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8

Government,
the Firm and
the Market
Reasons for Government Intervention

■ Government intervention and social


objectives
■ The objective of social efficiency
✜ marginal social benefits and costs
✦ MSB > MSC → produce (or consume) more
✦ MSC > MSB → produce (or consume) less
✜ socially efficient output where MSB = MSC
■ Equity
✜ concepts of fairness
■ Trade-offs between equity and efficiency
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
External costs in production
MC = S
Costs and benefits

P D

O Q1

Quantity
External costs in production
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
External benefits in production
MC = S
Costs and benefits

P D

O Q1
Quantity
External benefits in production
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
External costs and benefits in production

MSC MC = S MC = S MSC

Costs and benefits (£)


Costs and benefits (£)

External benefit

P D P D
External cost

O Q2 Q1 O Q1 Q2
Quantity Quantity

(a ) External costs (b) External benefits


Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
✜ External costs of consumption
MSB < MB
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
✜ External costs of consumption
MSB < MB
✜ External benefits of consumption
MSB > MB
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
✜ External costs of consumption
MSB < MB
✜ External benefits of consumption
MSB > MB
■ Public goods
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
✜ External costs of consumption
MSB < MB
✜ External benefits of consumption
MSB > MB
■ Public goods
✜ non-rivalry
Types of Market Failure
■ Externalities
✜ External costs of production
MSC > MC
✜ External benefits of production
MSC < MC
✜ External costs of consumption
MSB < MB
✜ External benefits of consumption
MSB > MB
■ Public goods
✜ non-rivalry
✜ non-excludability and the free-rider problem
Types of Market Failure

■ Market power
✜ market power can be used to raise the price
above the perfectly competitive level

✜ output below the socially efficient level


✦ MSB > MSC
A monopolist producing less than the social optimum
£
MC

P1

MC1
AR
MR
O Q1 Q
Monopoly output
A monopolist producing less than the social optimum
£
MC = MSC

P1

P2 = MSB
= MSC

MC1
AR = MSB
MR
O Q1 Q2 Q
Monopoly output Perfectly competitive output
Types of Market Failure
■ Imperfect information
✜ by consumers

✜ by firms

■ Protecting people’s interests


✜ dependants

✜ merit goods
Business Ethics & Corporate Social
Responsibility
■ Firms and social responsibility
✜ are managers solely responsible to shareholders?
✜ are they simply concerned to maximise profits?
✜ broader social interests
■ Business ethics
✜ a stakeholding society
✜ corporate social responsibility
✜ environmental scanning
■ Economic performance and social
responsibility
Government Intervention in the Market

■ Taxes and subsidies


✜ to correct externalities
Using taxes to correct a market distortion

MC = S
Costs and benefits

P D

O Q1

Quantity
Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
Using taxes to correct a market distortion
MSC
MC = S

Optimum tax = MSC – MC


Costs and benefits

P D

MC

O Q2 Q1

Quantity
Government Intervention in the Market

■ Taxes and subsidies


✜ to correct externalities
✜ to correct for monopoly
Government Intervention in the Market

■ Taxes and subsidies


✜ to correct externalities
✜ to correct for monopoly
✜ advantages of taxes and subsidies
✦ can
vary the rate according to the size of the
market distortion
Government Intervention in the Market

■ Taxes and subsidies


✜ to correct externalities
✜ to correct for monopoly
✜ advantages of taxes and subsidies
✦ can
vary the rate according to the size of the
market distortion
✜ disadvantages of taxes and subsidies
✦ infeasible to use different tax and subsidy rates
✦ lack of knowledge
Government Intervention in the Market

■ Legislation
✜ to control activities causing externalities
✜ to prevent firms giving inaccurate
information
✜ to prevent the abuse of monopoly power
■ Regulatory bodies
✜ purely investigative
✜ with powers to act (e.g. OFT)
Environmental Policy
■ The environment and production
■ Green taxes and subsidies
✜ use of green taxes around the world
Types of environmental taxes and charges
Types of environmental taxes and charges
Types of environmental taxes and charges
Types of environmental taxes and charges
Environmental Policy
■ Green taxes and subsidies (cont.)
✜ choosing the tax rate
✦ tax rate should equal the marginal external cost
✜ advantages of taxes and subsidies
✦ allows market to operate
✦ can vary with the size of the externality
✜ disadvantages of taxes and subsidies
✦ infeasible to use different tax rates
✦ lack of knowledge on extent of externality
Environmental Policy
■ Laws and regulations
✜ the command-and-control approach
✜ advantages
✦ simple to operate
✦ safe approach when size of externality not known
✜ disadvantages
✦ requires robust monitoring and enforcement
✦ lack of incentives for firms to do better
■ Tradable permits
✜ how tradable permits work
✜ assessing tradable permits
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
Profit maximising under monopoly
£ MC

MR
O Qm Q
Profit maximising under monopoly
£ MC
Total profit
AC

AR

AC

AR
MR
O Qm Q
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
✦ economies of scale
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
✦ economies of scale
✦ investment and innovation
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
✦ economies of scale
✦ investment and innovation
✜ approaches to competition policy
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
✦ economies of scale
✦ investment and innovation
✜ approaches to competition policy
✦ banning various activities
Competition Policy
■ Competition, monopoly and the public
interest
✜ the abuse of market power
✦ higher prices and profits
✦ lack of incentive to innovate
✜ market power can also bring benefits
✦ economies of scale
✦ investment and innovation
✜ approaches to competition policy
✦ banning various activities
✦ examining each case on its merits
Competition Policy

UK competition policy
✜ the OFT and the Competition Commission
✜ restrictive practices policy
✦ legislation under 2002 Enterprise Act
✦ criminal to engage in cartel arrangements
• price fixing, limiting supply, sharing out markets, collusive
tendering, agreements to pay low prices to suppliers
✦ OFT has discretion with other types of agreement
• vertical price fixing, agreements to exchange information
✦ powers of the OFT
✦ difficulties in rooting out collusion
Competition Policy
■ UK competition policy (cont.)
✜ monopoly policy
✦ Chapter 2 prohibition of 1998 Competition Act
• market-share criterion
• market contestability
✦ anti-competitive practices
• charging excessively high prices, price
discrimination, predatory pricing, vertical restraints
✦ test: do such practices restrict competition?
✜ merger policy (2002 Enterprise Act)
✦ role of OFT and Competition Commission
✦ criteria for judgment

■ Assessment of competition policy


The Regulation of Business
■ Regulation and the privatised industries
✜ nationalisation and privatisation

■ Regulation in practice:
✜ use of general competition policy
✜ specific regulation
✦ regulatory offices

✜ price-cap regulation
✦ the CPI–X formula
The Regulation of Business
■ Advantages of UK regulation
✜ discretionary
✜ flexible
✜ incentives
■ Disadvantages of UK regulation
✜ disincentives of changes to X
✜ complexity of regulation
✜ principal–agent problems between regulator
and industry managers
The Regulation of Business
■ Policies to increase competition
✜ allowing competition where there is no
natural monopoly
✦ limited extent of true natural monopoly
✜ allowing access to grids by competitors
✦ forbidding suppliers from being grid owners
✜ competitive franchising to make monopolies
contestable
■ Still need for regulation to prevent abuse
of monopoly power