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1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient No opportunities for mutual gain remain unexploited Any government intervention that changes the market quantity (say, a price ceiling or a price floor) will create inefficiency—a welfare loss But government can—and does—contribute to the economic efficiency of markets Provides infrastructure that permits markets to function Physical infrastructure—bridges, airports, waterways, and buildings Institutional infrastructure—laws, courts, and regulatory agencies Stepping in when markets are not working properly When they leave Pareto improvements unexploited and therefore fail to achieve economic efficiency

1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Page 1: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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The Efficiency Role of Government

• When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient– No opportunities for mutual gain remain unexploited– Any government intervention that changes the market quantity

(say, a price ceiling or a price floor) will create inefficiency—a welfare loss

• But government can—and does—contribute to the economic efficiency of markets– Provides infrastructure that permits markets to function

• Physical infrastructure—bridges, airports, waterways, and buildings• Institutional infrastructure—laws, courts, and regulatory agencies

– Stepping in when markets are not working properly• When they leave Pareto improvements unexploited and therefore fail

to achieve economic efficiency

Page 2: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

2

The Institutional Infrastructure of a Market Economy

• Americans take their institutional infrastructure almost completely for granted

• In some countries– Police are more likely to steal from citizens than to protect them from

thievery– People have no effective rights to their own property– If a person is injured by a drunk driver, there may be no system for

compensating her or punishing the drive

• In nations with highly developed and stable legal infrastructures, such incidents are the exception

• When countries are divided into three groups, according to the quality of their institutional infrastructure– There is a strong relation between infrastructure and output per worker

Page 3: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Figure 8: Government Infrastructure and Output per Worker

Low

Quality of Infrastructure

Medium High

Ave

rag

e O

utp

ut

per

Wo

rker

2,000

6,000

10,000

14,000

$18,000

Page 4: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

4

The Legal System: Criminal Law

• The backbone of a market economy’s institutional infrastructure is the legal system

• Criminal law– While criminal law has important moral and ethical

dimensions• Central economic function is to limit exchanges to voluntary

ones

– By making most involuntary exchanges illegal, criminal law helps to channel our energies into exchanges and productive activities that benefit all parties involved—Pareto improvements

• In this way, criminal law contributes to economic efficiency

Page 5: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

5

Property Law

• Property law gives people precisely defined, enforceable rights over things they own

• When property rights are poorly defined– Much time and energy are wasted in disputes about ownership

• People spend time trying to capture resources from others– Time that could have been spent producing valuable goods and services

• Property law contributes to economic efficiency by increasing total production– Raising total benefits that markets can provide by reducing

disputes about property– Channeling resources into production

Page 6: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Contract Law

• In countries in which contract law is less well defined or less strictly enforced, investors would worry that they would not be able to collect their share

• A contract is a mutual promise– Often one party does something first and the other

party promises to do something later

• Contracts play a special role in a market economy– Without them, only Pareto improvements involving

simultaneous exchange could take place• You get a bag of apples from a farmer and simultaneously

hand over some money

Page 7: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Contract Law

• Contracts enable us to make exchanges that take place over time and in which one person must act first– In this way, contracts help society enjoy the full benefits of specialization

and exchange• Legal enforcement of contacts is not the only force that makes people

keep promises– Parents, religious organizations, and schools teach people that keeping

promises is a moral obligation– A reputation for failing to keep promises would be harmful to a business or

a person• While socialization and concern over reputation are important,

contracts and the infrastructure for enforcing them play vital role in making economy more efficient

• Because of contract law, people are more willing to take a chance with a new business– Since they know that they have a law behind them if new business

reneges on a deal

Page 8: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Tort Law

• Deals with interactions among strangers or people not linked by contracts

• Specifically, a tort is a wrongful act—such as manufacturing an unsafe product—that causes harm to someone, and for which the injured person can seek remedy in court– Tort law defines types of harm for which someone can seek legal

remedy• And what sorts of compensation the injured person can expect

• When people and business are held responsible for injuries they cause, they act more carefully

• Also protects against fraud– In which a seller of something—a product, a business, shares of

stock—lies to the buyer in order to make the sale

Page 9: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Antitrust Law

• Designed to prevent business from making agreements or engaging in other behavior that limits competition and harms consumers– Operates in three areas

• Agreements among competitors– U.S. antitrust law—expressed in Section 1 of Sherman Act—prohibits

“contracts, combinations, or conspiracies” among competing firms that would harm consumers by raising prices

• Monopolization– Section 2 of Sherman Act Makes it illegal to monopolize or attempt to

monopolize a market• Mergers

– In a merger, two firms combine to form one new firm» The result is to increase the danger of higher prices from oligopoly or

monopoly» Mergers of this type are often blocked by U.S. government based on

Section 7 of Clayton Act

Page 10: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Regulation

• Important part of the institutional infrastructure that supports a market economy– Under regulation, a government agency—such as the Food and

Drug Administration (FDA), the Environmental Protection Agency (EPA), or a state public utilities commission—has power to direct business to take specific actions

• In addition to protecting public safety and health– Regulation is also used to help markets function more efficiently

• Regulation differs from use of legal procedures in a fundamental way– Regulators reach deep into the operations of business to tell them

what to do• While legal procedures typically result in fines or other penalties if

businesses do something wrong

Page 11: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Law and Regulation in Perspective

• Invisible hand of market system cannot operate on its own– Legal system, along with regulatory agencies,

creates an environment in which invisible hand can do its job

– Almost every Pareto improvement that we can think of relies on legal and regulatory infrastructure

• But what about cases where law and regulation don’t seem to be working perfectly?

– Does this mean that our institutional infrastructure is failing us?

Page 12: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Law and Regulation in Perspective

• Yes…and no– While instances like these are never welcome, society has chosen

not to eliminate them entirely– Must balance benefits—safer products, reduced crime—against

costs

• A legal and regulatory system that ensured the complete elimination of crime, unsafe products, and other unwelcome activities would be less efficient than a system that tolerated some amount of these activities– An efficient infrastructure must consider the costs, as well as the

benefits, of achieving our legal and regulatory goals

Page 13: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Market Failures

• Another vitally important role for government– To intervene in situations of market failure

• When a market equilibrium—even with the proper institutional support—is economically inefficient

• General types of market failures to which economists have devoted a lot of attention– Monopoly power– Externalities– Public goods

• While economists and policy-makers agree in theory on what causes a market failure– Dealing with real-world market failures remains one of

the most controversial aspects of government policy

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Monopoly and Monopoly Power

• A firm has monopoly power when it can influence the price that it charges for its product– A market with just one seller, or a few oligopolists who

cooperate and behave as a monopoly, is a more serious market failure

• Monopoly and imperfectly competitive markets—in which firms charge a single price greater than marginal cost—are generally inefficient– Price is too high, and output is too low, to maximize net

benefits in market• What can government do to make this monopoly

market more efficient?

Page 15: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Figure 9: The Welfare Loss fromMonopoly

1. A monopoly charges a higher price than a competitive market . . .

3. The result is a welfare loss . . .

4. from not producing the efficient quantity, at point E.

Number of Lessons per Week

Dollars

E

2,500

$22

$19

4,000

DMR

MC

2. and produces a lower quantity.

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Anti-trust Law as a Remedy

• In the case of the guitar-lesson monopoly, there may be a solution– Since this market would function very well under competitive

conditions, the government could use anti-trust law to break the monopoly into several competing firms

• But breaking up a monopoly would not make sense when the market would perform even worse with more competition

• Monopolies that arise from patents and copyrights, provide an incentive for artistic creations and scientific discovery

• Monopoly power that arises from network externalities offers benefits that would be hard to achieve under more competitive conditions

• When a monopoly arises as a natural monopoly– Using anti-trust law to break it up or even to prevent its formation

in the first place is a poor remedy

Page 17: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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The Special Case of Natural Monopoly

• A natural monopoly exists when, due to economies of scale, one firm can produce for the entire market at a lower cost per unit than can two or more firms– If government steps aside, such a market will naturally evolve

toward monopoly

• If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency?– One option is public ownership and operation

• Public takeover of private business is rare, except when certain conditions are present

– That leaves one other option • Regulation

Page 18: 1 The Efficiency Role of Government When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient

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Figure 10: Regulating A Natural Monopoly

B$15

$29

A

C

MC

$60

LRATC

50,000

DMR

85,000

100,000 Number of Household

s Served

Dollars

Unregulated monopoly

"Fair rate of return" production

F

Efficient production (requires subsidy)

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Regulation of Natural Monopoly

• Under regulation, a government agency digs deep into the operations of a business and takes some of the firm’s decisions under its own control– In the case of a natural monopoly, regulators are

interested in achieving economic efficiency, which they do by telling the firm what price it can charge

• At first glance, you might think that natural monopoly regulators have an easy job

• Unfortunately, it’s not that easy– There is the matter of information

• Regulators must be able to trace out firm’s MC curve as well as market demand curve

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Regulation of Natural Monopoly

• Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem– Look again at Figure 7—notice that MC curve

lies everywhere below LRATC curve– Problem for regulators

• If they set the efficient price of $15 so that buyers demand efficient quantity of 100,000, firm’s cost per unit is greater than $15

– Firm will suffer a loss– In long-run, it will go out of business

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Regulation of Natural Monopoly

• Leaves regulatory agency with two alternatives– Set prices to MC and subsidize the monopoly from the general

budget, to make up for the loss

• In practice, however, regulators in market economies around the world have usually chosen a different solution– Regulators determine a price that gives owners a “fair rate of

return” for funds they’ve put into the monopoly– Should give monopoly what economists call normal profit

• Profit just high enough to cover all of the owners’ opportunity costs, including the foregone interest of their own funds

• What price will accomplish this?– A fair rate of return is already built into LRATC curve– This strategy—called average cost pricing—is the most common

solution chosen by regulators of natural monopolies

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Regulation of Natural Monopoly

• With average cost pricing, regulators strive to set price equal to cost per unit where LRATC curve crosses demand curve– At this price, the natural monopoly makes zero economic profit

• Which provides its owners with a fair rate of return, and keeps the monopoly in business

• Average cost pricing is not a perfect solution– Does not quite make the market efficient– Provides little or no incentive for the natural monopoly to

economize on capital• Tendency of regulated natural monopolies to overinvest in capital is

known as the Averch-Johnson effect, after the two economists who first explained it

• Averch-Johnson effect is a specific example of a more general idea– When a firm is not striving to maximize profit (in this case, because the

government is guaranteeing a specific rate of return)» Firm need not economize on costs