10/19/2012
Chapter 10 Lecture:
Regulating Business
Underlying Reasons for Government
Regulation in the Private Sector
According to your authors, government
regulation of the private sector is
justified under two circumstances:
1. When flaws appear in the market that
produce undesirable consequences,
and
2. When adequate social, political, or
other reasons for government
regulations exist.
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Flaws in the Market
ƒ Natural monopoly
ƒ Destructive competition
ƒ Externalities
ƒ Inadequate information
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Natural Monopoly
ƒ French economist Antoine Cournot was the
first to recognize, in 1838, that when there
is only one seller in a market, that seller
will be incented to produce less than the
socially-optimal amount of his product.
ƒ The price the monopolist charges will be
higher, and the quantity manufactured and
sold per period time will be lower than
would occur if there were many sellers of
the same product.
ƒ Economist Alfred Marshall extended
Cournot’s insight in the 1890’s.
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Natural Monopoly
ƒ John Stuart Mill recognized in 1848 that
there were two principle types of monopoly:
natural monopoly and artificial monopoly.
ƒ A natural monopoly occurs when the upfront costs of manufacturing a good or
providing a service are very high, but the
marginal cost of providing the good or
service to one more buyer, once the
infrastructure is built, is very low.
ƒ Two classic examples are providing
electricity to homes, and providing Internet
service (DSL) to homes.
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Natural Monopoly
The best social welfare outcomes in a natural
monopoly situation are achieved by:
1. Permitting one firm to supply the entire
market, but
2. Making it illegal for that firm to charge
more than a specified price.
The government’s economists will attempt to
set the maximum price at the price the
market would set if the industry had lots of
competitors. If they can find this price, all the
benefits of having competition in the market
will be recaptured (in theory.)
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Destructive Competition
ƒ This is basically the other type of
monopoly. What John Stuart Mill
called “artificial monopoly.”
ƒ The best social welfare outcomes in
this situation are achieved by making
it illegal to be a monopolist or use
your monopoly power to dictate
terms to your customer, suppliers, or
other business partners.
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Externalities
ƒ An externality is any effect that a market
transaction or activity has on a person
who did not voluntarily elect to be affected
in that way.
ƒ An example is when poor people living in
low-lying island nations find their island is
overrun by rising sea levels because of
man-made global warming, and must
move.
ƒ If factories bear no cost for producing
carbon dioxide, they will produce more
than the socially-optimal amount.
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Externalities
ƒ There are many possible solutions to
economic externalities, and the best
solution depends on the circumstances.
ƒ One common solution suggested by
economists is that the factory pay a tax
per ton of carbon-dioxide emitted, and the
proceeds be given to the people affected.
The tax must be raised until the people
affected are indifferent between having
both the harm and the money, and
having neither the harm nor the money.
ƒ The factory will produce less CO2.
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Inadequate Information
ƒ One of the most important theories in
economics is the First Theorem of
Welfare Economics.
ƒ It consists of a mathematical proof
that, if 7 assumptions hold true, then
pure capitalism will produce the
highest level of social welfare
achievable through voluntary action;
that is, without coercing any of the
participants.
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Pure Capitalism…
ƒ 100% private ownership of the means
of production
ƒ Zero government regulations
ƒ Zero taxes
…will produce a “Pareto Optimal”
allocation of resources in the economy.
This means the social welfare
maximizing set of final goods and
services will be produced.
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Pareto Optimal
A Pareto Optimal allocation of
resources has two desirable qualities:
ƒ Allocative efficiency: It would not be
possible to tweak the mix of goods and
services made in such a way as to make
one person better off without making
someone else worse off.
ƒ Productive efficiency: All goods and
services will be made as cost-effectively
as possible without compromising quality.
(Helps us make more stuff.)
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Assumptions Needed to Prove the First
Theorem of Welfare Economics
1. Consumers’ preferences exhibit local
non-satiation.
2. Consumers are rational, and seek to
maximize utility subject to their
endowment and income constraints.
3. Consumers have perfect information.
4. All markets are frictionless.
5. All markets are perfectly competitive.
6. There are no externalities.
7. There are no public goods.
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Public Goods
ƒ Public goods in this context does NOT
mean “goods manufactured by government
and given for free to those who need them;”
although as we shall see, sometimes they
will be.
Public goods are goods that have
two characteristics:
1. They are non-excludable, and
2. They are non-rivalrous.
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Public Goods
Non-excludable: It is difficult or
impossible to prevent “free-riders” (nonpayers) from enjoying the benefits if you
produce more of these goods than you
did before.
Non-rivalrous: When one more person
“consumes” the good (benefits from the
good,) there is still just as much to go
around as before. It doesn’t diminish
the amount that is “left” for others.
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Examples of Public Goods
ƒ National defense
ƒ Police protection for a
neighborhood
ƒ Fire protection for a neighborhood
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Why Public Goods Show Up on
Our List of “Assumptions”
ƒ It turns out that public goods will
be “underproduced” relative to the
socially-optimal amount by purely
capitalist economies.
ƒ Solution: Raise taxes above zero
and have government provide
(produce) the socially-optimal
amount of each public good.
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Social and Political
Reasons for Regulation
ƒ Socially desirable goods and services
ƒ Socially desirable production methods
ƒ Resolution of national and global
problems
ƒ Regulation to benefit special interests
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My Thesis: Almost all government
intervention in markets in the U.S. can be
traced back to these five assumptions
needed to prove the First Theorem of
Welfare Economics!
2. Consumers are rational, and seek to
maximize utility subject to their
endowment and income constraints.
3. Consumers have perfect information.
5. All markets are perfectly competitive.
6. There are no externalities.
7. There are no public goods.
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Socially Desirable Goods and
Services Examples
ƒ The Department of Agriculture sets
standards for and inspects foods
entering the production process to
ensure the food we eat is safe.
ƒ The Department of Transportation
requires seat belts and air bags in
vehicles.
Neither would be necessary if
assumptions 2 and 3 held true!
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Socially Desirable Production
Methods, Part 1
Some regulations stop firms from
making products in harmful ways, for
example:
ƒ By exposing workers to danger, or
ƒ By releasing pollutants.
But these are both externalities!
Government is intervening to make it
illegal for firms to produce these
externalities! (Assumption 6)
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Socially Desirable Production
Methods, Part 2
Regulation is also used to protect civil rights at
work. The Equal Employment Opportunity
Commission enforces rules prohibiting
workplace discrimination.
ƒ If employers were rational utilitymaximizers (assumption 2,) they would be
color-blind when they hire.
ƒ If they also had perfect information
(assumption 3) about job candidates, they
would always hire the most qualified person.
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Resolution of National and
Global Problems
As the nation grew, the federal
government took on more responsibility
to solve national problems not
resolvable by state and local
governments or individuals. Examples
are:
1. Regulation of railroads (#5)
2. Regulation of banks (#3), and
3. Regulation of natural resources (#6).
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Regulation to Benefit Special
Interests
Some regulations protect special
interests that have the political strength
to pressure lawmakers for favorable
laws and rules. Many such regulations
apply narrowly to single companies, but
industries such as the steel industry and
big agricultural sectors such as cotton,
peanuts, sugar cane, and tobacco
benefit from protectionist rules and
subsidies.
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The Wheel of Business,
Government, and Society
Government passes
new laws and
regulations to
address society’s
complaints.
Government
Business
Business affects
society in a variety
of ways, some
positive, some
negative.
Society
Society complains
to government
about the negative
effects.
Figure 10.2: Historical Waves of
Government Regulation of Business
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc. All rights reserved
The Code of Federal Regulations
ƒ Contains all the federal regulations created
by federal administrative agencies currently
in effect.
ƒ It was 157,974 pages when your textbook
went to press.
ƒ That’s 394 books as long as your textbook.
ƒ Statutes passed by Congress would be
over and above that.
ƒ Statutes passed by the state legislature
would be over and above that.
ƒ Regulations created by state administrative
agencies would be over and above that.
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The Cost of Complying with
Federal Regulations
ƒ One study concluded that the total dollar cost
of complying with federal regulations in the
year 2000 was $876 billion, or 8.6 percent of
GDP.
ƒ An extrapolation from this study predicted
that the cost would rise to $1.2 trillion per
year by 2009.
ƒ But a follow up study found that the costs of
compliance had risen to $1.1 trillion by 2004
(11 percent of GDP,) 5 years earlier than
forecast!
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Figure 10.6: Estimated Cost of Administering (Writing
and Enforcing) Federal Regulations: 1960-2010
Figure 10.7: If Agencies Were Planets
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc. All rights reserved
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Benefits of
Government Regulation
ƒ Regulations have helped to:
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
Reduce discrimination
Clean the environment
Prevent monopoly
Reinforce free competition
Prevent corruption
Strengthen the banking system
Reduce industrial accidents
Provide resources for the elderly, and
Control communicable diseases
ƒ These benefits are enormous, but difficult to
quantify.
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Figure 10.8: The World Bank’s 2011 Ease of
Doing Business Rankings
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc. All rights reserved
The World Bank’s Ease of Doing
Business Studies: Four Basic Findings
ƒ Regulation varies widely around the
world.
ƒ Poor countries regulate business the
most.
ƒ Rich countries regulate business in a
consistent manner while poor countries
do not.
ƒ Developed countries engage in
continuous regulatory reform while there
is less reform in developing countries.
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Regulation Varies Widely Around the
World
ƒ Starting a business in Bolivia requires
15 steps that take 51 days, and paying
fees equal to 99% of the country’s
average per capita annual income.
ƒ Starting a business in Europe requires
an average of 6 steps over 13 days with
fees near 5% of the average per capita
annual income.
ƒ Starting a business in New Zealand
takes 1 day and costs $160.
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Poor Countries Regulate Business the
Most
And heavier regulation brings bad
outcomes, including delays, higher costs,
more corruption, lower productivity, and
less investment in businesses overall,
which means less job creation.
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Rich Countries Regulate Business in a
Consistent Manner, While Poor
Countries Do Not
Rich countries also regulate less on all
aspects of business activity.
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Developed Countries Engage in
Continuous Regulatory Reform, While
There is Less Reform in Developing
Countries
ƒ For example, the top 10 countries in
figure 10.8 made a total of 10 reforms in
2011 making it easier to do business in
their countries,
ƒ While the bottom 10 countries listed
made only 4 such reforms.
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Concluding Observations
ƒ There have been ups and downs in the trend of
government regulation of business, but the basic
direction has been up, with respect to both total
volume and the complexity of the regulations on
the books.
ƒ The cost of federal regulations is huge, but the cost
is offset in significant degree by the many benefits
of regulation to society as a whole, individuals,
companies, and industries.
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