Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 21: Understanding the Business Environment: The Economics of Regulation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Managerial Economics and Organizational Architecture, 5e Examples of Government Regulation Antitrust legislation Environmental protection laws Financial disclosure for publicly traded stock Intellectual property, labor, and safety laws Utilities regulation Financial services regulation Transportation industry regulation 21-2

Managerial Economics and Organizational Architecture, 5e Economic Motives for Government Intervention Provide laws and legal institutions that define and enforce property rights Seek to correct market failure –Externalities –Public good –Monopolies –Asymmetric information 21-3

Managerial Economics and Organizational Architecture, 5e Defining and Enforcing Property Rights Enforceable property rights increase incentive to invest and trade –patents, copyrights, trademarks Enforceable contracts reduce transactions costs –greater gains from trade, more wealth –Lower transactions costs of contracting 21-4

Managerial Economics and Organizational Architecture, 5e Redressing Market Failures Externalities –costs or benefits imposed on involuntary parties –pollution Public goods –nonrival consumption –nonexcludable –free riders 21-5

Managerial Economics and Organizational Architecture, 5e Redressing Market Failures Monopoly –antitrust laws –potential for regulators to be “captured” by the industry Informational failures 21-6

Managerial Economics and Organizational Architecture, 5e Redistributing Wealth Individuals have incentives to use regulatory powers to their advantage Lobbying for wealth transfers yields no productive benefits for society Taxi quotas raise the price above equilibrium reducing consumer surplus Taxi companies are willing to spend up to the increase in their profits to lobby 21-7

Managerial Economics and Organizational Architecture, 5e Wealth Transfers via Government Quotas on the Number of Taxis Government intervention yields higher price (P’) and lower output (Q’), reduces consumer surplus (shaded area) and transfers wealth to cab companies (π). Q Q’ Q* $ P’ P*S D π Lost potential gains from trade 21-8

Managerial Economics and Organizational Architecture, 5e Economic Theory of Regulation Special interests express demand for regulation or other favorable laws Politicians (self-interested) supply regulation and other laws Incentives to free ride and form coalitions –political power depends no ability to deliver votes and contributions –special interests are costly to form 21-9

Managerial Economics and Organizational Architecture, 5e Market for Regulation In competitive and unregulated industry, P c =MC Collusion among firms could yield monopoly price, P m >P c This will maximize profits in the industry If the industry is regulated, the firms will want P m and consumers will want P c 21-10

Managerial Economics and Organizational Architecture, 5e Industry Profits in Competitive and Monopolized Markets Price (in dollars) Quantity Profit $ $ P0P0 PmPm PcPc MC MR D Q QmQm QcQc P0P0 PmPm PcPc ΠmΠm 21-11

Managerial Economics and Organizational Architecture, 5e Regulatory Behavior Regulator seeks to maximize political support from constituents –businesses prefer higher profits –consumers prefer lower prices Political support functions illustrate tradeoff between prices and profits that yield the same political support 21-12

Managerial Economics and Organizational Architecture, 5e Political Support Functions ΠxΠx ΠyΠy Price (in dollars) $ p Profit PS 1 PS 2 PzPz PxPx PyPy Increasing political support 21-13

Managerial Economics and Organizational Architecture, 5e Regulatory Market Equilibrium Regulators choose the price and profit level that maximizes their political support Regulated price is determined by tangency between monopoly profit function and political support function Regulated price is P r *, P c <P r *<P m 21-14

Managerial Economics and Organizational Architecture, 5e Equilibrium Regulated Price Price (in dollars) $ Profit p PS 2 PS 1 P0P0 PmPm P* r PcPc Π*rΠ*r ΠmΠm 21-15

Managerial Economics and Organizational Architecture, 5e Market for Regulation Regulators do not always behave in obviously consistent ways Unorganized consumers offer regulators relatively little political support Political outcomes depend on relative effectiveness of special interests Government programs tend to benefit small groups at the expense of large groups 21-16

Managerial Economics and Organizational Architecture, 5e Managerial Implications Government regulations can create barriers to entry –directly (e.g., legal profession, mail delivery) –indirectly (e.g., restaurant health codes, imposition of payroll tax) Firms have incentives to push for regulations that raise their rival’s costs Importance of coalition formation Business participation in political process 21-17

Managerial Economics and Organizational Architecture, 5e Payroll Tax and Profits of Low-Labor Firms Price (in dollars) Quantity of rugs $ S1S1 S0S0 D Q 21-18