5Government,the Firm andthe Market

Reasons for Government Intervention

� Government intervention and social objectives

� The objective of social efficiency� marginal social benefits and costs

� MSB > MSC → produce (or consume) more� MSC > MSB → produce (or consume) less

� socially efficient output where MSB = MSC

� Equity� concepts of fairness

� Trade-offs between equity and efficiency

Types of Market Failure

� Externalities

� External costs of production MSC > MC

Q1

External costs in production

O

MC = S

DP

Co

sts

and

ben

efits

Quantity

O

MC = S

DP

MSC

Co

sts

and

ben

efits

Quantity

External cost

Q1Q2

Social optimum

External costs in production

Types of Market Failure

� Externalities

� External costs of production MSC > MC

� External benefits of production MSC < MC

External benefits in production

O

DP

MC = S

Q1

Co

sts

and

ben

efits

Quantity

O

MSC

DP

Q1

External benefit

Co

sts

and

ben

efits

Quantity

MC = S

Q2Social optimum

External benefits in production

O

MC = S

DP

Q1Q2

Cos

ts a

nd b

enef

its (

£)

Quantity

MSC

External cost

(a ) External costs

O

DP

Q2Q1

Cos

ts a

nd b

enef

its (

£)

Quantity

MSCMC = S

External benefit

(b) External benefits

External costs and benefits in production

Types of Market Failure

� Externalities� External costs of production

MSC > MC

� External benefits of production MSC < MC

� External costs of consumption MSB < MB

Types of Market Failure

� Externalities� External costs of production

MSC > MC

� External benefits of production MSC < MC

� External costs of consumption MSB < MB

� External benefits of consumption MSB > MB

Types of Market Failure

� Externalities� External costs of production

MSC > MC

� External benefits of production MSC < MC

� External costs of consumption MSB < MB

� External benefits of consumption MSB > MB

� Public goods

Types of Market Failure

� Externalities� External costs of production

MSC > MC

� External benefits of production MSC < MC

� External costs of consumption MSB < MB

� External benefits of consumption MSB > MB

� Public goods� non-rivalry

Types of Market Failure

� Externalities� External costs of production

MSC > MC

� External benefits of production MSC < MC

� External costs of consumption MSB < MB

� External benefits of consumption MSB > MB

� Public goods� non-rivalry� non-excludability and the free-rider problem

Types of Market Failure

� Market power

� market power can be used to raise the price above the perfectly competitive level

� output below the socially efficient level

� MSB > MSC

MC1

Q1

MC

MRAR

A monopolist producing less than the social optimum

O

P1

£

Monopoly outputQ

O

P1

MC1

MC = MSC

Q1

MRAR = MSB

Q2

P2 = MSB

= MSC

£

QMonopoly output Perfectly competitive output

A monopolist producing less than the social optimum

Types of Market Failure

� Imperfect information

� by consumers

� by firms

� Protecting people’s interests

� dependants

� merit goods

Business Ethics & Corporate Social Responsibility

� Firms and social responsibility� are managers solely responsible to shareholders?

� are they simply concerned to maximise profits?

� broader social interests

� Business ethics� a stakeholding society

� corporate social responsibility

� environmental scanning

� Economic performance and social responsibility

Government Intervention in the Market

� Taxes and subsidies

� to correct externalities

Q1O

MC = S

DP

Co

sts

and

ben

efits

Quantity

Using taxes to correct a market distortion

O

MC = S

DP

MSC

Co

sts

and

ben

efits

Quantity

External cost

Q1Q2

Social optimum

Using taxes to correct a market distortion

Q2

MC

Q1O

P

Co

sts

and

ben

efits

Quantity

Optimum tax = MSC – MC

MC = SMSC

D

Using taxes to correct a market distortion

� Taxes and subsidies

� to correct externalities

� to correct for monopoly

Government Intervention in the Market

� Taxes and subsidies

� to correct externalities

� to correct for monopoly

� advantages of taxes and subsidies

� can vary the rate according to the size of the market distortion

Government Intervention in the Market

� Taxes and subsidies

� to correct externalities

� to correct for monopoly

� advantages of taxes and subsidies

� can vary the rate according to the size of the market distortion

� disadvantages of taxes and subsidies

� infeasible to use different tax and subsidy rates

� lack of knowledge

Government Intervention in the Market

� Legislation

� to control activities causing externalities

� to prevent firms giving inaccurate information

� to prevent the abuse of monopoly power

� Regulatory bodies

� purely investigative

� with powers to act (e.g. OFT)

Government Intervention in the Market

Environmental Policy

� The environment and production

� Green taxes and subsidies

� use of green taxes around the world

Types of environmental taxes and charges

Types of environmental taxes and charges

Types of environmental taxes and charges

Types of environmental taxes and charges

Environmental Policy

� Green taxes and subsidies (cont.)

� choosing the tax rate

� tax rate should equal the marginal external cost

� advantages of taxes and subsidies

� allows market to operate

� can vary with the size of the externality

� disadvantages of taxes and subsidies

� infeasible to use different tax rates

� lack of knowledge on extent of externality

Environmental Policy

� Laws and regulations� the command-and-control approach� advantages

� simple to operate� safe approach when size of externality not known

� disadvantages� requires robust monitoring and enforcement� lack of incentives for firms to do better

� Tradable permits� how tradable permits work� assessing tradable permits

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

Profit maximising under monopoly

MR

£

Q O

MC

Qm

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Total profit

Profit maximising under monopoly

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits� economies of scale

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits� economies of scale

� investment and innovation

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits� economies of scale

� investment and innovation

� approaches to competition policy

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits� economies of scale

� investment and innovation

� approaches to competition policy� banning various activities

Competition Policy

� Competition, monopoly and the public interest� the abuse of market power

� higher prices and profits

� lack of incentive to innovate

� market power can also bring benefits� economies of scale

� investment and innovation

� approaches to competition policy� banning various activities

� examining each case on its merits

Competition Policy

UK competition policy� the OFT and the Competition Commission

� restrictive practices policy

� legislation under 2002 Enterprise Act

� criminal to engage in cartel arrangements

• price fixing, limiting supply, sharing out markets, collusive tendering, agreements to pay low prices to suppliers

� OFT has discretion with other types of agreement

• vertical price fixing, agreements to exchange information

� powers of the OFT

� difficulties in rooting out collusion

� UK competition policy (cont.)� monopoly policy

� Chapter 2 prohibition of 1998 Competition Act• market-share criterion• market contestability

� anti-competitive practices• charging excessively high prices, price

discrimination, predatory pricing, vertical restraints

� test: do such practices restrict competition?� merger policy (2002 Enterprise Act)

� role of OFT and Competition Commission� criteria for judgment

� Assessment of competition policy

Competition Policy

The Regulation of Business

� Regulation and the privatised industries

� nationalisation and privatisation

� Regulation in practice:

� use of general competition policy

� specific regulation

� regulatory offices

� price-cap regulation

� the CPI–X formula

� Advantages of UK regulation

� discretionary

� flexible

� incentives

� Disadvantages of UK regulation

� disincentives of changes to X

� complexity of regulation

� principal–agent problems between regulator and industry managers

The Regulation of Business

� Policies to increase competition� allowing competition where there is no

natural monopoly

� limited extent of true natural monopoly

� allowing access to grids by competitors

� forbidding suppliers from being grid owners

� competitive franchising to make monopolies contestable

� Still need for regulation to prevent abuse of monopoly power

The Regulation of Business