
21.
T
F
By increasing the wages of its members, the United Auto Workers
encourages auto companies to seek substitutes for union workers.
22.
T
F
If the demand for labor is elastic, a rise in the minimum wage will
increase the total wages paid to workers.
23.
T
F
Advocates of an increased minimum wage argue that it will encourage
labor to become more efficient, thus reducing the cost of producing
goods and increasing the demand for labor.
24.
T
F
Although international trade benefits many workers, not all workers gain
from trade.
25.
T
F
Suppose that U.S. wages are three times as high as Chinese wages. If
U.S. workers are more than three times as productive as Chinese
workers, U.S. workers are less costly.
26.
T
F
Nonunion workers at Japanese auto plants in the United States tend to
validate relatively high wages paid to unionized workers at Ford and
General Motors.
27.
T
F
On average, union workers are paid lower wages than comparable
nonunion workers.
Application Questions
1. The city council members of Fair City, Nofunland have decided that drinking is associated
with spillover costs. The council decides to impose a sin tax of one dollar per quart on
whiskey. The following table shows the market for whiskey in the absence of a tax.
Price
($/quart)
Quantity
Demanded
Quantity
Supplied
$5
1,000,000
1,000,000
$10
400,000
2,000,000
a. Graph the supply and demand curves. What is the equilibrium price and quantity?
b. Illustrate the changes in the market when the tax is imposed. Shade in the amount of
revenue that the government will generate from the tax.
Chapter 7: Government Markets
2. Assume that smoke detector alarms have significant spillover benefits. The following
analysis pertains to the market for smoke detector alarms in the small, densely populated
residential downtown of Paris, Texas.
a. If the government decides to pursue a hands-off approach, will this market allocate
resources efficiently?
b. The city government decides to subsidize the sellers of smoke alarms. Illustrate the
changes in the market. What happens to the equilibrium price and quantity?
c. The city government decides to subsidize the buyers of smoke alarms. Illustrate the
changes in the market. What happens to the equilibrium price and quantity?
Answers to Knowledge Check Questions
Key Concept Answers
1. j
4. k
2. f
5. e
3. d
6. c
7. a
8. b
9. g
10. l
11. h
12. i
Multiple Choice Answers
1. d
6. d
2. d
7. a
3. d
8. d
4. a
9. d
5. c
10. d
11.
12.
13.
14.
15.
a
d
d
d
c
16.
17.
18.
19.
20.
b
b
a
d
b
21.
22.
23.
24.
25.
a
c
d
b
a
26. d
True-False Answers
1. T
6. T
2. T
7. F
3. F
8. F
4. F
9. T
11.
12.
13.
14.
T
F
F
T
16.
17.
18.
19.
F
T
F
T
21.
22.
23.
24.
T
F
T
T
26. F
27. F
73
74
Chapter 7: Government Markets
5. F
10. F
15. F
20. F
25. T
Application Question Answers
1. a. Equilibrium price = $5.00
Equilibrium quantity = 1,000,000
The following diagram shows the supply and demand curves in the whiskey market.
Market for Whiskey
Price
S
$10
$5
$1
D
400,000
1,000,000
2,000,000
Quantity
Chapter 7: Government Markets
b. The following diagram shows the changes in the whiskey market when the sin tax is
imposed. The shaded area shows the amount of revenue the government will generate
from the tax.
Changes in the Whiskey Market
New Equilibrium
Price
S'
(after tax)
$10
S
(without tax)
$1

$5
TAX
Old Equilibrium

$1
$1
D
0
400,000
800,000
1,000,000
2,000,000
Quantity
2. a. No, the market will underproduce smoke alarms. The spillover benefits cause a market
failure.
b. The following diagram shows the market for smoke alarms with a subsidy to sellers.
Market for Smoke Alarms with Subsidy to
Sellers
Price
Market Equilibrium
without Subsidy
$30
S
S'
$20

$10

Market Equilibrium
with Subsidy
D
0
50
100
150
200
250
Quantity
75
Chapter 7: Government Markets
c. The following diagram shows the market for smoke alarms with a subsidy to consumers.
Market for Smoke Alarms with Subsidy to Consumers
Price
76
Market Equilibrium with
Subsidy
$30
S
$20


$10
Market Equilibrium
without Subsidy
D
D′
0
50
100
150
200
250
Quantity