Chapter 16 Government and Business Table of Contents • 16.1 Market Failure & Government Policy • 16.2 Regulation of Imperfectly Competitive Markets • 16.3 Antitrust Law & Competition Policy • 16.4 Externalities • 16.5 Open-Access, Club, & Public Goods • 16.6 Intellectual Property 16-2 © 2014 Pearson Education, Inc All rights reserved Introduction • Managerial Problem – – Consider a competitive market in which all firms use the same technology, but one firm invents a new, lower-cost process Should that firm patent its invention or keep it a trade secret? If the innovating firm manufactures the good itself, under what conditions can it charge the monopoly price? If the innovating firm obtains a patent, will the firm earn more if it produces itself or if it licenses its new process to other firms? • Solution Approach – We need to examine market failures that arise due to incomplete property rights and government policies that directly regulate, assign, and enforce property rights • Empirical Methods – – 16-3 Governments respond to market failures that arise from non-competitive market structures in a preventive or remedial approach with regulation, antitrust, and competition policy Governments also respond to externalities, a market failure due to incomplete property rights (open-access, club, public goods, patents, and copyrights) © 2014 Pearson Education, Inc All rights reserved 16.1 Market Failure & Government Policy • Economic Efficiency and Government Policy – Perfectly competitive markets achieve economic efficiency: total surplus is maximized However, most markets exhibit a significant market failure, which substantially reduce economic efficiency and result in deadweight losses – One important rationale for government policy is to reduce or eliminate market failure (deadweight loss), but some may win and others lose – Economists evaluate the desirability of government policy with two lenses: the Pareto Principle and Cost-Benefit Analysis • The Pareto Principle – Pareto Principle: change that benefits some people without harming anyone else – A government policy that eliminates a market failure is a Pareto improvement if the reallocation of goods or productive inputs helps at least one person without harming anyone else – The outcome is Pareto efficient once all possible Pareto improvements have occurred So, any additional change would harm at least one person 16-4 © 2014 Pearson Education, Inc All rights reserved 16.1 Market Failure & Government Policy • Cost-Benefit Principle – The cost-benefit principle: a change is desirable if its benefits exceed the costs – The cost-benefit principle supports policies that increase total surplus, even if some will be harmed • Pareto and Cost-Benefit Compared – Any policy that generates a Pareto improvement satisfies the cost-benefit principle If some people gain from a policy and no one suffers a loss, then the aggregate benefit is positive However, the converse is not true – In practice, policies that have large net benefits and small distributional effects tend to generate broad support But, policies with small net benefits and large distributional effects are likely to be more contentious, especially if the distributional effect is regressive (worse income distribution) 16-5 © 2014 Pearson Education, Inc All rights reserved 16.2 Regulation of Imperfectly Competitive Markets • First Approach to Eliminate Market Failure – A government can eliminate imperfectly competitive pricing by a monopolist with a direct approach: own the monopoly and set relatively low prices – Example: many governments own and operate electric power and water utilities • Second Approach to Eliminate Market Failure – A government can change the market structure using antitrust or competition laws – Example: the U.S government increased the number of aluminum manufacturers during World War II, ending Alcoa’s monopoly • Third Approach to Eliminate Market Failure – A government can regulate the industry to prevent firms from setting excessively high prices – We will focus on this third approach next 16-6 © 2014 Pearson Education, Inc All rights reserved 16.2 Regulation of Imperfectly Competitive Markets • Optimal Price Regulation: Cap Price – A government can eliminate the deadweight loss of monopoly by imposing a price cap equal to the price that would prevail in a competitive market – Example: Price cap regulation is used for telecommunications monopolies in 33 U.S states, and many countries including Australia, Canada, Denmark, France, Germany, Mexico, Sweden, and the U.K • Efficient Cap Price Regulation: Graph Analysis – In Figure 16.1, an unregulated monopoly maximizes its profit at em, where MR = MC The monopoly sells units at a price of $18 per unit, and society suffers a deadweight loss, –C – E – The government sets a price cap at $16 (horizontal demand for the monopolist) and the regulated monopolist maximizes profit at eo, where MRr = MC The monopolist sells units at the maximum price allowed of $16 – This is an optimal price cap because it gives a competitive price and the deadweight loss is eliminated 16-7 © 2014 Pearson Education, Inc All rights reserved 16.2 Regulation of Imperfectly Competitive Markets Figure 16.1 Optimal Price Regulation 16-8 © 2014 Pearson Education, Inc All rights reserved 16.2 Regulation of Imperfectly Competitive Markets • Non Optimal Price Regulation Due to Poor Information – Well-intentioned government regulators often fail to regulate monopolies optimally because of limited information about the monopoly’s demand and cost curves – If regulators rely on the monopoly or on industry experts for information, they may be misled, and the price cap may be above or below the efficient level resulting in a deadweight loss • Non Optimal Price Regulation Due to Inability to Subsidize – If a monopolist exhibits economies of scale, a price cap regulation based on MC may force the monopolist to shutdown because MC < AC, unless it gets a subsidy – Given that subsidizing a monopolist may not be politically viable, a better regulation is to set the price cap equal to the average cost so that firm continues to operate (Pareto improvement over marginal cost pricing) 16-9 © 2014 Pearson Education, Inc All rights reserved 16.2 Regulation of Imperfectly Competitive Markets • Regulatory Capture – Some regulators may be captured so that they regulate in the manner that the industry wants (the interests of the industry ahead of the public interest) – Firms engage in rent seeking practices (devote effort and expenditures to gain a rent of profit from government actions) to capture some regulators – A captured regulator’s objective might be to keep prices high rather than low, so they may impose entry restrictions to keep potential competitors out • Applying the Cost-Benefit Principle to Regulation – Regulating all markets where P > MC (market failure) will not increase total surplus because many regulations would not pass a cost-benefit test – Regulation has its own costs: costs of gathering information, costs of honest mistakes, costs of captured regulators, costs of rent seeking – Price regulation passes a cost-benefit test only when the market failure is large enough that the benefits from significantly reducing it exceed the cost associated with regulation 16-10 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities • Regulation to Reduce Externalities – If a government has sufficient knowledge about pollution damage, the demand curve, costs, and the production technology, it can force a competitive market to produce the social optimum – The government can control pollution directly or indirectly It can control pollution directly by setting emissions standards or taxing pollution with emission fees or effluent charges It can it indirectly by limiting outputs or inputs – Direct pollution regulation encourages firms to adopt efficient new technologies • Another Approach to Reduce Externalities: Property Rights – Government agencies or courts could clearly assign property rights giving one party the right to pollute or the other party the right to be free from pollution – If clear property rights can be established, pollution can be priced and the externality problem can be reduced or eliminated 16-18 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities • Emissions Standards – In Figure 16.2, the government can maximize total surplus by enacting an emission standard that prohibits paper mills to produce more than 84 units of paper per day (pollution is directly related to paper output) – Limitations: the government may not have full information to set the correct emission standard, or may have limited monitoring and enforcing resources • Emission Fees – In the paper mill case, if the government knows the marginal cost of the emissions, MCx, it can set the output tax, t(Q), which varies with output, Q, equal to this marginal cost curve: t(Q) = MCx – Usually, the government sets a specific tax rather than a tax that varies with the amount of pollution 16-19 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities • Property Rights and the Coase Theorem – Coase Theorem (Coase, 1960): a polluter and its victim can achieve the optimal levels of pollution if property rights are clearly defined and they can bargain effectively – The Coase Theorem demonstrates that unclear property rights is the root of the externality problem However, it may not be practical for most cases • Secret Garden Tea House & Fixit Car-body Shop Case – Fixit causes noise pollution, which hurts business at the Secret Garden – As Table 16.1 shows, if Fixit works on more cars per hour, its profit increases, but the resulting extra noise reduces the tea house’s profit The last column shows the total profit of the two firms Having the auto body shop work on one car at a time maximizes their joint profit Anything else is inefficient 16-20 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities Table 16.1 Daily Profits Vary with Production and Noise 16-21 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities • Unclear Property Rights for Fixit and Secret Garden – Initially, because property rights are not clearly defined, Fixit won’t negotiate with the Secret Garden After all, why would Fixit reduce its output and the associated noise, if the Secret Garden has no legal right to be free of noise? – So, Fixit works on two cars per hour and maximizes its profit at 400 (Table 16.1) The excessive noise drives the Secret Garden out of business; joint profit is 400 • Defining Clear Property Rights for Fixit & Secret Garden – Suppose the Secret Garden gets the right to silence If it forces Fixit to shut down, the Secret Garden makes 400 and their joint profit is 400 However, if Fixit works on one car, its gain is 300, while the Secret Garden loses only 200 – The firms should be able to reach an agreement where Fixit pays the tea house between 200 and 300 for the right to work on one car Under such an agreement, their joint profit is maximized at 500 – If Fixit gets the right to noise, a similar beneficial outcome is produced 16-22 © 2014 Pearson Education, Inc All rights reserved 16.4 Externalities • Three Lessons from the Coase Theorem – If property rights are not clear, one firm pollutes excessively and joint profit is not maximized – Assigning property rights maximizes joint profit, regardless of who gets the rights – Who gets the property rights affects the distribution of the joint profit • Coase Theorem Limitations: Transaction & Information Costs – If transaction costs are so high that it doesn’t pay for the two sides to meet, bargaining is not possible – If either party lacks information about the costs or benefits of reducing pollution, bargaining is not possible either – For these reasons, the Coase Theorem is not viable in many pollution cases 16-23 © 2014 Pearson Education, Inc All rights reserved 16.5 Open-Access, Club, & Public Goods • Rivalry and Exclusion Properties – Rivalry: If Jane eats an orange, that orange is gone so no one else can consume it – Exclusion: If Jane owns an orange, she can prevent others from consuming it – No-rivalry and no-exclusion: if Jane breaths clean air, others can still ‘consume’ clean air and she cannot prevent others from breathing – Oranges have rivalry and exclusion properties, while clean air has norivalry and no-exclusion properties • Goods and Rivalry and Exclusion Properties – – – – 16-24 Private Goods have rivalry and exclusion properties Open-Access Common Property have rivalry and no-exclusion properties Club Goods have no-rivalry and exclusion properties Public Goods have no-rivalry and no-exclusion properties © 2014 Pearson Education, Inc All rights reserved 16.5 Open-Access, Club, & Public Goods • Open-Access Common Property – Open Access Fishery: Anyone can fish in an open-access fishery so it is nonexclusive, but a fish is rival – Problem: Each fisher wants to catch a given fish before others so as to gain the property right to that fish, even if that means catching fish while they are still young and small The lack of clearly defined property rights leads to overfishing – Externality: The social cost of catching a fish is the private cost plus the externality cost from reduced current and future populations of fish Thus, the market failure arising from open-access common property is a negative externality – Other examples: Oil and natural gas reserves, public freeways • Solutions to Common Property – Government regulation that restricts access to the commons (first-come, first-served basis; entrance fee or tax) – Assigning Clear Property Rights converts open-access common property into private property and removes the incentive to overuse it 16-25 © 2014 Pearson Education, Inc All rights reserved 16.5 Open-Access, Club, & Public Goods • Club Goods – Golf or Swim Club: These clubs exclude people who not pay membership fees, but the services they provide, swimming or golfing, are nonrival until full capacity is reached – Problem: The marginal cost for the club of accepting an additional member is close to zero, but clubs charge more than that – Externality: The amount of the club good provided is less than the optimal based on zero marginal cost, so this is a market failure and creates a deadweight loss – Other example: Cable TV • Solutions to Club Goods – Although club goods create a market failure, government intervention is rare because it is difficult for the government to help Forcing a private firm to sell products at near zero marginal cost may force the firm to shut down, and the deadweight loss would be even bigger 16-26 © 2014 Pearson Education, Inc All rights reserved 16.5 Open-Access, Club, & Public Goods • Public Goods – Clean air: Clean air is nonrival and nonexclusive – Free rider problem: because clean air is nonexclusive, people benefit from the cleaning efforts (positive externality) without paying Consequently, it is very difficult for firms to profitably provide clean air or any public good because few people want to pay for the good no matter how valuable it is to them – Externality: public goods tend to be undersupplied by markets So, this is a market failure and creates a deadweight loss – Other examples: security services, national defense • Solutions to Free Riding – One solution is for the government to provide these goods – Other solutions require governmental or collective actions such as social pressure, mergers, privatization, and compulsion 16-27 © 2014 Pearson Education, Inc All rights reserved 16.6 Intellectual Property • Patents – A patent is a piece of intellectual property that can be treated like any other type of property It grants the inventor’s firm the exclusive rights over the invention for 20 years in the United States and in most other countries – The owner of a patent may choose to be the sole producer of the product, license others to produce the good for a fee, or sell the patent – The patent system greatly reduces the free-rider problem However, its key disadvantage is that a patent creates monopoly power • Alternatives to Patents – One important alternative is for the government to fund research by firms and universities, encouraging the knowledge from the discovery’s public or open source – Another method is to offer a prize for a discovery 16-28 © 2014 Pearson Education, Inc All rights reserved Managerial Solution • Managerial Problem – Should a firm patent its invention or keep it a trade secret? If the innovating firm manufactures the good itself, under what conditions can it charge the monopoly price? If the innovating firm obtains a patent, will the firm earn more if it produces itself or if it licenses its new process to other firms? • Solution – A firm may opt for patenting if the extra protection secures income generation, including license fees However, the firm may opt for trade secrets if it is costly to apply for a patent; if the firm may be able to maintain a secret indefinitely (Coca Cola formula); and if the firm doesn’t want others to use the patent to create another invention that is sufficiently different – The innovative firm can charge the monopoly price if this price is below the price of the competitive horizontal supply curve – The innovative firm may decide to produce itself as a monopoly or license the new process to other firms and create a competitive market depending on how much these firms are willing to pay for the license 16-29 © 2014 Pearson Education, Inc All rights reserved Figure 16.3 Using Taxes to Control Pollution 16-30 © 2014 Pearson Education, Inc All rights reserved Table 16.2 Rivalry and Exclusion 16-31 © 2014 Pearson Education, Inc All rights reserved Figure 16.4 Inadequate Provision of a Public Good 16-32 © 2014 Pearson Education, Inc All rights reserved ... (horizontal demand for the monopolist) and the regulated monopolist maximizes profit at eo, where MRr = MC The monopolist sells units at the maximum price allowed of $16 – This is an optimal price... the government may not have full information to set the correct emission standard, or may have limited monitoring and enforcing resources • Emission Fees – In the paper mill case, if the government. .. eliminate imperfectly competitive pricing by a monopolist with a direct approach: own the monopoly and set relatively low prices – Example: many governments own and operate electric power and