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, summarize the important economic principles and concepts in each of the assigned chapters.

Chapter 16
Government Regulation of
Business
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1-1
Learning Objectives
❖ Define social economic efficiency and explain why
well‐functioning competitive markets achieve social
economic efficiency without government regulation
❖ Explain the concept of market failure why it provides
economic justification for government intervention
❖ Identify deadweight loss associated with market power
and discuss ways antitrust policy, second‐best pricing,
and two‐part pricing can reduce the cost of market
power
❖ Discuss pollution as a negative externality and show
how government regulation can create incentives for
firms to choose the optimal level of pollution
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16-2
Learning Objectives
❖ Explain why common property resources and public
goods are underproduced and how government can
reduce market failure created by nonexcludability
❖ Discuss why imperfect information about product price
and quality can lead to market failure
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-3
Market Competition & Social
Economic Efficiency
❖ Social economic efficiency
~ Exists when the goods & services that
society desires are produced & consumed
with no waste from inefficiency
~ Two efficiency conditions must be met
 Productive efficiency
 Allocative efficiency
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16-4
Productive Efficiency
❖ Exists when suppliers produce goods &
services at the lowest possible total
cost to society
❖ Occurs when firms operate along their
expansion paths in both the short-run &
long-run “that line which reflects the
least cost method of producing different
levels of output, when factor prices
remain constant.”
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16-5
Allocative Efficiency
❖ Requires businesses to supply optimal
amounts of all goods & services
demanded by society
~ And these units must be rationed to individuals
who place the highest value on consuming
them (Equilibrium)
❖ Optimal level of output is reached when
the MB of another unit to consumers just
equals the MC to society of producing
another unit
~ Where P = MC (marginal cost pricing)
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16-6
Social Economic Efficiency
❖ Achieved by markets in perfectly
competitive equilibrium
~ At the intersection of demand & supply,
conditions for productive & allocative
efficiency are met
~ At the market-clearing price, buyers &
sellers engage in voluntary exchange that
maximizes social surplus
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-7
Efficiency in Perfect Competition
(Figure 16.1)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-8
Market Failure & the Case for
Government Intervention
❖ Competitive markets can achieve social
economic efficiency without government
regulation
❖ But, not all markets are competitive, and even
competitive markets can sometimes fail to
achieve maximum social surplus
❖ Market failure
~ When a market fails to achieve social economic
efficiency and, consequently, fails to maximize social
surplus
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-9
Market Failure & the Case for
Government Intervention
❖ Six forms of market failure can
undermine economic efficiency:
~ Monopoly power
~ Natural monopoly
~ Negative (& positive) externalities
~ Common property resources
~ Public goods
~ Information problems
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16-10
Market Failure & the Case for
Government Intervention
❖ Absent market failure, no efficiency
argument can be made for government
intervention in competitive markets
❖ Consumer Surplus + Producer Surplus
+ Externalities = Social Surplus
sometime you’ll see this abbreviated as:
CS + PS + Ex = SS or TS (Social or
Total Surplus)
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16-11
Market Power & Public Policy
❖ Firms with market power must price above
marginal cost to maximize profit (P > MC)
~ These firms fail to achieve allocative efficiency,
which reduces social surplus
 Lost surplus is a deadweight loss
~ Allocative efficiency is lost because the profitmaximizing price does not result in marginalcost-pricing
 At the profit-maximizing point, MB > MC
 Resources are under allocated to the industry
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16-12
Louisiana White Shrimp Market
(Figure 16.2)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-13
Market Power & Public Policy
❖ When the degree of market power
grows high enough, antitrust officials
refer to it legally as monopoly power
~ No clear legal threshold has been
established to determine when market
power becomes monopoly power
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16-14
Promoting Competition Through
Antitrust Policy
❖ A high degree of market power (or
monopoly power) can arise in three
ways:
~ Actual or attempted monopolization
(behavior is to create a monopoly)
~ Price-fixing cartels
~ Mergers among horizontal competitors
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16-15
Promoting Competition Through
Antitrust Policy
❖ Firms may be found guilty of actual
monopolization only if both of the
following conditions are met:
~ Behavior is judged to be undertaken for the
sole purpose of creating monopoly power
~ Firm successfully achieves high degree of
market power
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-16
Natural Monopoly & Market Failure
❖ Natural monopoly
~ When a single firm can produce total
consumer demand for a good or service at
a lower long-run total cost than if two or
more firms produce total industry output
~ Long-run costs are sub-additive (the cost of
two or more firms is higher than the cost of
only one firm)
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16-17
Natural Monopoly & Market Failure
❖ Breaking up a natural monopoly is
undesirable
~ Increasing number of firms drives up total
cost & undermines productive efficiency
❖ Under natural monopoly, no single price
can establish social economic efficiency
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16-18
Natural Monopoly & Market Failure
❖ With economies of scale, marginal-costpricing results in a regulated natural
monopoly earning negative economic
profit (marginal cost is always getting
less expensive)
❖ Two-part pricing is a solution that can
meet both efficiency conditions &
maximize social surplus (a flat access
fee and a per unit fee)
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16-19
The Problem of Negative Externality
❖ Externalities
~ When actions taken by market participants
create either benefits or costs that spill over
to other members of society
~ Positive externalities occur when spillover
effects are beneficial to society
~ Negative externalities occur when spillover
effects are costly to society
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-20
The Problem of Negative Externality
❖ Externalities undermine allocative
efficiency
~ Market participants rationally choose to
ignore the benefits & costs of their actions
that spill over to others (in order to
maximize profits)
~ Competitive market prices do not capture
social benefits or costs that spill over to
society (only private costs are considered)
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16-21
The Problem of Negative Externality
❖ Managers rationally ignore external
costs when making profit-maximizing
production decisions
~ Social cost of production:
Social cost = Private cost + External cost
or
Social cost – Private cost = External cost
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-22
Nonexcludability
❖ Two kinds of market failure caused by
nonexcludability:
~ Common property resources
~ Public goods
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16-23
Common Property Resources
❖ Resources for which property rights are
absent or poorly defined
~ No one can effectively be excluded from
such resources
~ Without government intervention, these
resources are generally overexploited &
undersupplied (over harvesting of natural
resources – whales, ivories, forests
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16-24
Public Goods
❖ A public good is non-excludable & nondepletable (can not exclude anyone and
“your consumption of the good does not
affect my consumption of the good)
(National Defense, Police agencies,
Emergency Services, Fire protection)
❖ The inability to exclude nonpayers
creates a free-rider problem for the
private provision of public goods.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-25
Information & Market Failure
❖ Market failure may also occur because
consumers lack perfect knowledge
~ Perfect knowledge includes knowledge
about product prices, qualities, and any
hazards
❖ Market power can emerge because of
imperfectly informed consumers
(information is costly) Does MB=MC?
(the internet has reduces the cost of
information)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-26
Information & Market Failure
❖ Consumers may over-or-under-estimate
quality of goods & services
~ If they over-value quality, they will demand
too much product relative to the allocative
efficient amount
~ If they under-value quality, they will
demand too little
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-27
Summary
❖ Social economic efficiency occurs when two efficiency
conditions are fulfilled: productive efficiency and
allocative efficiency
~ At the competitive market-clearing price, buyers and sellers
engage in voluntary exchange that maximizes social surplus
❖ Market failure occurs when a market fails to achieve
social economic efficiency
~ Absent market failure, no efficiency argument can be made for
government intervention in competitive markets
❖ The problem with market power is the loss of allocative
efficiency
~ Most industrialized nations rely on antitrust laws to reduce the
social cost of market power
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-28
Summary
❖ An important cause of market failure arises when
actions taken by market participants create benefits or
costs that spillover to other members of society
~ When spillover effects are beneficial to society, they are referred
to as positive externalities, and when they are costly to society,
they are called negative externalities
❖ When access to a good or a scarce resource cannot be
excluded, market failure usually results
~ Two kinds of market failure caused by lack of excludability are
common property resources and public goods
❖ Market power can also emerge in competitive markets
because imperfectly informed consumers do not have
complete knowledge of all producers and prices
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16-29

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