Managerial Economics &
Business Strategy
Chapter 14
A Manager’s Guide to
Government in the Marketplace
Michael R. Baye, Managerial Economics and Business Strategy, 5e.
McGraw-Hill/Irwin Copyright ©Copyright © 2006
2006 by The by The McGraw-Hill
McGraw-Hill Companies,
Companies, Inc. Inc.
AllAll rightsreserved.
rights reserved.
Overview
I. Market Failure
Market Power
Externalities
Public Goods
Incomplete Information
II. Rent Seeking
III. Government Policy and International Markets
Quotas
Tariffs
Regulations
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Market Power
• Firms with market
power produce socially P
Deadweight
inefficient output levels. Loss
MC
Too little output
PM
Price exceeds MC
PC
Deadweight loss
• Dollar value of society’s MC
welfare loss
D
QC Q
Q M
MR
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Antitrust Policies
• Administered by the DOJ and FTC
• Goals:
To eliminate deadweight loss of monopoly and promote
social welfare.
Make it illegal for managers to pursue strategies that foster
monopoly power.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Sherman Act (1890)
• Sections 1 and 2 prohibits price-fixing,
market sharing and other collusive
practices designed to “monopolize, or
attempt to monopolize” a market.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
United States v. Standard Oil of
New Jersey (1911)
• Charged with attempting to fix prices of petroleum
products. Methods used to enhance market power:
Physical threats to shippers and other producers.
Setting up artificial companies.
Espionage and bribing tactics.
Engaging in restraint of trade.
Attempting to monopolize the oil industry.
• Result 1: Standard Oil dissolved into 33 subsidiaries.
• Result 2: New Supreme Court Ruling the rule of reason.
Stipulates that not all trade restraints are illegal, only those that are
unreasonable are prohibited.
• Based on the Sherman Act and the rule of reason, how do
firms know a priori whether a particular pricing strategy is
illegal?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Clayton Act (1914)
• Makes hidden kickbacks (brokerage
fees) and hidden rebates illegal.
• Section 3 Prohibits exclusive dealing
and tying arrangements where the
effect may be to “substantially lessen
competition.”
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Cellar-Kefauver Act (1950)
• Amends Section 7 of Clayton Act.
• Strengthens merger and acquisition policies.
• Horizontal Merger Guidelines
Market Concentration
• Herfindahl-Hirschman Index: HHI = 10,000 wi2
• Industries in which the HHI exceed 1800 are generally
deemed “highly concentrated”.
• The DOJ or FTC may, in this case, attempt to block a
merger if it would increase the HHI by more than 100.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Regulating Monopolies: Marginal-
Cost Pricing
MC
PM
PC
Effective Demand
MR
QM QC Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Problem 1 with Marginal-Cost
Pricing: Possibility of ATC > PC
MC
PM
ATC ATC
PC
MR
QM QC Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Problem 2 with Marginal-Cost
Pricing: Requires Knowledge of MC
P
Deadweight loss
after regulation MC
PM
Deadweight loss
prior to regulation
PReg
Effective Demand
MR
QReg QM Q* Q
Shortage
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Externalities
• A negative externality is a cost borne by
people who neither produce nor consume
the good.
• Example: Pollution
Caused by the absence of well-defined property
rights.
• Government regulations may induce the
socially efficient level of output by forcing
firms to internalize pollution costs
The Clean Air Act of 1970
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Socially Efficient Equilibrium:
Internal and External Costs
P
Socially efficient equilibrium
MC external + internal
PSE MC internal
PC
MC external
Competitive
D
equilibrium
QSE QC Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Public Goods
• A good that is nonrival and nonexclusionary in
consumption.
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Public Goods
$
90
Total demand for streetlights
54 MC of streetlights
Individual
Consumer 30
Surplus
18 Individual demand
for streetlights
0 12 30 Streetlights
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Incomplete Information
• 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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Government Policies Designed
to Mitigate Incomplete
Information
• OSHA
• SEC
• Certification
• Truth in lending
• Truth in advertising
• Contract enforcement
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Rent Seeking
• 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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
An Example: Seeking
Monopoly Rights
• Firm’s monetary incentive to
lobby for monopoly rights: A Consumer
P Surplus
• Consumers’ monetary
A = Monopoly Profits
incentive to lobby against
monopoly: A+B. B = Deadweight Loss
• Firm’s incentive is smaller PM
than consumers’ incentives. A B MC
• But, consumers’ incentives are PC
spread among many different
individuals. D
• As a result, firms often MR
succeed in their lobbying
QM QC Q
efforts.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Quotas and Tariffs
Quota
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.
Tariffs
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Conclusion
• 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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
