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Chapter 16:
GOVERNMENT REGULATION OF BUSINESS
Essential Concepts
16.1 MARKET COMPETITION AND SOCIAL ECONOMIC EFFICIENCY
1. Social economic efficiency exists when the goods and services that society desires are produced and
consumed with no waste from inefficiency in either production or consumption. To reach this goal,
two efficiency conditions must be fulfilled: productive efficiency and allocative efficiency.
2. Productive efficiency exists when suppliers produce goods and services at the lowest possible total
3. Allocative efficiency requires businesses to supply the optimal amounts of all goods and services
demanded by society, and these units must be rationed to individuals who place the highest value on
4. Markets in perfectly competitive equilibrium achieve social economic efficiency because, at the
16.2 MARKET FAILURE AND THE CASE FOR GOVERNMENT INTERVENTION
2. Unfortunately, not all markets are competitive, and even competitive markets can sometimes fail to
achieve maximum social surplus. Market failure occurs when a market fails to achieve social
economic efficiency, and, consequently, fails to maximize social surplus.
3. Six forms of market failure can undermine economic efficiency: Monopoly power, natural monopoly,
4. Absent market failure, no efficiency argument can be made for government intervention in
16.3 MARKET POWER AND PUBLIC POLICY
1. Only perfectly competitive markets meet the necessary condition for allocative efficiency: marginal-
cost pricing. Price always exceeds marginal cost under monopoly, monopolistic competition, and
oligopoly because of the market power that all imperfectly competitive firms possess.
2. For all firms with market power, marginal revenue lies below the firm’s demand curve. For this
reason, prices charged by firms with market power always exceed marginal revenue: P > MR. Since
Chapter 16: Government Regulation of Business
3. While any degree of market power reduces social surplus, a “high” degree of market power may do
so much damage to social surplus that a government remedy may be warranted. When the degree of
4. Allocative efficiency is lost when firms possess market power because their profit-maximizing price
does not result in marginal-cost-pricing. Consequently, for the last unit of output produced and sold
5. Monopoly power, or a high degree of market power, can arise primarily in three ways: (1) actual or
attempted monopolization, (2) price-fixing cartels, and (3) mergers among horizontal competitors.
6. Firms may be found guilty of actual monopolization only if both of the following conditions are met:
Natural Monopoly and Market Failure
7. Natural monopoly arises when a single firm can produce the total consumer demand for a product or
service at a lower long-run total cost than if two or more firms produce the total industry output.
9. Breaking up a natural monopoly is undesirable because increasing the number of firms in the industry
drives up total cost and undermines productive efficiency. State regulators of public utilities –known
10. When LAC is declining due to economies of scale, marginal-cost-pricing creates a situation in which
11. Two-part pricing is a pricing solution that can meet both efficiency conditions and maximize social
surplus. A two-part pricing plan charges customers a fixed access charge (A) plus an additional usage
16.4 THE PROBLEM OF NEGATIVE EXTERNALITY
1. Another important cause of market failure in competitive markets arises when the actions taken by
2. External or spillover benefits and costs undermine allocative efficiency, because market participants,
when making consumption and production decisions, rationally choose to ignore the benefits and
costs of their actions that spillover to external members of society. Consequently, competitive market
prices do not capture the social benefits or costs that spillover to other members of society.
3. Managers rationally ignore external costs when making profit-maximizing production decisions. The
social cost of production is the sum of private cost incurred by producers plus any external or
spillover cost imposed on other members of society:
4. Figure 16.5 in the text (reproduced below) shows why the “wedge” of negative externality makes
allocative efficiency impossible to achieve in competitive markets. Competitive market equilibrium is
established at the intersection of demand and supply (point C), where QC units are produced and
consumed at price PC. Production of this good by competitive suppliers creates an external cost that
Chapter 16: Government Regulation of Business
16.5 NONEXCLUDABILITY
1. When access to a good or a scarce resource cannot be excluded, market failure may result. Two kinds
of market failure caused by lack of excludability: common property resources and public goods.
2. Common property resources are resources for which property rights are completely absent or so
3. Public goods are characterized by two properties: they are nonexcludable, and they are nondepletable.
In the case of public goods, the problem of nonexcludabiltiy is called the free-rider problem:
4. A pure public good is nonexcludable and nondepletable. The inability to exclude nonpayers creates a
free-rider problem for the private provision of public goods. Even when private firms do supply
public goods, a deadweight loss can be avoided only if the price of the public good is zero.
16.6 INFORMATION AND MARKET FAILURE
1. Market failure may also occur because consumers do not possess perfect knowledge. Perfect
2. Market power emerges in competitive markets because imperfectly informed consumers do not
possess complete knowledge of all producers and prices. Their incomplete knowledge about
substitutes creates market power for sellers, something that did not happen in the model of perfect
Chapter 16: Government Regulation of Business
3. Consumers may over- or under-estimate the quality of the goods and services they buy. If they over-
Answers to Applied Problems
1. While it is true that a different allocation of resources that makes everyone better off (i.e., a “win-
win” situation) clearly increases social welfare, “win-win” is a more restrictive condition for
2. A shortage definitely results in an underallocation of resources to an industry. However,
underallocation can happen without any shortage. For example, in a monopoly market there is no
3. Price ceilings set below the market-clearing price encourage buyers with low values – i.e., consumers
who value units of the good at less than the market-clearing price– to enter the market and compete or
the good with high-valued buyers. When a good is in short supply, it is usually rationed by waiting
lines on a first-come, first-served basis. This queuing process in no way guarantees that the good will
4. Anti-gouging laws are unlikely to be helpful to society. We recommend students read the editorial
from the Wall Street Journal (September 7, 2005, p. A 16), “In Praise of ‘Gouging’”.
5. The following figure shows the demand, marginal revenue, and constant cost conditions faced by
Mirk Labs for Zatab:
a. Mirk Labs sets the wholesale price at $40 per unit and sells 7 million units annually. It earns
annual profit of $245 million [= ($40 –$5) 7 million units].
b. Once this market becomes perfectly competitive, price will be bid down to LAC, $5. Point C in
Chapter 16: Government Regulation of Business
c. Annual deadweight loss is the area of triangle bCM in the figure: $122.5 million [= 0.5 $35 7
million]. Deadweight loss in this case represents the amount of consumer surplus lost because
buyers do not get to consume the 7 million units from point b to C, each of which is more
