Chap 17

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

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Market Performance, Market Conduct, and Market Structure Market basic supply and demand conditions

Feedback Effects

MARKET STRUCTURE

MARKET CONDUCT

MARKET PERFORMANCE Slide 2

Good Market Performance Depends on: •

• • •

Efficient resource allocation Technologically progressive Promote full employment Equitable distribution of income

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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

1. 2. 3. 4. 5. 6.

Condition of Entry Demand conditions. Control over input supplies. Legal barriers. Scale Economies. Large capital requirements Technological barriers.

closed

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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 » Suppose a fence costs $500,000 » Suppose damage to corn is $100,000 by cattle » What should happen?

• Corn Farmers » Suppose a fence costs only $100,000 » Suppose damage to corn is $500,000 by the cattle » What should happen?

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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