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The Efficiency Role of Government

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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

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