1. The Efficiency Role of Government
When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient
No opportunities for mutual gain remain unexploited
Any government intervention that changes the market quantity (say, a price ceiling or a price floor) will create inefficiency—a welfare loss
But government can—and does—contribute to the economic efficiency of markets
Provides infrastructure that permits markets to function
Physical infrastructure—bridges, airports, waterways, and buildings
Institutional infrastructure—laws, courts, and regulatory agencies
Stepping in when markets are not working properly
When they leave Pareto improvements unexploited and therefore fail to achieve economic efficiency

2. The Institutional Infrastructure of a Market Economy
Americans take their institutional infrastructure almost completely for granted
In some countries
Police are more likely to steal from citizens than to protect them from thievery
People have no effective rights to their own property
If a person is injured by a drunk driver, there may be no system for compensating her or punishing the drive
In nations with highly developed and stable legal infrastructures, such incidents are the exception
When countries are divided into three groups, according to the quality of their institutional infrastructure
There is a strong relation between infrastructure and output per worker

3. Figure 8: Government Infrastructure and Output per Worker
Low
Quality of Infrastructure
Medium
High
Average Output per Worker
2,000
6,000
10,000
14,000
$18,000

4. The Legal System: Criminal Law
The backbone of a market economy’s institutional infrastructure is the legal system
Criminal law
While criminal law has important moral and ethical dimensions
Central economic function is to limit exchanges to voluntary ones
By making most involuntary exchanges illegal, criminal law helps to channel our energies into exchanges and productive activities that benefit all parties involved—Pareto improvements
In this way, criminal law contributes to economic efficiency

5. Property Law
Property law gives people precisely defined, enforceable rights over things they own
When property rights are poorly defined
Much time and energy are wasted in disputes about ownership
People spend time trying to capture resources from others
Time that could have been spent producing valuable goods and services
Property law contributes to economic efficiency by increasing total production
Raising total benefits that markets can provide by reducing disputes about property
Channeling resources into production

6. Contract Law
In countries in which contract law is less well defined or less strictly enforced, investors would worry that they would not be able to collect their share
A contract is a mutual promise
Often one party does something first and the other party promises to do something later
Contracts play a special role in a market economy
Without them, only Pareto improvements involving simultaneous exchange could take place
You get a bag of apples from a farmer and simultaneously hand over some money

7. Contract Law
Contracts enable us to make exchanges that take place over time and in which one person must act first
In this way, contracts help society enjoy the full benefits of specialization and exchange
Legal enforcement of contacts is not the only force that makes people keep promises
Parents, religious organizations, and schools teach people that keeping promises is a moral obligation
A reputation for failing to keep promises would be harmful to a business or a person
While socialization and concern over reputation are important, contracts and the infrastructure for enforcing them play vital role in making economy more efficient
Because of contract law, people are more willing to take a chance with a new business
Since they know that they have a law behind them if new business reneges on a deal

8. Tort Law
Deals with interactions among strangers or people not linked by contracts
Specifically, a tort is a wrongful act—such as manufacturing an unsafe product—that causes harm to someone, and for which the injured person can seek remedy in court
Tort law defines types of harm for which someone can seek legal remedy
And what sorts of compensation the injured person can expect
When people and business are held responsible for injuries they cause, they act more carefully
Also protects against fraud
In which a seller of something—a product, a business, shares of stock—lies to the buyer in order to make the sale

9. Antitrust Law
Designed to prevent business from making agreements or engaging in other behavior that limits competition and harms consumers
Operates in three areas
Agreements among competitors
U.S. antitrust law—expressed in Section 1 of Sherman Act—prohibits “contracts, combinations, or conspiracies” among competing firms that would harm consumers by raising prices
Monopolization
Section 2 of Sherman Act Makes it illegal to monopolize or attempt to monopolize a market
Mergers
In a merger, two firms combine to form one new firm
The result is to increase the danger of higher prices from oligopoly or monopoly
Mergers of this type are often blocked by U.S. government based on Section 7 of Clayton Act

10. Regulation
Important part of the institutional infrastructure that supports a market economy
Under regulation, a government agency—such as the Food and Drug Administration (FDA), the Environmental Protection Agency (EPA), or a state public utilities commission—has power to direct business to take specific actions
In addition to protecting public safety and health
Regulation is also used to help markets function more efficiently
Regulation differs from use of legal procedures in a fundamental way
Regulators reach deep into the operations of business to tell them what to do
While legal procedures typically result in fines or other penalties if businesses do something wrong

11. Law and Regulation in Perspective
Invisible hand of market system cannot operate on its own
Legal system, along with regulatory agencies, creates an environment in which invisible hand can do its job
Almost every Pareto improvement that we can think of relies on legal and regulatory infrastructure
But what about cases where law and regulation don’t seem to be working perfectly?
Does this mean that our institutional infrastructure is failing us?

12. Law and Regulation in Perspective
Yes…and no
While instances like these are never welcome, society has chosen not to eliminate them entirely
Must balance benefits—safer products, reduced crime—against costs
A legal and regulatory system that ensured the complete elimination of crime, unsafe products, and other unwelcome activities would be less efficient than a system that tolerated some amount of these activities
An efficient infrastructure must consider the costs, as well as the benefits, of achieving our legal and regulatory goals

13. Market Failures Another vitally important role for government
To intervene in situations of market failure
When a market equilibrium—even with the proper institutional support—is economically inefficient
General types of market failures to which economists have devoted a lot of attention
Monopoly power
Externalities
Public goods
While economists and policy-makers agree in theory on what causes a market failure
Dealing with real-world market failures remains one of the most controversial aspects of government policy

14. Monopoly and Monopoly Power
A firm has monopoly power when it can influence the price that it charges for its product
A market with just one seller, or a few oligopolists who cooperate and behave as a monopoly, is a more serious market failure
Monopoly and imperfectly competitive markets—in which firms charge a single price greater than marginal cost—are generally inefficient
Price is too high, and output is too low, to maximize net benefits in market
What can government do to make this monopoly market more efficient?

15. Figure 9: The Welfare Loss from Monopoly
1. A monopoly charges a higher price than a competitive market . . . MC
Number of Lessons per Week
Dollars
3. The result is a welfare loss . . .
$22
$19 E
4. from not producing the efficient quantity, at point E. D MR
2. and produces a lower quantity.
2,500
4,000

16. Anti-trust Law as a Remedy
In the case of the guitar-lesson monopoly, there may be a solution
Since this market would function very well under competitive conditions, the government could use anti-trust law to break the monopoly into several competing firms
But breaking up a monopoly would not make sense when the market would perform even worse with more competition
Monopolies that arise from patents and copyrights, provide an incentive for artistic creations and scientific discovery
Monopoly power that arises from network externalities offers benefits that would be hard to achieve under more competitive conditions
When a monopoly arises as a natural monopoly
Using anti-trust law to break it up or even to prevent its formation in the first place is a poor remedy

17. The Special Case of Natural Monopoly
A natural monopoly exists when, due to economies of scale, one firm can produce for the entire market at a lower cost per unit than can two or more firms
If government steps aside, such a market will naturally evolve toward monopoly
If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency?
One option is public ownership and operation
Public takeover of private business is rare, except when certain conditions are present
That leaves one other option
Regulation

18. Figure 10: Regulating A Natural Monopoly
Number of Households Served
Dollars
Unregulated monopoly
"Fair rate of return" production A
$60
Efficient production (requires subsidy) C
$29
LRATC F
$15 MC B MR D
50,000
100,000
85,000

19. Regulation of Natural Monopoly
Under regulation, a government agency digs deep into the operations of a business and takes some of the firm’s decisions under its own control
In the case of a natural monopoly, regulators are interested in achieving economic efficiency, which they do by telling the firm what price it can charge
At first glance, you might think that natural monopoly regulators have an easy job
Unfortunately, it’s not that easy
There is the matter of information
Regulators must be able to trace out firm’s MC curve as well as market demand curve

20. Regulation of Natural Monopoly
Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem
Look again at Figure 7—notice that MC curve lies everywhere below LRATC curve
Problem for regulators
If they set the efficient price of $15 so that buyers demand efficient quantity of 100,000, firm’s cost per unit is greater than $15
Firm will suffer a loss
In long-run, it will go out of business

21. Regulation of Natural Monopoly
Leaves regulatory agency with two alternatives
Set prices to MC and subsidize the monopoly from the general budget, to make up for the loss
In practice, however, regulators in market economies around the world have usually chosen a different solution
Regulators determine a price that gives owners a “fair rate of return” for funds they’ve put into the monopoly
Should give monopoly what economists call normal profit
Profit just high enough to cover all of the owners’ opportunity costs, including the foregone interest of their own funds
What price will accomplish this?
A fair rate of return is already built into LRATC curve
This strategy—called average cost pricing—is the most common solution chosen by regulators of natural monopolies

22. Regulation of Natural Monopoly
With average cost pricing, regulators strive to set price equal to cost per unit where LRATC curve crosses demand curve
At this price, the natural monopoly makes zero economic profit
Which provides its owners with a fair rate of return, and keeps the monopoly in business
Average cost pricing is not a perfect solution
Does not quite make the market efficient
Provides little or no incentive for the natural monopoly to economize on capital
Tendency of regulated natural monopolies to overinvest in capital is known as the Averch-Johnson effect, after the two economists who first explained it
Averch-Johnson effect is a specific example of a more general idea
When a firm is not striving to maximize profit (in this case, because the government is guaranteeing a specific rate of return)
Firm need not economize on costs