MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter 17

GOVERNMENT AND
BUSINESS
 OBJECTIVES

• Ensure that managers understand the legal

environment of business
• Antitrust laws
• Fair trade laws
• Employment laws
• Safety laws
• Environmental issues and laws
• Securities laws
• Patents and copyrights
 OBJECTIVES

• Ensure that managers understand the role of

government in the business environment
• Economic regulation (banks)
• Noneconomic regulation (safety)
• Tax and subsidy policies
• Price controls
• Spending
• Infrastructure maintenance
• Controls in cases of market failure (externalities like
pollution)
 COMPETITION VERSUS MONOPOLY

• According to economists, as well as the U.S.

Supreme Court, competition is generally
preferable to monopoly because it results in a
better allocation of resources.
• In the United States, commissions like the FCC
regulate the behavior of monopolists. Antitrust
laws are meant to promote competition and
control monopoly.
 COMPETITION VERSUS MONOPOLY

• Global policies are often ambiguous with regard

to promoting competition.
• The United States also promotes monopoly with
patents, licenses, and copyrights.
 REGULATION OF MONOPOLY

• Monopolies that exist because of economies of

scale (natural monopolies) are often regulated.
 REGULATION OF MONOPOLY

• Example: Acme Water Company

• Figure 17.1: Regulation of Acme Water Company:
Maximum Price
• Without regulation, price = P0 and output = Q0
• With regulation that sets a maximum price of P1, output is
equal to Q1.
• Figure 17.2: Regulation of Acme Water Company: Fair
Rate of Return
• Price is set equal to P2, where average total cost is equal
to demand.
• Valuation based on a fair rate of return involves
controversies.
REGULATION OF ACME WATER COMPANY:
MAXIMUM PRICE

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THE SOCIAL COST OF MONOPOLY

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REGULATION OF ACME WATER COMPANY:
FAIR RATE OF RETURN

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EFFECTS OF REGULATION ON EFFICIENCY

• Regulated monopolies are guaranteed a fair rate

of return no matter how poorly they are
managed. Managers have no incentive to
increase efficiency.
• Regulatory lag: Delay between a proposed price
change and its ultimate disposition
EFFECTS OF REGULATION ON EFFICIENCY

• Regulatory lags that are long penalize

inefficiency and reward efficiency. An increase in
efficiency enhances profits for a longer period
with long regulatory lags. The opposite is true for
a failure to increase efficiency.
 CONCENTRATION OF ECONOMIC POWER

• Antitrust laws address the concentration of

market power.
• Market concentration ratio: Percentage of total
sales or production accounted for by an
industry's four largest firms
 CONCENTRATION OF ECONOMIC POWER

• Herfindahl-Hirschman index (HHI): Index that

equals the sum of the squared market shares of
all the firms in the market of manufacturing
industries
• HHI can range from 10,000 (one firm) to 0 (atomistic
competition).
• If the HHI will be 1,000 or less after a merger, the
merger is unlikely to be challenged.
 CONCENTRATION OF ECONOMIC POWER

• Herfindahl-Hirschman index (HHI): Index that

equals the sum of the squared market shares of
all the firms in the market of manufacturing
industries (cont’d)
• If the HHI will be between 1,000 and 1,800 and the index
changes by less than 100 points as a result of the merger, the
merger is unlikely to be challenged.
• If the HHI will be greater than 1,800 and the index changes by
less than 50 points as a result of the merger, the merger is
unlikely to be challenged.
 CONCENTRATION OF ECONOMIC POWER

• Table 17.1: Concentration Ratios and Herfindahl-

Hirschman Indexes (HHI) by Economic Sectors for
Largest (by Revenue) Subsector for Each Three-Digit
NAICS Sector and by Largest and Smallest Four Firm
Concentration Ratio of HHI for Each Sector: 2007
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 SHERMAN ACT

• Passed in 1890
• Prohibits restraint of trade and monopolistic
practices in trade among states or foreign
nations
• Prohibits collusion to fix prices, etc., among firms
engaged in interstate or international trade
CLAYTON ACT, ROBINSON-PATMAN ACT, AND
FEDERAL TRADE COMMISSION ACT

• Clayton Act
• Passed in 1914 and amended in 1936
• Outlawed unjustified price discrimination
• Outlawed tying contracts unless a firm needs to
maintain control over complementary goods and
services to ensure that its product works properly
• Outlawed mergers that substantially lessen
competition
CLAYTON ACT, ROBINSON-PATMAN ACT, AND
FEDERAL TRADE COMMISSION ACT

• Celler-Kefauver Act
• Passed in 1950
• Expanded Clayton Act to include mergers
accomplished through acquisition
• Federal Trade Commission Act
• Prevents undesirable and unfair, or predatory,
competitive practices
• Outlaws untrue and deceptive advertising
 INTERPRETATION OF THE ANTITRUST
LAWS

• Rule of reason: Rule stating that only

unreasonable combinations in restraint of trade,
not all trusts, required conviction under the
Sherman Act
• Put forth by the Supreme Court in 1911 in
cases brought against the Standard Oil
Company and the American Tobacco
Company. The companies were required to
divest many of their holdings.
 INTERPRETATION OF THE ANTITRUST
LAWS

• Rule of reason: Rule stating that only

unreasonable combinations in restraint of trade,
not all trusts, required conviction under the
Sherman Act (cont’d)
• 1920: Interpreted in favor of U.S. Steel, saying
monopoly itself is not a crime
• 1945: Prosecution of Alcoa (Aluminum Company of
America) resulted in a conviction based on violation of
antitrust laws
 INTERPRETATION OF THE ANTITRUST
LAWS

• Antitrust laws are vague and ambiguous.

• Mergers that significantly lessen competition are
frowned on, but it is not clear in many cases what “the
market” actually is.
• Example: Staples and Office Depot
• Court determined that the market was “category killers” that
provided a broad range of products and services
• Antitrust policies, and their enforcement, vary among
political administrations in the United States.
 THE PATENT SYSTEM

• U.S. patent laws grant an inventor exclusive

control over the use of an invention for 20 years
(from initial filing) in exchange for making the
invention public knowledge.
 THE PATENT SYSTEM

• Justification for patent laws

• Incentives to:
induce inventors to produce inventions;
induce managers to take the risk of implementing a new
technology;
disclose inventions to get patent protection
 THE PATENT SYSTEM

• Argument against patent laws

• Once new knowledge is created, the marginal cost of
using it is virtually zero. Patent laws, by limiting the
use of new knowledge, reduce economic efficiency.
• Patent protection is less effective than it appears
because of the opportunity for imitation.
 TRADE AND TRADE POLICY

• Foreign Trade
• Trade accounts for a very significant part of every
modern country’s output and consumption
• It allows specialization, and specialization increases
output.
• Countries specialize in the production of goods and
services in which they have a comparative advantage.
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 TRADE AND TRADE POLICY

• Using Demand and Supply to Determine the

Country of Import and the Country of Export
• Assume that the cost of transporting a product
between countries is zero and that the price of the
product after trade will be the same in both countries
after accounting for the exchange rate.
 TRADE AND TRADE POLICY

• Using Demand and Supply to Determine the

Country of Import and the Country of Export
(cont’d)
• Example
• In the United States, demand is QDU = 8 – PU and supply is
QSU = –2 + PU so autarky equilibrium is PU = 5 and QU = 3.
• In the Netherlands, demand is QDN = 6 – 2PN and supply is
QSN = –2 + 2PN so autarky equilibrium is PN = 2 and QN = 2.
 TRADE AND TRADE POLICY

• Example (cont’d)
• Exchange rate: 0.5PU = PN, so the autarky equilibrium price
in the United States is PN = 2.5 and the autarky equilibrium
price in the Netherlands is PU = 4.
• Note: Since the autarky price in the Netherlands is lower
than the U.S. price, after accounting for the exchange rate,
the Netherlands will export to the United States under free
trade.
 TRADE AND TRADE POLICY

• Example (cont’d)
• Equilibrium: QDU + QDN = QSU + QSN
8 – PU + 6 – 2PN = –2 + PU – 2 + 2PN
8 – PU + 6 – PU = –2 + PU – 2 + PU
14 – 2PU = –4 + 2PU
PU = 4.5 and PN = 2.25
• In the United States, QDU = 3.5 and QSU = 2.5, so the United
States is importing one unit.
• In the Netherlands, QDN = 1.5 and QSN = 2.5, so the
Netherlands is exporting one unit.
 TRADE AND TRADE POLICY

• Analyzing the Argument for the Government’s

Advocacy of Free Trade Using Producer and
Consumer Surplus
• Figure 17.3: Consumer and Producer Surplus
in the United States Before and After Trade
• Figure 17.4: Consumer and Producer Surplus
in the Netherlands Before and After Trade
 TRADE AND TRADE POLICY

• Analyzing the Argument for the Government’s

Advocacy of Free Trade Using Producer and
Consumer Surplus (cont’d)
• U.S. imports must match Dutch exports in a two-
country, one-good trading world. The United States
has a trade deficit, and the Netherlands has a trade
surplus, equal to the value of the traded goods. The
United States must obtain foreign exchange sufficient
to compensate the sellers.
CONSUMER AND PRODUCER SURPLUS IN THE
UNITED STATES BEFORE AND AFTER TRADE

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CONSUMER AND PRODUCER SURPLUS IN THE
UNITED STATES BEFORE AND AFTER TRADE

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 TRADE AND TRADE POLICY

• Use of Tariffs and Quotas to Mitigate the Gains

from Trade
• Consumers gain and producers lose when a good is
imported.
• There are relatively few producers, so there is an opportunity
to organize lobbying to seek protectionist legislation.
• Quotas specify the maximum a country can export to the
importing country.
• Tariffs are a tax on imports.
 TRADE AND TRADE POLICY

• Use of Tariffs and Quotas to Mitigate the Gains

from Trade (cont’d)
• Figure 17.5: Consumer and Producer Surplus in the
United States Before and After Trade with an Import
Quota of QDAQ – QSAQ Units
• An equivalent tariff would reduce the loss of
consumer surplus to the United States.
TRADE AND TRADE POLICY

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 TRADE AND TRADE POLICY

• Trade Policy When the Market Is Not Perfectly

Competitive
• Some economists argue that government should
control the access of foreign firms to our domestic
markets and promote the activities of our firms in
foreign markets.
 TRADE AND TRADE POLICY

• Some economists argue that government should

control the access of foreign firms to our domestic
markets and promote the activities of our firms in
foreign markets. (cont’d)
• Government should use subsidies or tariffs to promote U.S.
interests when appropriate; for example, economies of scale.
• Strategic industries should be protected in this way. It is not
clear how government can identify “strategic industries,” and
industries have an incentive to argue that they are strategic,
whether they are or not.
 TRADE AND TRADE POLICY

• Trade Policy When the Market Is Not Perfectly

Competitive (cont’d)
• Case of Boeing (U.S.) and Airbus (European Union)
• Game-theoretic model of strategic trade policy
• Figure 17.6: Payoff Matrix Airbus and Boeing
• If either firm is the sole producer, then production will be
profitable. Otherwise, it won’t.
• Figure 17.7: Payoff Matrix Airbus and Boeing (sssumes that
Airbus will get a subsidy of 10 if they produce the plane)
• Airbus will choose to produce and Boeing will not.
PAYOFF MATRIX: AIRBUS AND BOEING

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NEW PAYOFF MATRIX: AIRBUS AND
BOEING

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GOVERNMENT PRICE CEILINGS AND PRICE
FLOORS

• Price floor: The government will not allow a price

to fall to its market level because of a belief or
political pressure that the market-determined
price is too low.
• Figure 17.8: Impact of a Government Price
Floor
IMPACT OF A GOVERNMENT PRICE FLOOR

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GOVERNMENT PRICE CEILINGS AND PRICE
FLOORS

• Price ceiling: The government will not allow a

price to rise to its market level because of a
belief or political pressure that the market-
determined price is too high.
• Figure 17.9: Impact of a Government Price Ceiling
• Deadweight loss: Social welfare under perfect
competition minus social welfare under
alternative pricing
IMPACT OF A GOVERNMENT PRICE
CEILING

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 THE WELFARE IMPACT OF TAXES

• Figure 17.10: The Incidence and Welfare Costs

of a Per-Unit Tax
THE INCIDENCE AND WELFARE COSTS OF A
PER-UNIT TAX

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 REGULATION OF ENVIRONMENTAL
POLLUTION

• External Economies and Diseconomies

• External economy: Action by a firm or individual gives
uncompensated benefits to others
• External diseconomy: Action by a firm or individual
results in uncompensated costs or harm to others
• The Genesis of the Pollution Problem
• Actual level of pollution exceeds optimal level
because of external diseconomies. The polluter does
not pay the full social cost of pollution.
 REGULATION OF ENVIRONMENTAL
POLLUTION

• The Optimal Level of Pollution Control

• Figure 17.11: Pollution Cost
• Figure 17.12: Pollution Control Cost
• Figure 17.13: Sum of the Pollution Cost and the
Pollution Control Cost
POLLUTION COST

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POLLUTION CONTROL COST

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SUM OF THE POLLUTION COST AND THE
POLLUTION CONTROL COST

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 REGULATION OF ENVIRONMENTAL
POLLUTION

• Forms of Government Regulation

• Direct regulation of pollution
• Effluent fee: Fee a polluter must pay to the
government for discharging waste
• Figure 17.14: Marginal Cost of Pollution and Marginal
Cost of Pollution Control
• Transferable emissions permits: Permits to generate
a particular amount of pollution
• Coase’s Theorem: Says that a law that makes
someone liable for the damage caused by pollution
can lead to a negotiated agreement that is efficient
 MARGINAL COST OF POLLUTION AND
MARGINAL COST OF POLLUTION CONTROL

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 REGULATION OF ENVIRONMENTAL
POLLUTION

• Effects of the Regulation-Induced Cost Increase

on Price and Output (Model)
• Marginal cost before regulation: MC = 20 + 40Q
• Profit maximizing output: P = 20 + 40Q or Q = –0.5
+ 0.025P
• Supply curve for 1,000 producers: QS = –500 +
25P
• Market demand: QD = 3,500 – 15P
 REGULATION OF ENVIRONMENTAL
POLLUTION

• Effects of the Regulation-Induced Cost Increase

on Price and Output (Model) (cont’d)
• Equilibrium: P = 100 and Q = 2,000
• Marginal cost after regulation: MC = 25 + 50Q
• Profit maximizing output: P = 25 + 50Q or Q = –0.5 + 0.02P
• Supply curve for 1,000 producers: QS = –500 + 20P
• Market demand: QD = 3,500 – 15P
• Equilibrium: P = 114.29 and Q = 1,785.71
• Incidence of cost increase depends on the price elasticities
of supply and demand.
 PUBLIC GOODS

• Public good: Good that can be consumed by one

person without reducing amount available to
others. Cannot be provided by markets.
• National defense; Flood control; Environmental
protection
• Public goods are nonrival (one person’s consumption
does not influence the availability of the good to others)
and nonexcludable (if the good is available to anyone, it
is available to everyone).
 PUBLIC GOODS

• Public good: Good that can be consumed by one

person without reducing the amount available to
others. Cannot be provided by markets. (cont’d)
• Marketable public goods are nonrival and excludable.
• Common property goods are rival and nonexcludable.
• Private goods are both rival and excludable.
• CLASSIFICATION OF GOODS

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