Government Regulation

1
Chapter 14

• Government Regulation

2
Market Failure

• Government intervenes when markets fail to be
  efficient
• 1. market power
• 2. externalities
• 3. public goods
• 4. incomplete information
• Regulations change behavior by changing incentives

3
Monopoly Inefficiency

• Market power inefficient pricing because P gt MC
• Reduced gains from trade because of reduced trade.

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• At monopoly QM, MR MC but MB gt MC.
• Dead-weight loss is area A, where MB gt MC.
• At Q, MB MC, maxd gains from trade.

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Antitrust Policy

• Reduce deadweight loss by minimizing monopoly
  power by prohibiting
• 1. price fixing and collusion
• 2. efforts to restrict trade
• 3. predatory pricing
• 4. price discrimination that promotes monopoly
• 5. horizontal mergers that monopolize an industry

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Difficult to Administer

• Determining whether particular actions are
  illegal is difficult.
• Example Microsoft.
• Mergers can result in lower costs.
• Herfindahl-Hirshman index used to measure
  concentration post merger.
• FTC issues cease-and-desist orders.
• DOJ issues fines.

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Natural Monopolies

• Price regulation is used to take advantage of
  economies of scale from a monopoly.
• Economies of scale are due to large fixed costs.
• Average cost is declining out to market demand.
• Price regulation changes production incentives.
• Optimal price is equal to marginal cost.

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• If the regulated price PR equals the market
  clearing price P, then efficient production
  occurs.
• MR PR so firm chooses Q where P MC(Q)

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• Problem is to find P where P MC.
• If PR ? P, production QR will be inefficient.
• If PR lt P, too little is produced.

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Economies of Scale

• Firm profits under price regulation depend on ATC

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• At PM, profits are positive, because PM gt ATC
• At PR MC, profits are negative because PR lt ATC
• In the long run, the firm will exit the market.
• Subsidies can make up for low price.
• If government subsidies guarantee zero profits,
  firm has no incentive to minimize costs.

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Externalities

• Externalities are effects on people who are not
  party to the production or consumption of the
  good.
• Externalities can be negative or positive.
• Pollution is a negative externality.
• Landscaping your yard provides a positive
  externality.

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Negative Externality

• If firms do not bear the costs of negative
  externalities, then they produce too much.

14
Over-Production

• The competitive market clearing quantity with
  private costs is QC.
• But MCsocial gt MB
• The socially optimal quantity is QS, where
• MCsocial MB

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Solution Property Rights

• Basic problem with externalities is lack of
  property rights.
• If firms have right to produce air pollution,
  then those affected can bribe firms to produce
  less.
• If others have right to clean air then firms must
  pay for polluting it.
• Problem is bargaining costs.

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Pollution Taxes

• Government can enforce rights to clean air by
  taxing polluters.
• A per-unit tax on production increases MCprivate
• The correct tax is equal to the per-unit cost of
  pollution.

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• Now firms have MCprivateT and produce QS where
  MCprivateT D.
• External costs of pollution are internalized.
• Pollution is reduced with production.

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Pollution Permits

• Pollution permits can be sold to other firms.
• Firms with the highest abatement costs will buy
  permits and continue to pollute.
• Firms with low abatement costs will sell permits
  and reduce pollution.
• This reduces pollution at the lowest cost
• Also provides incentives to develop new abatement
  technologies.

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Public Goods

• Public goods are goods that can be enjoyed by all
  once they are provided.
• Nonexclusionary people cannot be excluded if
  they do not pay.
• Nonrivalrous use by one person does not diminish
  use by others.
• Examples broadcast signals, national defense,
  lighthouses, building security.

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Government Provision

• Public goods will not be provided privately.
• Producer cannot force consumers to pay for the
  good.
• Consumers can be free riders.
• Government can force payment for public goods
  through taxation.

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Private Provision

• Private companies provide quasi-public goods for
  employees, like security guards, public rooms and
  facilities.
• Employees pay for these through reduced
  salaries.
• How many security guards should be supplied?

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High-risk Employees

• If each of the 3 employees values guards
  according to this demand function
• Pi 30 ? Q
• then this is the price each would be willing to
  pay for Q guards.
• Total amount that all would be willing to pay is
• P ?i Pi 90 ? 3Q

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Optimal Security

• If the MC of providing a guard is 54 then choose
  Q so that P 54.

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• This optimal number of guards is Q 12 and each
  of the three employees values each of them at
  18.
• If each paid 18 for each guard, then total is 3 ?
  18 54 MC.
• However, no employee would voluntarily pay.
• Security is a public good.
• Each would want to enjoy the security without
  having to pay.

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Determining Valuations

• If asked, none would reveal their true valuation
  of the guards.
• The firm can still provide the security guards,
  but it will not know true valuations of
  employees.
• Each employee will under-represent valuations if
  required to pay that reported value.
• Each will over-represent if they do not have to
  pay the represented valuation.

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Information as a Public Good

• Incomplete information can prevent trade from
  taking place.
• In some markets, government policy provides
  information or restricts its use to improve
  efficiency of markets.
• Costs make it prohibitive for individuals to
  provide it for themselves.
• Examples health hazards of products and foods,
  safety regulations in the workplace.

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Private Information

• Insider trading discourages others informed will
  sell only if price will fall and buy only if
  price will rise.
• Either way, the uninformed makes a bad trade.
• Others argue that by trading on private
  information, markets are more efficient.

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Regulating Information

• Certification requires that physicians, teachers,
  etc. satisfy minimum standards.
• Individuals do not have expertise to evaluate
  professionals.
• Truth in Lending is meant to assure all borrowers
  of full information of the conditions under which
  they are borrowing.
• Regulations increase the cost of lending.

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Justice is a Public Good

• Truth in advertising laws are meant to prevent
  misleading information to consumers about
  products.
• Both consumers and competitors can sue under
  these laws.
• Contract enforcement is meant to prevent
  opportunistic behavior and prevent end game
  cheating.
• The judicial system is a public good.

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Power Corrupts

• Government remedies can lead to power brokering.
• Government power leads to efforts to influence
  policy.
• Consumers prefer more competitive markets.
• Firms prefer monopolies.
• Each may allocate resources to lobby for bills
  that are in their interest.

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Limited Government

• If the benefits of legislation are concentrated
  and costs are dispersed, then lobbying will be
  done to pass bills.
• The more power the government has, the more
  lobbying will be done.
• By reducing the governments power to affect
  individuals interests, lobbying efforts would be
  decreased.