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Government and Business

by: Morgan Breitenberg

Government and Business ECON 356

Morgan Breitenberg
GPA 3.67

Thomas Tenerelli

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Thomas Tenerelli
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This 22 page Class Notes was uploaded by Morgan Breitenberg on Monday October 5, 2015. The Class Notes belongs to ECON 356 at Central Washington University taught by Thomas Tenerelli in Fall. Since its upload, it has received 19 views. For similar materials see /class/218985/econ-356-central-washington-university in Economcs at Central Washington University.


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Date Created: 10/05/15
Econ 356 Chapter 2 Greer The Market Ideal amp Real 1 Equot Purpose of this course to identify areas where the government can intervene in a free market economy to bring about a more ef cient result 7 more ef cient in the sense of moving to a new outcome where the net social valuebene t is greater a Social Value Social Net Bene t Social Bene t 7 Social Cost b The terms net social valuebene t social welfare and ef ciency will be used interchangeably in this course Therefore an outcome that is more ef cient is one that has a greater net social valuebene t and a great level of social welfare Theoretical Background a Consumer amp Producer Surplus i Consumer Surplus The difference between what they would be willing to pay and what they actually pay 1 CS value net bene t to buyers willingness to pay 7 P 2 CS area below D and above P up to Q a The sum of the vertical lines below D and above F ii Producer Surplus The difference between the total dollar amount producers receive and the amount they must give up to cover their costs 1 PS value net bene t to sellers P 7 cost 2 PS area above S and below P up to Q a The sum ofthe vertical lines above S and below F iii Demand MPB 1 Demand represents willingness to pay 2 At each point on the demand curve the height of the demand curve represents the Marginal Private Bene t to the consumer represented at that point on the demand curve iv Supply MPC 1 Supply represents cost of production 2 At each point on the supply curve the height of the supply curve represents the Marginal Private Cost to the producer represented at that point on the supply curve curve b Externalities i MSB MPB external bene t ii MSC MPC external cost iii Only one S and D curve 1 D is the sum of the individual demand curves 2 S is the sum of the individual rm supply cost curves iv No Externality l D MPB MSB S MPC MSC Marginal Social Value Marginal Social Net Bene t MSB 7 MSC Marginal Social Value is maximized where MSB MSC a This is at the market equilibrium with no extemalities V Negative Externality l D MPB MSB 59 2 S MPC a Note there is only one supply curve where S the sum of the individual rm supply curves the individual rm MC curves b Hence there is only one market equilibrium 3 MSC MPC external cost 4 External cost at each level of production is the cost to other members in the economy besides producers External cost denotes the cost of each marginal additional unit of production a Example the marginal additional cost to the shing industry and to people who sh for sport of the pesticidesfertilizer associated with each additional unit of production ton of owers 5 Marginal Social Value Marginal Social Net Bene t MSB 7 MSC 6 Social Value Social Net Bene t is maximized where MSB MSC 7 Market level of production MSB lt MSC gt decrease production 8 To get to the ef cient level of production MSB MSC a Use a tax equal to the external cost to bring the after tax supply curve in line with the MSC curve 9 Solutions a Impose a tax on output i A tax involves both an increase in social value and a transfer from both consumers and producers to society others in the economy b Impose a tax on pollutants c Tradable pollution permits i Equivalent to a tax on pollutants d Regulate pollutants either through quotas on pollution or through requirements that rms utilize technological innovations to reduce pollutants e Quotas on output i Lowest cost producers aren t guaranteed to produce under a quota system Therefore some value ef ciencysurplus may be lost f Price oor not a viable solution i Low cost producers may not be ones who sell ii Overproduction may occur g Social norms h The Coase Solution i When property rights are well de ned regardless of who has them and there are no transaction costs the ef cient solution will occur 10 Note no negative extemality e g pollution is usually inef cient We maximize social value social net bene t by having an optimal level of a negative extemality e g pollution To maximize social value output and the associated negative extemality should be reduced until the MSB of the reduction just equals the MSC of the reduction Vi Positive Externality l D MPB a Note there is only one demand curve where D the sum of the individual consumer demand curves b Hence there is only one market equilibrium N MSB MPB external bene t S MPC MSC External bene t at each level of production is the bene t to other members in the economy besides consumers External bene t denotes the bene t of each marginal additional unit of production a Example the marginal additional bene t to passers by other than the actual consumers who view the owers at homes and businesses associated with each additional unit of production ton of owers Marginal Social Value Marginal Social Net Bene t MSB 7 MSC Social Value Social Net Bene t is maximized where MSB MSC Market level of production MSB gt MSC gt expand production To get to the ef cient level of production MSB MSC a Give a subsidy to consumers of the good i Use a subsidy equal to the external bene t to bring the after subsidy demand curve in line with the MSB curve Then the after subsidy demand curve and supply curve will intersect at the optimal level of Q b Give a subsidy to producers of the good i Use a subsidy equal to the external bene t to create an after subsidy supply curve that intersects the demand curve at the optimal level of Q c Social norms 5 9 89 3 Ideal Answers to the Basic Economic Questions a Static Ef ciency We maximize the social value net social bene t from the use of our resources subtracting the total social costs from the total social bene ts i iii vi Social Value Net Social Bene t Social Bene ts Social Costs 1 Marginal Social Value MSB MSC 2 So long as Net Marginal Bene t is above zero expanding production results in additional net social bene t As long as the marginal social bene t MSB of using our resources in some way e g producing pizzas is greater than the marginal social cost MSC we should expand that production 1 MSB the added total bene t to society of an added unit 2 MSC the added total cost of the added unit 3 When MSB MSC net bene t is maximized 4 Producing units beyond the point of MSB MSC reduces net bene t Production ef ciency requires that the cost of producing any given amount be as low as possible This is assumed for Figure 21 In simple English production ef ciency requires that we produce as much of each desirable good or service as we can given the production of other desirable goods and services Allocative ef ciency requires that the quantity produced be just right to maximize the total net bene t given production ef ciency Figure 21 1 In short panel b of Figure 21 depicts static ef ciency because 1 the costs in MSC are as low as possible and 2 output Qo yields the greatest net bene t N with MSB MSC Pareto Optimality Another way of expressing static ef ciency A situation in which no one can be made better off without making someone else worse off Figure 22 illustrates Pareto optimality for a simple society comprised of only Al and Barb 2 Any point inside the boundary like X is not Pareto optimal because from there the welfare of either of these individuals could be improved with no loss to the other All points on the boundary are equitable but you may not think they are all equitable The social value maximizing solution the quantity associated with the intersection of the MSB and MSC curves is Pareto Optimal With a negative extemality for example although it unambiguously improves welfare have a tax you may not think the result the resultant transfers which arise from a tax is equitable a However it is generally true that so long as social value has increased and thus the pie has grown everyone can at least theoretically be made better off since there is enough to give everyone what they had before plus a little more 7 its just a matter of redistributing in the appropriate way E 4 V39 b Equity i The ideal regarding the question of who gets the goods and services Theorists have not yet devised a sweeping definition of equity that wins a consensus of approval Unlike efficiency equity grapples directly with issues of distribution ii Notice in Figure 22 that point Z is a point of static efficiency Pareto optimality but it could be considered inequitable c Dynamic Ef ciency i Takes into account future generations ii An allocation of resources to future time periods is dynamically efficient if it maximizes the present value of the total net benefits that could be received from all possible ways of allocating those resources over those future time periods iii All future net benefits are discounted into present values before they are added together for a calculation of dynamic efficiency iv By imagining a sequence of triangular total net benefits such as the one shown along in panel b of Figure 21 a sequence like the frames in a strip of motion picture film v The concept of dynamic efficiency is useful though for demonstrating that the future consequences of today s actions can be momentous Energy policy cannot ignore conservation 2 Environmental policy cannot look only to present day impacts of CFC s nuclear wastes or other materials that could mangle the wellbeing of future centuries Today s investments in research and development will bring amazing future technological changes vi For many purposes static efficiency is much too tightly bound to the present to this year and maybe the next to be useful even in theory 4 The Conditions for Markets to Achieve Static Ef ciency a Comment Limited though it may be the ideal of static efficiency carries tremendous weight in Washington because it provides the foundation for benefitcost analysis which guides much governmental decision making E b Conditions for Static Efficiency Under certain ideal conditions the free market will in theory obtain static efficiency Those conditions include the following i ii An absence of external bene ts MPB MSB An absence of external costs MPC MSC iii Pure competition P MC 1 A very large number of buyers and sellers such that none of them acting individually can affect the market s price 2 A standardized product 3 Easy entry and exit 4 Then Sellers have no power over price so price will match their marginal private costs P MPC including a normal profi 5 Graph iv Full information MPB P 1 Meeting this condition of full information assures that buyers will not be ripped off 2 Specifically each buyer s marginal private benefit must equal the price ie MPB P V No public goods or common property resources 1 Public goods benefit everyone within their range so excluding people from them is either impossible or too expensive a As explained later the market cannot cope with public goods chie y because of the free rider problem b Classical examples include national defense and abatement of air pollution 2 Common property resources are a variant of this theme because they are resources open to use by anyone without restriction a The underlying root of the problem with common property resources is that Because anyone can use common property resources they tend to be wastefully overused b Examples are ocean fishing or the air before the days of environmental protection 3 Strictly private goods and private properties meet this requirement vi All the above conditions imply that MSB MSC See Table 2 1 5 How the Market Achieves Static Efficiency Under Ideal Conditions a Figure 23 6 Problems with Real Markets a Imperfections i Monopoly Power 1 Three assumptions of the purely competitive model preclude the possibility of monopoly power 7 a large number of relatively small sellers easy entry and standardized products Though Farmer Brown may fit this mold IBM GM Procter amp Gamble DuPont and the other giant firms that account for the bulk of our industrial output do not Most of these enterprises are oligopolists operating in industries dominated by just a few sellers industries also protected by barriers to entry and providing differentiated not standardized products These several characteristics bestow monopoly power of various degrees N 4 The static insufficiency created by pure monopoly is sketched in Figure 24 Monopoly raises price and reduces output in comparison with the purely competitive case shown in Figure 23 The result is a MSB gt MSC b The shaded triangular area to the right of monopoly output shows the lost net bene t caused by monopoly In the AntiTrust and the Economic Regulation sections of this course we will talk about various government strategies for dealing with monopoly power Information Inadequacies N Equot 4 0 Definition Realworld buyers are often led astray by ignorance misjudgrnent and sundry other deviations Evidence Consumer ineptitude emerges from studies of the correlation between price level and brand quality observed correlations are on average always much closer to zero than to one and the range across products includes a substantial number of goods with negative correlations Problems in the market for information Potential sellers are reluctant to produce information Inappropriability When private producers of information are not rewarded in just proportion to the social value of their effort It often applies to information because information may be spread by means outside the control of the information s original producer 7 for example piracy by word of mouth The result is producers of information expend less effort than is socially optimal Potential buyers are reluctant to purchase information Buyers of information cannot be truly well informed about the information they want to buy Buyers of information therefore do not know the value of the product they seek information Advertising can actually contribute towards informational inadequacies rather than diminish them a Advertising is meant to persuade While advertising can be informative its purpose is to persuade so it is informative only to the extent the informative approach persuades which is true mainly of ads for producers goods not consumers goods Advertisements can mislead Still worse advertisers frequently have an incentive to mislead misrepresent and even lie behaviors that cannot be said to contribute to consumer competence Directions of consumer error E Fquot Fquot a Errors of commission results in more spending than accuracy would entail and a consequent overallocation of resources to the favored brand or product b Errors of omission arise when buyers buy less than they would with full knowledge The misallocation here would obviously be an underallocation Solution Examples a The Food amp Drug Administration FDA i Drug safety b The National Highway Traffic Safety Administration NHTSA i Crash standards for vehicles c The Consumer Product Safety Commission CPSC i Safety standards for cribs the 95 solution 2375 vs 35 b Market Failures Externalities i Equot Definition an external effect on another produced by for example the transaction between buyers and sellers in a market External Bene ts a Example the market for education b Figure 25 c Result With external benefits there is too little output MSB gt MSC That is the free market results in a level of output that falls short of the point where MSB MSC d Solution i Give a subsidy to consumers of the good 1 Use a subsidy equal to the external benefit to bring the after subsidy demand curve in line with the MSB curve Then the after subsidy demand curve and supply curve will intersect at the optimal level of ii Give a subsidy to producers of the good 1 Use a subsidy equal to the external benefit to create an after subsidy supply curve that intersects the demand curve at the optimal level of iii Social norms e Other examples External Costs a Example the market for steel and the resultant pollution b Figure 26 c Result With external costs there is too much output MSB lt MSC That is the free market results in a level of output that goes beyond the point where MSB MSC Solutions i Impose a tax on output 1 A tax involves both an increase in social value and a transfer from both consumers and producers to society others in the economy ii Impose a tax on pollutants iii Tradable pollution permits 1 Equivalent to a tax on pollutants iv Regulate pollutants either through quotas on pollution or through requirements that firms utilize technological innovations to reduce pollutants v Quotas on output 1 Lowest cost producers aren t guaranteed to produce under a quota system Therefore some value efficiencysurplus may be lost vi Price oor not a viable solution 1 Low cost producers may not be ones who sell 2 Overproduction may occur vii The Coase Solution 3 1 1 When property rights are well de ned regardless of who has them and there are no transaction costs the ef cient solution will occur e Other examples Public Goods 1 4 De nition 1 there are three elements common to most de nitions a Their production and consumption usually coincide so they cannot be inventoried b NonRival One individual s consumption does not subtract from any other individual s consumption c Additional consumers can partake of these goods at no additional social cost or near zero cost De nition 2 a Non Excluded Consumers are not or cannot be excluded from using the product b Non Rival One individual s consumption does not subtract from any other individual s consumption Examples highways bridges national defense clean air Problem A main problem with free market provision of these goods is the free rider problem The free rider is one who does not pay for the good but who hopes to receive the bene t of consuming the good Result The good is not producedconsumed despite the fact that MSB gt MSC a Producers have no incentive to produce the good as few are willing to pay for the good b With the marginal social costs of consumption approaching zero any positive price charged for these goods as would be necessary to reward free market suppliers would exceed marginal cost The resulting P gt MC or more generally MSB gt MSC would then lead to the free market s underallocation ofresources to these goods Excludable Public Goods a Definition public goods from which consumers can be excluded from using b Examples highways amp bridges c Solution i People can in principle excluded from the use of highways and bridges by the judicious construction of limited entry points and fares can be collected with toll booths ii Pay for the goods with tax proceeds if the bene ts exceed the costs 7 essentially forcing consumers to pay for the product 1 Produce at the level where MSB MSC Nonexcludable Public Goods a Definition public goods from which consumers cannot be excluded from using b Examples national defense basic research clean air catalytic converters Solution If the bene ts exceed the costs of the good force consumers to pay for the good by for example 1 paying for it with tax proceeds national defense or 2 by mandating that consumer purchase the good catalytic converters O iii i Produce at the level where MSB MSC 8 Bene t Cost Analysis Determining 1 when the bene ts exceed the costs of a public good and 2 the optimal level of the public good a See Ch 2 of Viscusi b Example The town can spend 10000 to build and operate a traf c light at a 0 3 1 town intersection that now has only a stop sign The bene t of the traf c light is increased safety The engineer estimates based on data from similar intersections that the traf c light would reduce the risk of a fatal traf c accident over the lifetime of the traf c light from 16 to 11 percent Should you spend the money for the new light Mankiw 2007 p 230 At rst you may be tempted to conclude that a human life is priceless After all there is probably no amount of money that you could be paid to voluntarily give up your life or that of a loved one This suggests that a human life has an in nite dollar value For the purposes of costbene t analysis however this answer leads to nonsensical results If we truly placed an in nite value on human life we should place traf c lights on every street comer and we should all drive large cars loaded with all the latest safety features Yet traf c lights are not at every corner and people sometimes choose to pay less for smaller cars without safety options such as sideimpact air bags or antilock brakes Mankiw 2007 p 230 Once we have accepted the idea that a person s life has an implicit dollar value how can we determine what the value is One approach sometimes used by courts to award damages in wrongfuldeath suits is to look at the total amount of money a person would have earned if he or she had lived Economists are often critical of this approach It has the biza1re implication that the life of a retired or disabled person has no value A better way to value human life is to look at the risks that people are voluntarily willing to take and how much they must be paid for taking them Mortality risk varies across jobs for example By comparing wages in risky and less risky occupations controlling for education experience and other determinants of wages economists can get some sense about what value people put on their own lives Studies using this approach conclude that the value of a human life is about 10 million Mankiw 2007 p 230 We can now return to our original example and respond to the town engineer The traf c light reduces the risk of fatality by 05 percentage points Thus the expected bene t from having the traf c light is 0005 x 10 million or 50000 This estimate ofthe bene t well exceeds the cost of 10000 so you should approve the project Mankiw 2007 p 230 Common Property Resources 1 De nition a Non Excluded Consumers are not or cannot be excluded from using the product b Rival One individual s consumption DOES subtract from another individual s consumption 2 Examples sheries radio spectrum deepocean minerals and at one time oil 3 Problem There is an externality problem 7 speci cally an external cost A sherman for example will face costs for fuel labor seaworthy capital equipment and so on He will also impose costs on others however because additions to his catch reduce the sh available to other sherman causing them to spend more time effort and energy for any given number of sh they may successfully net 4 Result People overuse of the good That is they use the good at a level where MSB gt MSC Often the good will be overused to the point of depletion a This communal working at crosspurposes is a form of external cost which when not taken into account leads to an error in the direction of overallocation or in this case over shing 5 Solutions a Improved de nition of property rights b Quota systems c Taxes d Government stewardship through public ownership c Dynamic Incapacities i Micro Instability and Transition Immobilities 1 Micro Instability Substantial shifts of a market s supply and demand curves 7 due to cyclical swings the vagaries of the weather and other contingencies 7 can cause rocky instability a Example During the rst decades of the 203911 Century for instance prior to federal intervention in agriculture farm incomes in some regions varied hundreds of percentage points from one year to the next b Solutions price supports commodity agreements and insurance reserves 2 Transition Immobilities Disequilibrium in particular markets may also accompany marked changes from one equilibrium to another a Example frictional unemployment The move from Q4 to Q3 in Figure 2 6 for instance bene ts society as a whole but may hurt the paper makers steelworkers and others whose relocation out of polluting industries is necessitated by the transition b 39 44 I F J r im job training and payments to transform industries hard hit by import competition ii Macro Instability 1 Example Depression and recession are undesirable because they frustrate the employment and income aspirations of many people In ation has been an even more bruising bane 2 Solution Federal Reserve iii Growth short run protection and promotion for long run gain In the week these words were rst written Business Week published a special issue bemoaning the Us economy s languid growth and urging a massive effort by business government and labor to achieve the Reindustrialization of America 2 These events illustrate society s doubt that the freemarket system can always perform satisfactorily on these scores 7 Ethical Criteria Other Than Ef ciency a Purpose i These criteria provide a framework for understanding policies which are not necessarily consistent with raising efficiency net social valuebenefit ii The last broad category of Table 22 acknowledges that freemarket solutions may be rejected on value judgment grounds rather than net social benefitvalue grounds b Equity i Horizontal Equity equals should be treated equally 1 Horizontal equity was the main force behind such legislation as the Equal Pay Act of 1963 the Civil Rights Act of 1964 and the Equal Employment Opportunity Act of 1972 ii Vertical Equity unequals should be treated unequally 1 Equity between the rich amp poor Sympathy for the poor instructs that we should not reward the rich with pennies taken from the poor that the chief cost burden of a government program should not fall on the poor and that if price differentials are to be permitted they should favor the poor rather than the rich 2 Equity between generations Future generations may not appreciate our shoddy storage of millions of tons of toxic wastes c Merit and Demerit Goods i Definition goods that are deemed to be good merit or bad demerit for consumers 139 of the 1 f ii Examples Merit Goods education fuelefficient cars motorcycle helmets and retirement insurance iii Examples Demerit Goods cigarettes liquor narcotics gambling snakeoil medicines and easytoopen poison containers iv Consumer Sovereignty Intervention on grounds of merit and demerit goods tramples on the ethic of consumer sovereignty which asserts that people s preferences are somehow given and unchanging that those preferences ought to be fully respected and that the market is efficient because it forces producers to satisfy those sacred preferences as well as possible within the bounds of scarcity d Morality i Closely related to merit amp demerit goods are areas where policy is brought into play largely on moral grounds where the consumer s or producer s material welfare is not so much at issue as in the preceding but his or her behavior is in itself judged to be right or wrong Gladiatorial contests pornography painful slaughter of animals extermination of species like the bald eagle and great blue whale abortion 7 each of these fires strong moral indignation among millions in our society e Miscellaneous Political and Social Goals i Decentralization of economic power ii Small business iii Other honesty amp fairness truthful advertising fair competition limited payola bribery Chapter 2 V iscusi et al Making of Regulation Packet p 24 34 1 The Nature of the Regulatory Oversight Process a Analyzing the Usefulness of Regulation Bene t Cost Analysis 11 i The ratio of bene ts to costs or the bene t cost ratio must exceed 10 for a policy to be potentially attractive ii Figure 2 1 Costs a The cost of providing environmental quality rises as the level of environmental quality improves b Moreover the cost increases at an increasing rate i because improvements in environmental quality become increasingly costly to achieve As the most promising policy alternatives are exploited one must dip into less effective means of enhancing environment quality and resorting to these contributes to the rise in costs 2 Bene ts a Bene ts increase b Bene ts increase at a decreasing rate i The initial gains are the greatest as they may affect our life and well being in a fundamental manner The additional health and welfare effects of environmental quality improvements eventually diminish 3 The maximum is achieved at the point where the gap between the bene t and cost curves is the greatest b Present value and discounting deferred effects i Present value ZBi Ci 1 ri c Regulatory success stories i Centerhigh mounted stop lamps ii Phasedown of lead in gasoline 2 Some issues relating to cots The Criteria Applied in the Oversight Process a Promotion of cost effective regulation i Performance oriented regulation this concern with the ends rather than the means 1 Enforcement can be more expensive b Distortion of bene t and cost estimates i The scientific analyses underlying risk regulations typically include a variety of assumptions for the purpose of conservatism but which in effect distort the assessment of the merits of the regulation 1 Various conservatism factors are used by different agencies 2 Examples a Focusing on the upper limit of the potential risk b risk analysts simply multiplying these risks by a factor of 1000 c The regulatory role of price and quality 3 i A general principle that has guided the development of regulation and in particular the deregulation effort is that regulation of prices and production in competitive markets should be avoided ii we also do not wish to standardize quality except when there are legitimate reasons for doing so as in the case of provision of minimal safety levels for cars 1 Give consumers right to buy only what they value Assessing the Costs of Regulation The Impact of the Oversight Process a The Cost of Regulation i Much of the impetus for regulatory oversight has been a concern with the excessive costs imposed by unattractive regulations ii Direct Costs In 1990 President Bush notes the staggering levels of costs involved Federal regulations impose estimated direct costs of more than 1700 for every taxpayer in the United States iii Indirect Costs The Council of Economic Advisors estimates that airline deregulation led to 15 billion worth of gains to airline travelers and airline companies The total saving from deregulation efforts in the transportation field airlines trucking railroads are on the order of 60 billion per year a substantial payoff indeed for a return to greater reliance on market forces b Other Measures of the Size of Regulation i Total Cost The total cost level in 1995 was 668 billion which includes regulations that were simply transfers such as the minimum wage Transfers accounted for 147 billion ofthe costs From an economic standpoint this is not an efficiency loss the gains to workers offset the losses to firms ii Proportion of GDP In 1995 the regulatory cost share ofthe GDP was 92 1 72 net of transfers iii Per Household Costs In 1995 these costs were estimated to be 6809 per household 1 5311 net oftransfers iv Note If the regulations generate benefits that exceed the costs then it is desirable to promote such regulation rather than discourage i c What do Regulators Maximize i In theory regulator agencies serve to maximize the national interest subject to their legislative mandates What is clear at this stage is that there are certainly in uences at work other than those that are formally specified ii The Capture Theory 1 Under the capture theory of regulation such as that espoused by George Stigler the regulatory agency is captured by the economic interests that it serves a Regulation of airline fares can for example provide a oor on airline rates that enables firms to make greater profits than if there were price competition b Similarly minimum quality standards for products can promote the interests of the more established and advanced rms in the industry Chapter 4 Greer The History of Regulation p 71 84 1 2 3 1877 1920 Concentration amp Progressivism 1921 1959 Crash Collectivization and Security 1961 79 The Era of Social Regulation Antitrust Policy Ch 5 10 Greer 1 Equot The Problem Concentration Collusion amp Monopoly Formation Market Power a Various factors contribute towards 1 industry concentration which can result in 2 collusion and monopoly formation which in turn can cause 3 market power b Market power is the ability of a rm or rms to in uence pro ts production ef ciency and innovation within an industry Market Concentration Measures amp Problems a Measures i The market share of the leading rm is thus one method of measuring market concentration ii The market share of the leading four rms the four rm concentration ratio iii HIndexes square the shares of all rms and then add them b Potential Problem Market concentration creates the potential for market power but it does not guarantee it i Bertrand versus C0urn0t solutions 1 Bertrand rms lower price in order to capture a signi cantly larger market share This is done until economic pro ts are zero 2 Coumot rms tacitly cooperate to share industry pro ts ii By one estimate pretax return on investment rises about 5 percentage points for every 10 percentagepoint increase in market share iii Figure 53 Market Concentration Sources a Natural Market Structure i Large economies of scale 1 Occurs when average total costs decline by a large degree with expansion of output and or decline over a wide range of output 2 Causes include low or decreasing marginal costs and large xed costs a High xed costs are prevalent in capital intensive industries like chemicals petroleum steel autos etc ii Natural Barriers to Entry 1 Large economies of scale 2 Large xed costs iii Other 1 Scarce resource inputs 2 Early or late stages in the industry s life cycle b Arti cial i iii Mergers 1 Horizontal 2 Vertical 3 Conglomerate Monopolization Predatory pricing 1 De nition A relatively large deeppocketed rm aggressively cuts prices below cost for purposes of imposing losses on smaller existing rivals or threatening nancial injury to potential rivals thereby driving them from the market or softening them up for eventual merger Exclusionary Practices exclusionary practices are practices that exclude certain customers and may be aimed at driving out competitors in an attempt to gain market power Each of these practices can have legitimate and ethical goals Unfortunately they can also have the illegitimate and unethical intended or unintended consequences of reducing competition in certain markets Chapters 9 amp 10 Greer 7 ch 10 is not included in packet 1 Exclusive dealing Chapter 10 Greer a De nition when a seller prohibits his buyers from buying goods from the seller s rivals b Example During the 1980s Pillsbury Company tried to maintain market share for its HaagenDazs ice cream by imposing exclusive dealing on its distributors c Bene ts i Positive incentives for suppliers retailersdistributors 1 Financial remuneration a Opportunities for suppliers retailersdistributors to capitalize on market strength in a competitive retailerdistributor industry a reasonable goal 2 More certain supplies 3 Lower inventories due to reduced uncertainty 4 Territorial restrictions implemented that protect supplier d Costs i Reduced competition and hence encourages cartel formation in the producer market 1 Dominant firms can have significant leverage over retailers amp distributors and use it to sti e competition at the producer level 15 e The net effect is ambiguous and depends on the particular conditions 2 Territorial restrictions Chapter 10 Greer a Fquot c 1 d i e 1 De nition a restriction on the area that retailersdistributors can sell a product placed on the retailersdistributors by the producer of the product Example Franchised retailers were bound by contract not to sell except from locations approved by Sylvania The strategy encouraged retailers to promote Sylvania sets more aggressively than before thereby booting Sylvania s market share from about 2 percent in 1962 to 5 percent in 1965 Bene ts Provides incentives for retailerdistributor activities that encourage market share of producer For example retailers will market more aggressively because they can better capture the gains from their marketing expenses This helps both producers and sellers retailersdistributors l Retailers distributors have greater potential pro t 2 The producer has greater potential pro t Interbrand competition is increased in the seller s retailer sdistributor s market Costs Intrabrand competition is reduced in the seller s retailer sdistributor s market because there are less sellers The net effect on horizontal competition among retailers is ambiguous and depends on the particular conditions The gains of increased market share of the product a legitimate goal have to be weighed against the costs of decreased competition at the retailer distributor level The greater the concentration at the manufacturer or franchisor retailer level the greater the problem 3 Resale price maintenance Chapter 10 Greer a b i c 1 De nition agreement between producers and retailers distributors that the price of the produce stay above a certain level Bene ts Increases incentives for retailer distributor activities that encourage market share of producer a reasonable goal because sellers know they can t be undercut on price Costs Reduces competition and hence encourages cartel formation in the seller s market 1 In fact resale price maintenance may be made in response to retailers amp distributors Reduces competition in the producer s market 16 d l 2 Aids cartel discipline by identifying cheaters Cements vertical relationships that increase exclusive dealing The net effect is ambiguous and depends on the particular conditions i The critical question for legality has become whether manufacturers conspire with some retailers to eliminate others p 208 4 Tying Arrangements Chapter 10 Greer a Fquot 0 De nition When a seller gives buyers access to one line of the seller s goods only if the buyer purchases others as well Example International Salt had a limited patent monopoly over salt dispensing machines used in food processing Users of the machines had to buy their salt from International or find other machines Bene ts i Goodwill For example a franchisor can assure standardization of quality among his many franchisees The increased standardization increases the market share of producer a reasonable goal Price discrimination heavier users of the product are charged more through their purchase of the elevated price tyed good d Costs e i Reduces competition in the producer s market for the tied good 1 2 The net effect is ambiguous and depends on the particular conditions It can raise barriers to entry in the market of the tied good It can seriously disadvantage smaller tied good competitors 5 Price discrimination Chapter 9 Greer a De nition Whenever a seller sells the same commodity or service at more than one price Here we will only discuss price discrimination that occurs when producers sell to sellers retailers distributors as this is typically deemed potentially much more damaging to competition then price discrimination to downstream customers like reduced senior or student prices b Bene ts c i Pass on cost savings of producers to suppliers retailersdistributors in the form of lower prices Costs i Reduces competition in the producer s market Primary level injury ii Reduces competition in the seller s retailer sdistributor s market Secondary level injury d Types of price discrimination i Quantity Discounts Quantity discounts are based on the amount purchased in a single transaction with large quantities lowering price ii Volume discounts Volume discounts are based on cumulative purchases involving numerous transactions during some stated period of time such as one year 1 Of the two volume discounts are least likely to be costjustifiable and more anticompetitive in the broad sense For these reasons the FTC has attacked volume discounts much more vigorously than it has quantity discounts 2 Reduces competition in the producer s market Territorial Price Discrimination This type of discrimination takes two forms 1 selective geographic price cutting and 2 f1ctional freight charges imposed under basingpoint pricing systems 1 Selective geographic price cutting potentially reduces competition in the producer s market due to predatory pricing or collusion 2 Fictional freight charges reduce competition in the seller s retailer sdistributor s market and the producer s market to the extent that base point pricing is a form of collusion iv Functional Discounts Discounts are determined by the place of buyers in the traditional distribution network 1 Reduces competition in the seller s market when sellers at different points in the distribution process compete in the same segment a For example a problem arises when a buyer performs a dual role say wholesaling and retailing in which case the buyer may get a large wholesaler s discount that gives him a competitive advantage when reselling as a retailer v Arti cial Barriers to Entry 1 Patents 2 Occupational Licensing 4 Collusive Actions Chapter 8 Greer a Explicit Collusion rivals enter into an express cartel agreement to fix prices to allocate sales territories or to curb competition in some other way i Explicit collusion is observed most commonly in moderately to tightly knit oligopolistic markets b Implicit Collusion rivals act uniformly to obtain the same goals of explicit collusion through tacit understanding i Implicit collusion is possible only when concentration is quite high and entry is at least partially impeded c Clear Evidence Cases Cases with clear evidence of anticompetitive collusion i Single sales agency producers refuse to sell directly to their customers and instead sell through a common central agency that sets the pr8ice for all participants ii Contracts for example to sell at an agreed upon price 18 iii Market Allocation each cartel member is assigned exclusive access to certain geographic areas or customers iv Example Addyston Pipe amp Steel case of 1899 Six manufacturers of cast iron pipe including Addyston entered into an agreement that among other things assigned certain southern and central United States cities to individual member s of the cartel The price at which pipe was sold in each reserved city was determined jointly by members of the cartel To give the appearance of continued competition other members submitted ctitious bids to customers in reserved cities ctitious because these bids were always at prices higher than those charged by the designated member d Circumstantial Evidence Cases Cases offering no more than circumstantial evidence i Trade associations 1 Because education is a prime purpose of trade associations it is quite common for them to collect and disseminate information on a wide variety of subjects prices included that can be used by members to aid in price xing and other collusive behavior 2 Example American Column and Lumber case Excessive information was shared on prices sales and production Additionally the following statements were made during one of the monthly trade association meetings If there is no increase in production particularly in oak there is going to be good business and No man is safe in increasing production The Supreme Court decided this was not the conduct of competitors ii Base Point Pricing 1 The old Pittsburgh Plus single basingpoint system of the steel industry Until 1924 all steel producers regardless of their mill locations quoted prices as if they were shipping from Pittsburg iii Professional Societies 1 A common restraint of competition has been the prohibition of price advertising or all advertising 2 In a study comparing retail prices of eyeglasses in the 1960s in states that did and did not legally restrict optometrists advertising the following results were found Comparing the most and least restrictive states average prices were 3748 and 1798 respectively 5 Market Power the ability of a rm or rms to in uence pro ts production ef ciency and innovation within an industry The manifestations of market power are the following a Increased Pro t Pro t can be problematic when it is excessive that is when the levels are tied to unacceptable conduct issues largely leading to concentration 0 More than 100 statistical studies have tested the relationship between pro t level and various measures of market power and most have found a positive relationship 0 Excessive pro t derives primarily from pricing power 19 b Reduced Production Ef ciency i See text p 9798 c Reduced Product Innovation Progressiveness i See text p 98 6 Enforcement of the Antitrust Policy a The Antitrust Division of the Department of Justice 1 An investigation usually springs from the complaints of citizens of businessmen of other government agencies or from reports in the business press From there the investigation may progress to rather formal stages including the use of a grand jury in criminal proceedings Most investigations never go beyond preliminary probing but for those that do a draft complaint is drawn up a supporting report is written and numerous consultations are held among division personnel Upon approval of the Assistant Attorney General for Antitrust the case is then led in one of our ninety federal district courts for trial or settlement sanction From there on the federal courts become the instrument through which the Department of Justice must work b The Federal Trade Commission 1 The Federal Trade Commission is headed by a panel of ve commissioners each appointed to sevenyear terms by the president and approved by the Senate A supporting staff includes over 900 others 7 administrative law judges lawyers economists and so on c See Table 55 i Number of antitrust Violations by regulatory body 7 Exemptions from Antitrust Policy a Since passage of the Sherman Act in 1890 exemptions from antitrust law have accumulated like attic junk Some of the most important of them guard export cartels labor unions agricultural cooperatives and regulated industries from the reaches of the law i ii iii b Export cartels likely due to small negative effects on Americans Labor unions likely due to historically large though recently severely diminished political power Agricultural cooperatives likely due to large though declining political power Regulated industries Natural monopolies argue for protection based on cost efficiencies 1 But to the extent the efficiencies of the companies are real they likely wouldn t have to rely on antitrust law exemptions In recent years the deregulation movement has stripped some industries of their most comfortable immunities exposing them to the cold winds of competition 8 The Methods amp Results of Antitrust Policy Chapter 6 Greer 20 o The key question then is whether an arrangement has the purpose or effect of seriously damaging competition In turn this question may be answered through application of one of two subsidiary rules a per se rule or rule of reason a Rules i Per se rule If conduct is governed by a per se rule prosecuting authorities need only prove that the offending conduct actually occurred No inquire into the rationale of the conspirators or the economic condition of the industry or the impact on price level or other considerations need be made 1 Examples a Exchanges of letters from competitors agreeing to collusive behavior b Minutes from meeting of competitors agreeing to collusive behavior Frequently prosecuted offenses 7 rm behavior which unambiguously reduces N competition has not legitimate and ethical goals a Collusion to restrain output b Collusion to divide market territories c Collusion to allocate customers ii Rule of reason a more open ended analysis where circumstances consequences and motives play a big part 1 Frequently prosecuted offenses 7 rm behavior which does not necessarily reduce competition and which does have legitimate and ethical goals a Monopolizing b Merging c Tying d Exclusive dealing b Laws amp Rules Used to Prosecute Anti Competitive Behavior i Collusion 1 Under section 1 of the Sherman Act it is illegal to enter into a contract combination or conspiracy in restraint of trade This forbids cartelization to fix prices or allocate territories and bans collective boycotts 2 Typically prosecuted under the per se rule due to the fact that there are no well identified legitimate and ethical purposes of collusive behavior Therefore the courts typically must simply decide whether the collusive behavior likely occurred ii Exclusionary Practices Predatory Pricing Exclusive Dealing Territorial Restrictions Retail Price Maintenance and Tying l The Clayton Act in Section 2 as amended by the RobinsonPutnam Act and Section 3 prohibits price discrimination exclusive dealing tying and related practices when the effect may substantially lessen competition 2 Typically prosecuted under the rule of reason due to the fact that there are potentially both legitimate and illegitimate also ethical and unethical purposes 21 iii iv for the behavior Therefore the courts must decide whether the costs in terms of reduced competition are large enough to warrant ruling against the company 3 See discussion of Exclusionary Practices above Mergers 1 Section 7 of the Clayton Act as amended by the CellerKafauver Act bans mergers that may substantially lessen competition Monopolization 1 Under section 2 of the Sherman Act it is illegal to monopolize to attempt to monopolize or to combine or conspire to monopolize trade Despite the word monopolize market shares of less than 100 percent may be in Violation c Violations Numbers 1 iii In 1980 Fortune magazine canvassed the 1043 companies that appeared at some point on its lists of the 800 largest corporations during the 1970 s The startling results disclosed that 117 or 11 percent of these corporations proved to be seriously delinquent at least once during the 1970s and many of them were multiple offenders 1 In all 163 separate offenses were tabulated and the lion s share of these 8 were antitrust Violations A major contributor to the problem of widespread and repeated offenses has been the prevalence of small penalties Until recently criminal Violations were merely misdemeanors f1nes could be measured in peanuts 50000 at most suspended sentences were fashionable jailings were rare and brief and many civil cases were brought A trend toward stiffer penalties has developed however The Sherman Act was amended to make criminal Violation a potential felony punishable by as many as three years in prison 1 From 1890 to 1970 only 19 people actually went to jail for pure antitrust Violations for a total of 28 months Yet during the 1980s more than 250 people receivedjail sentences for a total exceeding 960 months 22


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