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Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 21: Understanding the Business Environment: The Economics of Regulation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. Managerial Economics and Organizational Architecture, 5e Examples of Government Regulation • Antitrust legislation • Environmental protection laws • Financial disclosure for publicly traded stock • Intellectual property, labor, and safety laws • Utilities regulation • Financial services regulation • Transportation industry regulation 21-2 Managerial Economics and Organizational Architecture, 5e Economic Motives for Government Intervention • Provide laws and legal institutions that define and enforce property rights • Seek to correct market failure – Externalities – Public good – Monopolies – Asymmetric information 21-3 Managerial Economics and Organizational Architecture, 5e Defining and Enforcing Property Rights • Enforceable property rights increase incentive to invest and trade – patents, copyrights, trademarks • Enforceable contracts reduce transactions costs – greater gains from trade, more wealth – Lower transactions costs of contracting 21-4 Managerial Economics and Organizational Architecture, 5e Redressing Market Failures • Externalities – costs or benefits imposed on involuntary parties – pollution • Public goods – nonrival consumption – nonexcludable – free riders 21-5 Managerial Economics and Organizational Architecture, 5e Redressing Market Failures • Monopoly – antitrust laws – potential for regulators to be “captured” by the industry • Informational failures 21-6 Managerial Economics and Organizational Architecture, 5e Redistributing Wealth • Individuals have incentives to use regulatory powers to their advantage • Lobbying for wealth transfers yields no productive benefits for society • Taxi quotas raise the price above equilibrium reducing consumer surplus • Taxi companies are willing to spend up to the increase in their profits to lobby 21-7 Managerial Economics and Organizational Architecture, 5e Wealth Transfers via Government Quotas on the Number of Taxis $ Government intervention yields higher price (P’) and lower output (Q’), reduces consumer surplus (shaded area) and transfers wealth to cab companies (π). Lost potential gains from trade P’ π P* S D Q’ Q* Q 21-8 Managerial Economics and Organizational Architecture, 5e Economic Theory of Regulation • Special interests express demand for regulation or other favorable laws • Politicians (self-interested) supply regulation and other laws • Incentives to free ride and form coalitions – political power depends no ability to deliver votes and contributions – special interests are costly to form 21-9 Managerial Economics and Organizational Architecture, 5e Market for Regulation • In competitive and unregulated industry, Pc=MC • Collusion among firms could yield monopoly price, Pm>Pc • This will maximize profits in the industry • If the industry is regulated, the firms will want Pm and consumers will want Pc 21-10 Managerial Economics and Organizational Architecture, 5e Industry Profits in Competitive and Monopolized Markets $ Price (in dollars) $ P0 P0 Pm Pm Pc MC D MR Qm Pc Q Π Qc Quantity m Profit 21-11 Managerial Economics and Organizational Architecture, 5e Regulatory Behavior • Regulator seeks to maximize political support from constituents – businesses prefer higher profits – consumers prefer lower prices • Political support functions illustrate tradeoff between prices and profits that yield the same political support 21-12 Managerial Economics and Organizational Architecture, 5e Political Support Functions Increasing political support Price (in dollars) $ PS1 Pz Py PS2 Px Πx Πy p Profit 21-13 Managerial Economics and Organizational Architecture, 5e Regulatory Market Equilibrium • Regulators choose the price and profit level that maximizes their political support • Regulated price is determined by tangency between monopoly profit function and political support function • Regulated price is Pr*, Pc<Pr*<Pm 21-14 Managerial Economics and Organizational Architecture, 5e Equilibrium Regulated Price $ P0 Price (in dollars) PS1 Pm PS2 P*r Pc Π*r Πm p Profit 21-15 Managerial Economics and Organizational Architecture, 5e Market for Regulation • Regulators do not always behave in obviously consistent ways • Unorganized consumers offer regulators relatively little political support • Political outcomes depend on relative effectiveness of special interests • Government programs tend to benefit small groups at the expense of large groups 21-16 Managerial Economics and Organizational Architecture, 5e Managerial Implications • Government regulations can create barriers to entry – directly (e.g., legal profession, mail delivery) – indirectly (e.g., restaurant health codes, imposition of payroll tax) • Firms have incentives to push for regulations that raise their rival’s costs • Importance of coalition formation • Business participation in political process 21-17 Managerial Economics and Organizational Architecture, 5e Payroll Tax and Profits of Low-Labor Firms Price (in dollars) $ 310 S1 305 S0 300 D Q 250 400 Quantity of rugs 21-18
