CHAPTER 14

A Manager’s Guide to Government in the

Marketplace

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Identify four sources of market failure.
2. Explain why market power reduces social welfare, and identify two
types of government policies aimed at reducing deadweight loss.
3. Show why externalities can lead competitive markets to provide
socially inefficient quantities of goods and services; explain how
government policies, such as the Clean Air Act, can improve resource
allocation.
4. Show why competitive markets fail to provide socially efficient levels
of public goods; explain how the government can mitigate these
inefficiencies.
5. Explain why incomplete information compromises the efficiency of
markets, and identify five government policies aimed at mitigating
these problems.
6. Explain why government attempts to solve market failures can lead
to additional inefficiencies because of “rent-seeking” activities.
7. Show how government policies in international markets, such as
quotas and tariffs, impact the prices and quantities of domestic
goods and services.
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 Market Failure
Market Power
• The socially efficient quantity in a market occurs
where price equals marginal cost. This quantity
maximizes the sum of consumer and producer
surplus.
– This socially efficient price and quantity arise naturally in
a perfectly competitive market.
• When a firm in a market produces an output that is
less than the socially efficient level because it
charges a price that exceeds marginal cost, the firm
has market power.
– The value to society of producing another unit is greater
than the cost to produce another unit.
– Government may intervene in the market in attempt to
increase social welfare.
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 Market Failure

Welfare and Deadweight

Loss Under Monopoly In Action
Price
Social welfare

MC
𝑀
𝑃

Deadweight loss

Demand
MR

𝑄𝑀 Quantity

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 Market Failure
Antitrust Policy
• The purpose of antitrust policy is to eliminate
the deadweight loss of monopoly by making it
illegal for manager to engage in activities that
foster monopoly power.

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 Market Failure

Antitrust Policy: Sherman Act, Section 1

• The cornerstone of U.S. antitrust policy are Sections
1 and 2 of the Sherman Antitrust Act of 1890:
– Section 1: Every contract, combination in the form of
trust or otherwise, or conspiracy, in restraint of trade or
commerce among the several states, or with foreign
nations, is hereby declared to be illegal. Every person
who shall make any such contract or engage in any such
combination or conspiracy shall be deemed guilty of a
felony, and, on conviction thereof, shall be punished by
fine not exceeding five thousand dollars (one million
dollars if a corporation, or, if an other person, one
hundred thousand dollars) or by imprisonment not
exceeding one (three) years, or by both said
punishments, in the discretion of the court.
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 Market Failure
Antitrust Policy: Sherman Act, Section 2
– Section 2: Every person who shall monopolize, or
attempt to monopolize, or combine or conspire with
any person or persons, to monopolize any part of
the trade or commerce among the several States, or
with foreign nations, shall be deemed guilty of a
felony, and, on conviction thereof, shall be punished
by fine not exceeding five thousand dollars (one
million dollars if a corporation, or, if any other
person, one hundred thousand dollars) or by
imprisonment not exceeding one (three) years, or
both said punishments, in the discretion of the
court.
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 Market Failure
Antitrust Policy: Rule of Reason
• Interpretation of antitrust policy is shaped by the
courts, which rule on ambiguities in the law and
previous cases.
• In the Supreme Court’s ruling on Standard Oil Trust,
the Court defined a new rule of reason, which
effectively stipulates
– that not all trade restraints are illegal; rather, only those
that are “unreasonable” are prohibited.
• Problems with the rule of reason:
– It is difficult for managers to know in advance whether
particular pricing strategies or other actions used to
enhance profits are in fact violations of the law.

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 Antitrust Policy: Market Failure

Clayton and Robinson-Patman Acts

• To make more precise what actions are deemed
illegal in antitrust law the U.S. Congress passed
the Clayton Act (1914) and Robinson-Patman
Act (1936).
– These acts make price discrimination – aimed to
substantially lessen competition or tend to create a
monopoly in the line of commerce, or injure,
destroy, or prevent competition – illegal.
– Price discrimination is permitted under these acts
when
• it arises because of cost or quality differences.
• it is necessary to meet a competitor’s price in a market.

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 Market Failure
Antitrust Policy: Clayton Act
• Illegal actions for firms under the Clayton Act:
– Hide kickbacks as commissions or brokerage fees.
– Use rebates unless they are made available to all
customers.
– Engage in exclusive dealings with a supplier unless the
supplier adds to the furnishing of the buyer and/or
offers to make like terms to all other potential suppliers.
– Fix prices or engage in exclusive contracts if such a
practice will lead to lessening of competition or
monopoly.
– Acquire one or more other firms if such an acquisition
will lead to a lessening of competition.
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 Market Failure
Antitrust Policy: Celler-Kefavuer Act
• The Celler-Kefavuer Act (1950) strengthened the
Clayton Act by making it more difficult for firms
to engage in mergers and acquisitions without
violating the law.
• Merger policy was furthered changed when new
horizontal merger guidelines were written in
1982; amended in 1984, and revised in 1992,
1997, and 2010.
– Guidelines based on the Herfindahl-Hirschman
index (HHI): 𝐻𝐻𝐼 = 10,000 𝑁 𝑤
𝑖=1 𝑖
2 , where 𝑤 is
𝑖
firm 𝑖’s market share.

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 Antitrust Policy: Market Failure

Horizontal Merger Guidelines

• Horizontal Merger Guidelines
– Merger that increases HHI by less than 100 or leads to an
unconcentrated market (post-merger 𝐻𝐻𝐼 < 1,500) is
typically permitted.
– Markets are considered moderately concentrated when the
post-meger results in: 1,500 < 𝐻𝐻𝐼 < 2,500
• Mergers with an HHI in this range and increase the HHI by more than
100 points potentially raise antitrust concerns.
– Markets are considered highly concentrated when the post-
merger 𝐻𝐻𝐼 > 2,500.
• Mergers with an HHI in this range and increase the HHI between 100
and 200 points potentially raise antitrust concerns.
– If a merger increases the HHI by more than 200 points and
leads to a highly concentrated market, it is presumed to
enhance market power.
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 Market Failure

Hart-Scott-Rodino Antitrust
Improvement Act
• The Hart-Scott-Rodino Act (1976) requires that
the parties to an acquisition notify both the
Department of Justice (DOJ) and Federal Trade
Commission (FTC) of their intent to merge,
provided that the dollar value of the transaction
exceeds a certain threshold (currently about $80
million).

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 Market Failure
Hart-Scott-Rodino Antitrust
Improvement Act
• Following this premerger notification, the
parties of the merger must wait 30 days before
they may complete the merger transaction.
– If the DOJ and FTC determine that further
examination is warranted, a second request is issued
that extends the waiting period. Once the additional
information is requested, the government has
another 30 days to review the information and file a
complaint to block the merger or permit it to move
forward.
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 Market Failure
Price Regulation
• The presence of large scale economies may
make it desirable for a single firm to service an
entire market.
– In these instances, government may permit a
monopoly to exist, but regulate its price in effort to
reduce the deadweight loss.

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 Market Failure

Regulating a Monopolist’s Price at

the Socially Efficient Level
Price

MC
𝑀
𝑃

𝑃𝐶 Regulated price

Effective demand
Demand
MR

𝑄𝑀 𝑄𝐶 Quantity

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 Market Failure

Regulating a Monopolist’s Price

Below the Socially Efficient Level
Price
Deadweight loss
after regulation

MC
𝑀
𝑃

Deadweight loss
before regulation

𝑃∗ Regulated price
Demand
MR

𝑄𝑅 𝑄𝑀 𝑄∗ Quantity

Shortage
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 Market Failure
A Case Where Drives the
Monopolist Out of Business
Price

MC ATC

𝑃𝑀

𝑃𝐶 Regulated price

Demand
MR

𝑄𝑀 𝑄𝐶 Quantity

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 Market Failure
Externalities
• Negative externalities exist when costs are
borne by parties who are not involved in the
production or consumption of a good or service.
• The reason externalities cause a “market
failure” is the absence of well-defined property
rights.
• The failure is often resolved when a government
defines itself to be the owner of the
environment, and uses its power to induce the
socially efficient levels of output and pollution.
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 Market Failure

The Socially Efficient Equilibrium in

the Socially
Presence of External Costs
Price Marginal cost to society of
of efficient producing steel
steel equilibrium (internal and external costs)
C 𝑁
𝑃𝑆 𝑆= 𝑖=1 𝑀𝐶𝑖 (internal costs)
B Free market
𝑃𝐶 equilibrium Marginal cost of
pollution to society
(external costs)

Demand

0 𝑄𝑆 𝑄𝐶 Output of steel

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 Market Failure
Externalities: The Clean Air Act
• To solve the externality problem caused by
pollution, the U.S. Congress passed the Clean Air
Act in 1970 and made sweeping changes with
amendments in 1990.
• Firms that operate in industries that release over 10
tons per year, or 25 tons per year of a combination
of pollutants, on a specified list are required to
obtain a permit to emit pollution into the
environment.
• The Clean Air Act causes firms to internalize the
cost of emitting pollutants since the permits are
costly to acquire.
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 Impact of the Market Failure

Clean Air Act In Action

Price

𝑆𝑢𝑝𝑝𝑙𝑦1

Due to reduction in
𝑃1
output by all firms
𝑆𝑢𝑝𝑝𝑙𝑦0

𝑃0

Demand

0 𝑄1 𝑄0 Market output

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 Market Failure
Public Goods
• A public good is another type of good that leads
to a market failure.
• A public good is:
– A good that is nonrival and nonexclusionary in
nature, and therefore, benefit persons other than
those who buy the goods.
• Nonrival goods: the consumption of the good by one
person does not preclude other people from also
consuming the good.
• Nonexclusionary good: once provided, no one can be
excluded from consuming the good.

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 Market Failure
Public Goods and Inefficiencies
• Public goods leads the market to provide
inefficient quantities since everyone gets to
consume a public good once it is available, but
individuals have little incentive to purchase the
good; they prefer others to pay for it.
– When a group of individuals rely on the efforts or
payments of others to provide a good, we say there
is a free-rider problem.

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 Market Failure

Demand for a Public a Good

Price

90

54 𝑀𝐶of streetlights

Total demand for streetlights

Individual consumer surplus = $72

30
18 Individual demand for streetlights

0 12 30 Quantity of
streetlights
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 Market Failure

The Free-Rider Problem

Price
Price
60

𝑀𝐶 of
54 streetlights A’s consumer
surplus from = $85.50
free-riding
Total demand
30 30
by B and C
27 27
A’s demand
B’s and C’s for streetlights
individual demand

0 3 30 Quantity 3 30 Quantity
of streetlights of streetlights

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 Market Failure
Incomplete Information
• Efficiently functioning markets require
participants to have reasonably good
information about prices, quality, available
technologies, and the risks associated with
working particular jobs or consuming particular
products.
– Market inefficiencies result when participants have
incomplete information.
– One severe source of market failure is asymmetric
information, where some market participants have
better information than others.
• Implication: buyers may refuse to purchase from sellers.
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 Market Failure
Government Policies Dealing
with Asymmetric Information
• Rules against insider trading
• Certification
• Truth in lending
• Truth in advertising
• Enforcing contracts

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 Rent Seeking
Rent Seeking
• Government policies can improve the allocation
of resources to alleviate market failures.
• These policies, however, generally benefit some
parties at the expense of others.
– Implications: lobbyists spend considerable sums in
attempt to influence government policy; a process
known as rent seeking.

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 Rent Seeking
Incentives to Engage in
Rent-Seeking Activities
Price

C
𝑃𝑀
A B
𝑃𝐶 MC = AC

Demand
MR

𝑄𝑀 𝑄𝐶 Quantity

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 Government Policy and International Markets
Quotas
• A quota is a government restriction that limits
the quantity of imported goods that can legally
enter the country.
– Implications:
• Reduces competition in domestic market
• Higher domestic prices
• Higher profits for domestic firms
• Lower consumer surplus for domestic consumers
– Conclusion: Domestic producers benefit at the
expense of domestic consumers and foreign
producers
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 Government Policy and International Markets

The Impact of a Foreign Import Quota

on the Domestic Market
Price 𝑆 𝐹 Quota 𝑆𝐹𝑜𝑟𝑒𝑖𝑔𝑛

𝑆 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐
𝑆 𝑄𝑢𝑜𝑡𝑎
Market supply
E after quota
𝑃𝐷 M 𝑆 𝐹+𝐷
𝑃𝑄𝑢𝑜𝑡𝑎 Market supply
A K before quota
𝑃𝐹+𝐷

G B
Demand

𝑄𝑢𝑜𝑡𝑎 𝑄𝐷 𝑄𝑄𝑢𝑜𝑡𝑎 𝑄𝐹+𝐷 Quantity in the

domestic market

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 Government Policy and International Markets
Tariffs
• A tariff is designed to limit foreign competition
in the domestic market to benefit domestic
producers, which accrue at the expense of
domestic consumers and foreign producers.
– Lump-sum tariff: fixed fee that foreign firms must
pay the domestic government to be able to sell in
the domestic market.
– Excise (per-unit) tariff: the fee an importing firm
must pay to the domestic government on each unit
it brings into the country.

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 Government Policy and International Markets

Impact of a Lump-Sum Tariff on a

Foreign Firm
Price Average cost
Average cost After lump-sum tariff
MC AC2
before
lump-sum tariff
AC1
𝑃2

𝑃1

Quantity of
𝑞1 𝑞2
individual
foreign firm’s
output
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 Government Policy and International Markets
Impact of a Lump-Sum Tariff on
Market Supply
Price 𝑆𝐹𝑜𝑟𝑒𝑖𝑔𝑛

𝑆 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐
𝑆 𝐹+𝐷
A
𝑃2

Market supply curve

after lump-sum tariff
𝐸
Market supply curve
before lump-sum tariff
Quantity in the
domestic market

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 Government Policy and International Markets
Impact of an Excise Tariff on Market
Supply
Price 𝑆 𝐹+𝑇
𝑆𝐹
Supply after
excise tax
𝑆𝐷

𝑆 𝐹+𝐷+𝑇
E 𝑆 𝐹+𝐷
C
H

B
Demand
Supply before
A excise tax
Quantity in the
domestic market

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