Managerial Economics
ninth edition
Thomas
Maurice
Chapter 16
Government
Regulation of Business
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics, 9e
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Managerial Economics
Market Competition & Social
Economic Efficiency
• Social economic efficiency
• Exists when the goods & services that
society desires are produced &
consumed with no waste from
inefficiency
• Two efficiency conditions must be met


16-2
Productive efficiency
Allocative efficiency
Managerial Economics
Productive Efficiency
• Exists when suppliers produce
goods & services at the lowest
possible total cost to society
• Occurs when firms operate along
their expansion paths in both the
short-run & long-run
16-3
Managerial Economics
Allocative Efficiency
• Requires businesses to supply optimal
amounts of all goods & services
demanded by society
• And these units must be rationed to
individuals who place the highest value on
consuming them
• Optimal level of output is reached when
the MB of another unit to consumers
just equals the MC to society of
producing another unit
• Where P = MC (marginal-cost-pricing)
16-4
Managerial Economics
Social Economic Efficiency
• Achieved by markets in perfectly
competitive equilibrium
• At the intersection of demand &
supply, conditions for productive &
allocative efficiency are met
• At the market-clearing price, buyers &
sellers engage in voluntary exchange
that maximizes social surplus
16-5
Managerial Economics
Efficiency in Perfect Competition
(Figure 16.1)
16-6
Managerial Economics
Market Failure & the Case for
Government Intervention
• Competitive markets can achieve social
economic efficiency without government
regulation
• But, not all markets are competitive, and
even competitive markets can sometimes
fail to achieve maximum social surplus
• Market failure
• When a market fails to achieve social economic
efficiency and, consequently, fails to maximize
social surplus
16-7
Managerial Economics
Market Failure & the Case for
Government Intervention
• Six forms of market failure can
undermine economic efficiency:
•
•
•
•
•
•
16-8
Monopoly power
Natural monopoly
Negative (& positive) externalities
Common property resources
Public goods
Information problems
Managerial Economics
Market Failure & the Case for
Government Intervention
• Absent market failure, no efficiency
argument can be made for
government intervention in
competitive markets
16-9
Managerial Economics
Market Power & Public Policy
• Firms with market power must price
above marginal cost to maximize profit
(P > MC)
• These firms fail to achieve allocative
efficiency, which reduces social surplus

Lost surplus is a deadweight loss
• Allocative efficiency is lost because the
profit-maximizing price does not result in
marginal-cost-pricing


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At the profit-maximizing point, MB > MC
Resources are underallocated to the industry
Managerial Economics
Louisiana White Shrimp Market
(Figure 16.2)
16-11
Managerial Economics
Market Power & Public Policy
• When the degree of market power
grows high enough, antitrust
officials refer to it legally as
monopoly power
• No clear legal threshold has been
established to determine when market
power becomes monopoly power
16-12
Managerial Economics
Promoting Competition Through
Antitrust Policy
• A high degree of market power (or
monopoly power) can arise in three
ways:
• Actual or attempted monopolization
• Price-fixing cartels
• Mergers among horizontal competitors
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Managerial Economics
Promoting Competition Through
Antitrust Policy
• Firms may be found guilty of actual
monopolization only if both of the
following conditions are met:
• Behavior is judged to be undertaken
for the sole purpose of creating
monopoly power
• Firm successfully achieves high degree
of market power
• Firms can also be guilty of
attempted monopolization
16-14
Managerial Economics
Natural Monopoly & Market
Failure
• Natural monopoly
• When a single firm can produce total
consumer demand for a good or
service at a lower long-run total cost
than if two or more firms produce
total industry output
• Long-run costs are subadditive
16-15
Managerial Economics
Subadditive Costs & Natural
Monopoly (Figure 16.3)
16-16
Managerial Economics
Natural Monopoly & Market
Failure
• Breaking up a natural monopoly is
undesirable
• Increasing number of firms drives up
total cost & undermines productive
efficiency
• Under natural monopoly, no single
price can establish social
economic efficiency
16-17
Managerial Economics
Regulating Price Under Natural
Monopoly (Figure 16.4)
16-18
Managerial Economics
Natural Monopoly & Market
Failure
• With economies of scale, marginalcost-pricing results in a regulated
natural monopoly earning negative
economic profit
• Two-part pricing is a solution that
can meet both efficiency
conditions & maximize social
surplus
16-19
Managerial Economics
The Problem of Negative
Externality
• Externalities
• When actions taken by market
participants create either benefits or
costs that spill over to other members
of society
• Positive externalities occur when
spillover effects are beneficial to
society
• Negative externalities occur when
spillover effects are costly to society
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Managerial Economics
The Problem of Negative
Externality
• Externalities undermine allocative
efficiency
• Market participants rationally choose
to ignore the benefits & costs of their
actions that spill over to others
• Competitive market prices do not
capture social benefits or costs that
spill over to society
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Managerial Economics
The Problem of Negative
Externality
• Managers rationally ignore external
costs when making profitmaximizing production decisions
• Social cost of production:
Social cost = Private cost + External cost
Or
Social cost – Private cost = External cost
16-22
Managerial Economics
Negative Externality & Allocative
Inefficiency (Figure 16.5)
16-23
Managerial Economics
Pollution as a Negative Externality
(Figure 16.6)
16-24
Managerial Economics
Finding the Optimal Level of
Pollution (Figure 16.7)
16-25
Managerial Economics
Optimal Emission Taxation
(Figure 16.8)
16-26
Managerial Economics
Nonexcludability
• Two kinds of market failure caused
by nonexcludability:
• Common property resources
• Public goods
16-27
Managerial Economics
Common Property Resources
• Resources for which property
rights are absent or poorly defined
• No one can effectively be excluded
from such resources
• Without government intervention,
these resources are generally
overexploited & undersupplied
16-28
Managerial Economics
Public Goods
• A public good is nonexcludable &
nondepletable
• The inability to exclude nonpayers
creates a free-rider problem for the
private provision of public goods
• Even when private firms supply public
goods, a deadweight loss can be
avoided only if the price of the good is
zero
16-29
Managerial Economics
Information & Market Failure
• Market failure may also occur
because consumers lack perfect
knowledge
• Perfect knowledge includes knowledge
about product prices, qualities, and
any hazards
• Market power can emerge because
of imperfectly informed consumers
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Managerial Economics
Information & Market Failure
• Consumers may over- or underestimate quality of goods &
services
• If they over-value quality, they will
demand too much product relative to
the allocatively efficient amount
• If they under-value quality, they will
demand too little
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Managerial Economics
Imperfect Information on Product
Quality (Figure 16.9)
16-32