Government Regulation

Chapter 17
• Corporations are legal entities which exist only
because governments allow them to exist.
• Governments impose many restrictions on
firms: mergers, patents, licensing, or subsidies.
• The stated intention of governments is set
restrictions that promote social welfare, but
they sometimes benefit particular groups or
individuals.
2002South-Western Publishing Slide 1
 Market Performance, Market
Conduct, and Market Structure
Market basic supply and demand conditions

MARKET STRUCTURE
Feedback
Effects

MARKET CONDUCT

MARKET PERFORMANCE

Slide 2
 Good Market Performance
Depends on:
• Efficient resource allocation
• Technologically progressive
• Promote full employment
• Equitable distribution of income

Slide 3
 Market Conduct
• Pricing behavior
• Product policy
• Sales promotion and advertising
• R&D and innovation strategies
• Legal tactics with regard to entry

Slide 4
 Market Structure
• Seller and buyer concentration in a
market. With one buyer we have monopsony
power of buyers.
• Product differentiation. A market structure
of highly differentiated products may be
monopolistically competitive.
• Conditions surrounding entry conditions.
The ease of entry and exit are market structure
determinants.
Slide 5
open
Condition of Entry
closed
1. Demand conditions.
2. Control over input supplies.
3. Legal barriers.
4. Scale Economies.
5. Large capital requirements
6. Technological barriers.
Slide 6
 Contestable Markets
• Economists have thought that structure influences conduct
and performance in an industry.
» This is the central paradigm in the economic field
known as industrial organization.
• The idea of contestable markets is applied in markets
with scale economies.
» A perfectly contestable market has many "potential
entrants" with the same cost functions as the incumbent
firms.
» They enter or not depending on the incumbent's price,
which causes the incumbent firms to set prices equal to
marginal costs
Slide 7
 Market Concentration
• The market or industry concentration ratio sum
the market shares of the largest 4, 8, 20, 50 firms.
» A four-firm concentration ratio (4CR) of 80 says that
the top for firms comprise 80% of the sales in the
industry.
• Herfindahl-Hirschman Index (HHI) is:
HHI = Σ Si2, which is the sum of the squares of the
market shares of all firms in the industry.
• With small market shares, HHI is small. With large market
shares, HHI is large.
• If two firms with 50% market shares each HHI = 502 +502
= 5,000. With 100 firms of 1% each, HHI only 100. Slide 8
Antitrust: Government Regulation
of Market Conduct and Structure
• In trusts, the voting rights to the several
firms are conveyed to a legal trust to
manage the group of firms as if it were one
firm. This tends to create monopolization
of an industry.
• The Sherman Antitrust Act (1890)
outlawed monopolies per se and attempted
monopolization.
Slide 9
 The Clayton Act
• The Clayton Act (1914) extended the list of
conduct that was anti-competitive:
a. price discrimination. (section 2)
b. tying contracts force customers to buy
added products with one product. (section 3)
c. purchasing shares of competing firms as an
anti-merger section. (section 7)
d. corporate directorship interlocks occur
when the same people are in
directorships of competing firms. (section 8)
Slide 10
• The Federal Trade Commission was established
in 1914 to prohibit unfair methods of competition.
• The Celler-Kefauver Antimerger Act (1950)
restricted mergers through asset acquisition when the
acquisition "may be substantially to lessen competition."
• The Hart-Scott-Rodino Antitrust
Improvement Act (1976) requires notification by
large firms to the Justice Department of impending
mergers.
• The Robinson-Patman Act of 1936 amended
section 2 of the Clayton Act on price
discrimination when it injures competition.
Slide 11
Robinson-Patman Act of 1936
Section 2(a) prohibits price discrimination which
"substantially lessen competition".
Section (2b) provides a cost justification for price
discrimination.
Section (2c) prohibits some kinds of brokerage
commissions.
Sections (2d-2e) prohibits discounts to buyers not
afforded to other customers.
These sections are the basic laws against
price discrimination.
Slide 12
 Regulatory Constraints
An Economic Analysis
• Operating controls appear in environmental pollution
and product quality and safety issues.
The government, mandates that automobile manufacturers must
sell cars with seat-belts and must attain certain emissions
standards for their fleet.
EXAMPLES: DuPont forced to reduce emissions of
chlorofluorocarbons (CFCs), or Palladium Metal-Casting
» Adding an additional fixed cost (to reduce smoke)
lowers profit without changing the price.
» If the operating controls raise variable costs, the
output and price changes in the directions you would
expect: higher prices and lower output.
Slide 13
 The Deregulation Movement
• Airline and trucking have been
deregulated.
• They are no longer "infant industries."
• Deregulation of long-distance occurred
due in large part to technological
changes in transmitting phone
messages by microwave.

Slide 14
Government Support to Business

• Governments historically have helped

some companies by restricting or
eliminating competition.
• Examples
» Licensing of professions (or businesses)
» Patents of ideas or processes restricts
use of the idea
» Restrictions on price competition

Slide 15
Other Governmental Regulations
• Import Quotas and Import Tariffs
• Government Subsidies
• Government Promotion occurs when
the government spends money on
research & development or on the
benefits of particular life styles or
practices.
• Tax as a Regulatory Tool.
Slide 16
 Economic Externalities and Market Failure
Appendix 17A
Types of Externalities
• Production Externalities:
» External Production Economies  expansion 
generates benefits to other firms.
» External Production Diseconomies  expansion 
generates uncompensated costs on other firms.
• Consumption Externalities:
» External Consumption Economies  an increase in 
use of this product increases the utility of others.
» External Consumption Diseconomies  an increase 
in use results in uncompensated costs on others.
Slide 17
 The Coase Theorem
The Coase Theorem: if the transaction costs
for private contracting between parties
are very low, the problems of
externalities will be resolved without
governmental intervention.
Even if governments and the courts can
assign property rights or duties however
they wish, the solution is unaffected when
transaction costs are low.
Slide 18
 More on the Coase Theorem
• Cattle Ranchers • Corn Farmers
» Suppose a fence costs » Suppose a fence
$500,000 costs only $100,000
» Suppose damage to » Suppose damage to
corn is $100,000 by corn is $500,000 by
cattle the cattle
» What should happen? » What should
happen?

Slide 19
 But Property Rights Matter
in a world with transaction costs
• It is often costly to arrange contracts between
ranchers and farmers
• Suppose the fence costs more than the damage
» If the property right to safe crops is established, the
farmer will want a fence regardless of cost. An
uneconomic fence is constructed.
» If the property right is to open range grazing, the
rancher will not want a fence. No fence is built.
» Therefore, who gets the property right matters!
Slide 20
 Solutions to Externalities
Solution by:
• Prohibition
• Directive
• Voluntary Payment
• Merger
• Taxes and Subsidies
• Sale of Pollution Rights
• Regulation
Slide 21