A MANAGER’S GUIDE TO GOVERNMENT IN THE MARKET PLACE
TABLE OF CONTENTS
According to Mr. Michael Bay, author of the Book, “Managerial Economics and Business Strategy”, they have treated the market as a place where firms and consumers come together to trade goods and services with no intervention from government. But as you are aware, rules and regulations that are passed and enforced by government enter into almost every decision firms and consumers make. As a manager, it is important to understand the regulations passed by government, why such regulations have been passed, and how they affect optimal managerial decisions. We will begin by examining four reasons why free markets may fail to provide the socially efficient quantities of goods: (1) market power, (2) externalities, (3) public goods, and (4) incomplete information.
The book analysis includes an overview of government policies designed to alleviate these “market failures” and an explanation of how the policies affect managerial decisions. The power of politicians to institute policies that affect the allocation of resources in markets provides those adversely affected with an incentive to engage in lobbying activities. The book will illustrate the underlying reasons for these types of rent-seeking activities. The book will examine how these activities can lead politicians to impose restrictions such as quotas and tariffs in markets affected by international trade.
•Identify four sources of market failure
•Explain why market power reduces social welfare, and identify two types of government policies aimed at reducing deadweight loss.
•Show why externalities can lead competitive markets to provide socially inefficient quantities of goods and services; explain how government policies, such as the Clean Air Act, can improve resource allocation. •Show why competitive markets fail to provide socially efficient levels of public goods; explain how the government can mitigate these inefficiencies.
•Explain why incomplete information compromises the efficiency of markets, and identify five government policies aimed at mitigating these problems.
•Explain why government attempts to solve market failures can lead to additional inefficiencies because of “rent-seeking” activities. •Show how government policies in international markets, such as quotas and tariffs, impact the prices and quantities of domestic goods and services.
Market failure is a concept within economic theory describing when the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off. Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view.
The existence of a market failure is often used as a justification for government intervention in a particular market. Economists, especially microeconomists, are often concerned with the causes of correction. Such analysis plays an important role in many types of public policy decisions and studies. However, some types of government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations, including attempts to correct market failure, may also lead to an inefficient allocation of resources, sometimes called government failure. HOW IT WORKS / EXAMPLE:
Under free market conditions, prices are determined almost exclusively by the forces of supply and demand. Any shift in one of these results in a price change that signals a corresponding shift in the other. Then, the prices return to an equilibrium level. A market failure results when prices cannot achieve equilibrium because of market distortions (for example, minimum wage requirements or price limits on specific goods and services) that restrict economic output. In the other words, government regulations implemented to promote social wellbeing inevitably result in a degree of market failure.
Market power is the ability of a form to profitably raise the market price of a good or service over marginal cost. In perfectly competitive markets, market participants have no market power. A firm with total market power can raise prices without losing any customers to competitors. Market participants that have market power are therefore sometimes referred to as “price makers”, while those without are sometimes called “price takers”. Significant market power is when prices exceed marginal cost and long run average cost, so the firm makes economic profits. HOW IT WORKS / EXAMPLE:
The macroeconomics concept of perfect competition assumes that no one producer can set a price for the whole market. Among companies that produce similar goods and services, all have varying levels of market power, but none are sufficient to effect a sustainable price change. In other words, all producers must compete based on a collective market price. A monopoly is the best example of a company with substantial market power. With little or no competition, a monopoly can, for example, raise market prices by reducing its level of output.
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
Dollar value of society’s welfare loss
An antitrust policy is designed to affect competition. The general goal behind such a policy is to keep markets open and competitive. These regulations are used by different governments around the world although the laws often vary. Broadly speaking, antitrust law seek to wrong competitor businesses from anti competitive practices. The goals of antitrust policy is to (1) To eliminate deadweight loss of monopoly and promote social welfare and (2) Make it illegal for managers to pursue strategies that foster monopoly power.
Government oversight or direct government control over the price charged in a market, especially by a firm with market control. Price regulation is most commonly used for public utilities characterized as natural monopolies. If allowed to maximize profit restrained, the price charged would exceed marginal cost and production would be inefficient. However, because such firms, as public utilities, produce output that is deemed essential or critical for the public, government steps in to regulate or control the price. The two most common methods of price regulation are marginal-cost pricing and average-cost pricing.
Graphical presentation of Marginal-Cost Pricing:
An externalities is a cost or benefit which results from an activity or transaction and which results from an activity or transaction and which affects an otherwise uninvolved party who did not choose to incur that cost or benefit. For example, manufacturing activities which cause air pollution impose health and clean-up costs on the whole society, while the neighbors of an individual who chooses to fire-proof his home may benefit from a reduced risk of a fire spreading to their own house. If external cost exist, such pollution, the producer may choose to produce more of the product than would be produced if he were required to pay all associated environmental costs.
If there are external benefits, such as in public safety, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved. Thus, it is said that, for good with externalities, unregulated market prices do not reflect the full social costs or benefit of the transaction. Government regulations may induce the socially efficient level of output by forcing firms to internalize pollution costs. Example of this is the Clean Air Act of 1970. EXAMPLES OF EXTERNALITIES
A negative externality is an action of a product on consumers that imposes a negative effect on a third party; it is “social cost”. Air pollution – from burning fossil fuels causes damages to crops, (historic) buildings and public health. Anthropogenic climate change – is attributed to greenhouse gas emissions from burning oil, gas and coal. Water pollution – by industries that adds effluent which harms, animals and human. Noise pollution – which may be is mentally and psychologically disruptive. System risk – describe the risks to the overall economy arising from the risks which the banking system takes. Socially Efficient Equilibrium: Internal and External Costs
In economics, a public good is a good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others. Examples of public goods include fresh air, knowledge, lighthouses, national defense, flood control systems and street lighting. Public goods that are available everywhere are sometimes referred to as global public goods.
Many public goods may at times be subject to excessive use resulting in negative externalities affecting all users; for example air pollution and traffic congestion. Public goods problems are often closely related to the “free-rider” problem, in which people not paying for the good may continue to access it, or the tragedy of the commons, where consumption of a shared resource by individuals acting in their individual and immediate self-interest diminishes or even destroys the original resource. Thus, the good may be under-produced, overused or degraded. Public goods may also become subject to restrictions on access and may then be considered to be club goods or private goods; exclusion mechanisms include copyright, patents, congestion pricing, and pay television.
Uncoordinated markets driven by self-interested parties may be unable to provide these goods. There is a good deal of debate and literature on how to measure the significance of public goods problems in an economy, and to identify the best remedies.
Graphical presentation of Public Goods:
Nonrival: A good which when consumed by one person does not preclude other people from also consuming the good. •Example: Radio signals, national defense
Nonexclusionary: No one is excluded from consuming the good once it is provided. •Example: Clean air
“Free Rider” Problem – Individuals have little incentive to buy a public good because of their nonrival & nonexclusionary nature. Public goods provide a very important example of market failure, in which market-like behavior of individual gain-seeking does not produce efficient results. The production of public goods results in positive externalities which are not remunerated. If private organizations don’t reap all the benefits of a public good which they have produced, their incentives to produce it voluntarily might be insufficient.
Consumers can take advantage of public goods without contributing sufficiently to their creation. This is called the free rider problem, or occasionally, the “easy rider problem” (because consumers’ contributions will be small but non-zero). If too many consumers decide to ‘free-ride’, private costs exceed private benefits and the incentive to provide the good or service through the market disappears. The market thus fails to provide a good or service for which there is a need.
The free rider problem depends on a conception of the human being as homo economicus: purely rational and also purely selfish—extremely individualistic, considering only those benefits and costs that directly affect him or her. Public goods give such a person an incentive to be a free rider.
For example, consider national defense, a standard example of a pure public good. Suppose homo economicus thinks about exerting some extra effort to defend the nation. The benefits to the individual of this effort would be very low, since the benefits would be distributed among all of the millions of other people in the country. There is also a very high possibility that he or she could get injured or killed during the course of his or her military service.
For markets to function efficiently, participants must have reasonably good information about things such as prices, quality, available technologies, and the risks associated with working in certain jobs or consuming certain products. When participants in the market have incomplete information about such things, the result will be inefficiencies in input usage and in firms’ output.
•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.
Government Policies Designed to Mitigate Incomplete Information •OSHA (Occupational Safety and Health Administration) – the regulations are carried out by the Occupational Safety and Health Administration (OSHA). One of the more severe causes of market failure is asymmetric information, a
situation where some market participants have better information than others •SEC (Security and Exchange Commission)
•Certification – Another policy government uses to disseminate information and reduce asymmetric information is the certification of skills and/or authenticity. The purpose of certification is to centralize the cost of gathering information.
•Truth in lending – Regulation Z and TLSA require that all creditors comply with the act. A creditor is defined as anyone who loans money subject to a finance charge, where the money is to be paid back in four or more installments. A creditor must also be the person to whom the original obligation is payable. TLSA has some exemptions regarding the types of loans covered, the most notable being business, agricultural, and commercial loans.
•Truth in advertising – This advantage may give firms an incentive to make false claims about the merits of their products to capitalize on consumers’ lack of information.
•Contract enforcement – Another way government solves the problems of asymmetric information is through contract enforcement.
For example, suppose your boss “promised” you payment for labor services at the end of the month. After you have worked for a month, your boss refuses to pay you—in effect gaining a month’s worth of your labor for free.
Rent seeking is an attempt to obtain economic rent by manipulating the social or political environment in which economic activities occur, rather than by creating new wealth. A simple definition of rent seeking is spending resources in order to gain by increasing one’s share of existing wealth, instead of trying to create wealth.
•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.
An Example: Seeking Monopoly Rights
•Firm’s monetary incentive to lobby for monopoly rights: A •Consumers’ monetary incentive to lobby against monopoly: A+B.
•Firm’s incentive is smaller than consumers’ incentives.
•But, consumers’ incentives are spread among many different individuals.
•As a result, firms often succeed in their lobbying efforts.
Sometimes rent seeking manifests itself in the form of government involvement in international markets. Such policies usually take the form of tariffs or quotas that are designed to benefit specific firms and workers at the expense of others. In this section, we will examine how government tariff and quota policies affect managerial decisions.
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.
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.
Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace. Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters.
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