Role of Government in the Economy MBS First Year

8/8/2019 Role of Government in the Economy MBS First Year

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Role of Government in the Economy

Government is an institution which plays an important role in all types of economicsystem.The role of government in all types of economic system is very essential in presentsituation. By using its power, government can enact the law to regulate differenteconomic activities. The Government intervenes, the activities of private firm byusing various specific policies, such as industrial policy, commercial policy, labourpolicy, environment policy etc.

In primitive societies, the government role was neglected. They believed that thegovernment is best which governed least. They preferred the minimum role ofgovernment. Their economic ideas were based on laissez-fair doctrine, whichmeans the system of economic liberty. In nineteen century in England "thatgovernment was considered the best which does the least". Due to thisgovernment control and the role in the economy had declined.

In laissez-fair economy there was rapid economic growth and on the other theevils, such as unequal distribution of income and wealth, monopolistic exploitation,exploitation of unskilled labour. Consequently, the role of government again beganto increase all over the world. After World War I, Russian revolution which lead tothe abolition most private property and put state in control through central planningof all economic activities. During the period of 1929 33, there occurred GreatDepression in the capitalist countries which caused huge unemployment of labourand other resources in those countries and as a result level of national income felldown. Due to depression many factories were closed and factories which wereworking were also not being used to their full productive capacity. As a result,unemployment, low income, low production was created. Since World War II mostof the economists had taken increasing public sector as the natural and essential

factor of development. The objectives like economic efficiency, growth,macroeconomic stability, poverty alleviation, equal distribution of income, provisionof public of goods cannot be achieved only through private agencies. During theperiod of 1967s there was re-emergence of private interest views in public sector.In this way controversy about the role of government has not subsided. Manyresearch has been made regarding government involvement has hindered orfacilitate in economic sector.

The Government, Culture and Geography, Environment and Natural Resources aretaken as the basic pillars of economic growth. Economists point out the need forgovernments role mainly due to the market failure. It is therefore governments roleis important in the economy mainly because of the following reasons:

a) Providing public goods such as rule of law, effective regulation anddevelopment of physical infrastructure.

b) Managing positive externalities such as those emanating from theinvestment in education, health, and research, and the negative ones suchas the effect of the pollution.

c) Controlling and monitoring monopoly, andd) Managing the coordination failure occurring in the private sector


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A number of world economies that were at the same level with their neighbouringeconomies in terms of education, health, per capita income and natural resourcessome five decades ago, have been successful in attaining significantly higher levelof economic development because of the governments role. Countries like SriLanka, Botswana, China, and South Africa have proved that significant progresscould be achieved even in a short period mainly due to the qualitative

improvements in and effectiveness of the government's role. The HumanDevelopment Report 2003 highlights that Sri Lanka had increased life expectancyof her people from 46 years to 58 years during 1946 to 1953. Botswana was ableto increase the primary school enrolment rate from 46 percent to 89 percent during1970 through 1985. China successfully reduced the poverty rate from 33 percent to18 percent in the decade of 1990s. And South Africa was able to reduce thenumber of people lacking access to clean drinking water from 15 million to 7 milliononly in a period of 4 years during 1997 through 2001. In the background of thesetheories and instances, Nepals need of the hour is to develop a far-sighted visionto ensure an effective state mechanism, even taking into account the experiencesof other economies, that facilitates in attaining higher level of economic growth.

Source: David N. Weil, Economic Growth (2005) and UNDP Human Development Report (2003)

According to World Bank Report, 1988, government was involvement mainly onpublic goods, defence, diplomacy, macroeconomic management, justice, legalmatters and infrastructure like social, physical, education, health, transportation,and environment protection.

Regulatory and Promotional Role of the Government

Any country's the prosperity and obstacles of economic growth results from

activities of government. That means, government plays important role in economicactivities. In free market economies government plays important activities. It has toperform role to prevent market failure. As we know that market does not yieldeconomically efficient outcome every time as the result market fails to operate. Infree market economy government has designed activities to stimulate and assistprivate enterprise and to regulate or control business practices so that theiroperations are consistent with the public interest. There are various forms ofgovernment regulation especially to regulate the activities of private firms.

a) Industrial products are subject to operating regulations, governing plant andpollutant emission, product packaging and labelling, worker safety and healthetc.

b) Financial Regulations; Banks and Financial Institutions are subject to both thegovernment as well as the control made by the Central Bank for financialsoundness.


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A. Rational for Regulation

1) Economic Consideration; and2) Political Consideration

1. Economic Consideration

Economic consideration is related to the cost and efficiency implications of variousregulatory methods. From economic view point a given mode of regulation orchange in regulatory policy is desirable to the extent that benefit exceeds the cost.Political consideration relate to equity rather than efficiency.

Economic consideration has an important role in formulating regulatory policy. Infact, it is due to market imperfection that need of regulation in production andmarketing activities was felt. If unregulated, the market activities itself createsinefficiency or waste and market failure.

Market failure is mainly two types

a) Failure by market structure

In order to achieve the economically efficient outcome there must be manyproducers and consumers within each market. This condition is unfulfilled in somemarket such as water power, telecommunication etc. If these sectors are allowedfor private sectors natural monopoly situation come to exist. They may exploit theconsumers by charging higher prices and reduces the volume of output and earnexcessive profit. Under such situation market does not yield economically efficientoutcomes and creates the situation of market failure.

b) Failure by incentive

Second kind of market failure is due to lack of incentive. The market failure due topresence of externalities is known as incentive failure. Production of the firms andconsumption of individuals are interdependent of each other. Differences betweensocial and private costs or benefit are called externality. Pollution caused in thewater supply in the lower part of the city by the carpet factory situated in the upperpart of the city and Plantation of trees in the certain part of the community benefitsthe community as a whole are the examples of negative and positive externalities.

2. Political Consideration

In formulating regulatory policy, political manifesto of the ruling party and theopposition parties needs to be taken into consideration for political consensus andcommitments. From political viewpoint there are two reasons for regulation:


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a) Preservation of consumer sovereignty

The preservation of consumer's choice or consumer sovereignty is an inherentaspect of democracy. Consumers have free to decision regarding to theirconsumption. This is possible only in the competitive market. In competitive marketprice is set at minimum point of LAC curve in the long run. Therefore monopoly

market regulatory policy can be valuable tool to restore control over the price andquality decision making process to the public.

b) Limit concentration of economic and political power

In a democratic society it is not desirable to have economic and political powerconcentrated in limited group. It is regarded that the economic and political powerremains linked with one another. Economically active power oriented personsusually are seen interfering in political activities as well. Therefore, thedevelopment of large structures is prevented through regulatory policy. The aim ofthe government is equitable distribution of wealth and income. For the purposegovernment should interfere in the market.

B. Promotional Role

In the free enterprises economy, the major role of government is to promote privatesector participation. To promote private sector, government has to develop physicalinfrastructure such as transport, energy, development of irrigation, telecomnetworking. The social and economic overheads created by the government helpprivate business at least in two ways:

a) Economic growth

The building of economic and social overhead accelerates the pace of economicgrowth. Economic growth enlarges the size of market to the advantage of privatebusiness through a sustained increase aggregate demand.

b) External economies

The adequate supply of economic and social overhead creates external economieswhich reduces the private cost of production. The social, economic overheadcreated by the government helps the growth of private business, facilitatingacquisition of inputs such as labour, raw material, skilled labour.

GOVERNMENT RESPONSE TO MARKET FAILURE

Market failure refers to a market that fails to provide efficient outcomes for thesociety. In other words, market works efficiently only when there exist perfectcompetition or when exclusion principle could be applied in the free market.

Exclusion principle requires that, those who do not pay for as goods should beexcluded from its consumption and those who derive any benefit from goods


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should bear its cost. According to Pappas and Herschey "market failure can bedescribed as the failure of a system of market institutions to sustain sociallydesirable activities or to eliminate undesirable ones."

In free market economy the main responsibility of the government is to prevent themarket from failure. Market failure can be summarized in two ways:

1) Market failures due to incentive or incentive failure2) Market failures due to structure or structure failure

1) Market failure due to incentive or incentive failure

The market failure due to the presence of externalities is known as incentivefailure. The free market mechanism does not function effectively when exclusionprinciple is not applicable. Exclusion principle requires that, those who do not payfor as goods should be excluded from its consumption and those who derive anybenefit from goods should bear its cost.

But in the complex world there are many such goods and services where evenpeople do not use goods and services are bearing cost in terms of loss of welfare,and even though people do not pay for the goods they are benefited by the goodsand services. Such situations are called externalities.

The market mechanism does not compensate or charge those who are affected byexternalities. Thus, collective action is needed by the government to charge thosebenefit from and compensate those who suffer from externalities. In order toprevent the market from failure, government response to incentive failure in twoways:

A) Consumption externality; andB) Production externality

A) Consumption externality

In traditional economics, consumption is supposed to be independent, but in reality,consumption of an individual is not independent. It is affected by externalenvironment. For Example: those who smoke in a bus reduce the utility of thosewho do not smoke. Externalities may arise from either consumption or production

Consumption externalities are of two kinds:a) Positive externality in consumption; andb) Negative externality in consumption.

a) Positive externality in Consumption

The consumption externality occurs if the welfare of the person is affected by theconsumption pattern of other person. In other words, if an individual getssatisfaction with out incurring any cost. It is the case of positive externality. For


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example when individual paint his house, it increases the beauty of the wholesociety. Consumption decision of one, others receive value without payingcompensation.

b) Negative externality in consumption

An external diseconomy of consumption arises when the purchase andconsumption of goods or services results in disutility for people not involved in thetransaction. For example, when an individual use loud speaker to listen the radio, itadversely affects the students who is planned to appear an examination.

In both cases, there is difference between social cost and private cost. In case ofpositive externality in consumption social value is grater than private values. Incase of negative externality in consumption social cost is greater than private cost.The environment pollution is the glaring example of negative externality. If firmdischarge polluted water in the river, swimming fishing comes to a halt. If the firmpulls water from the river is not available to others. People bear the cost in terms ofsocial welfare without using the product or service. In this sense, government

charges compensate made to firm.

B) Production externalitiesProduction externality is also divided in the following two parts.

a) Positive externality in production; andb) Negative externality in production.

a) Positive externality in production

An external economy of production arises when an increase in the firm's productionresults in some benefit to society or another firm. As for example construction ofhigh way reduces the transportation cost of the firm, the research conducted bygovernment benefit all the firms etc, are the positive externality in production. Otherexamples of positive externalities in production are:

Fig: This Resort is a positive externality


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i) Training program of on firm increases the supply of skilled labour for all the

firms.ii) If a person increases the apple trees the output of honey producers

automatically increases.

If we introduce the external economy, it reduces the cost of production, In this time,quality production id OQ1 is greater than OQ, the output without external economy.Figure:

Fig: This Park is a positive externality which provides people with a place to relax without paying the construction cost for it.


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b) Negative externality in production

Negative externality in production arises when expansion of the firm's productionresults in adverse effects (social cost) that are not paid for by the firm and aretherefore not reflected in the prices of its production. For example:

i) The water pollution created by carpet industry cost on societyii) Factory vehicles produces air pollution and imposes cost in the societyiii) The factory car, plane, pollutes air by discharging smoke and create noise

pollution by creating loud noise

When there are negative externalities PMC curve lies below SMC curve. i.e. socialcost is greater than private cost.

Fig: Effects of Negative Externalities


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Government Responses in incentive failure

In order to prevent the market form failure, positive externalities should beincreased. Market does not have any mechanism to encourage such activities.Government should take the following steps to prevent market failure: Grant patents; and

Provide operating subsidies

Patent

Patents are a government grant of exclusive right to produce, use or sell andinventions or ideas for a specified period of time. They are essentially a limitedgrant of legal monopoly power designed to encourage inventions and innovation.Patents arose response to the fact that a firm which develops an importanttechnological breakthrough cannot begin to reap the full benefits of its efforts ifother firms can freely begin making the new product or using the new productionprocess without having to compensate the originator. Without patent rights andprotection, few firms would devote resources to research, and the economy wouldobtain few of the benefits which flow from such research efforts.

Advantagesi) Patent is necessary incentive to induce the business firms to work more and

invest in new and creative projects.ii) The inventions are disclosed soon due to the patent act. Consequently, since

there is sooner dissemination of information, it facilitates other inventions.

Disadvantagesi) There are some perversions of the patent law that directly effects competition.

Controlling output, dividing markets, fixing prices are some perversions due to

patent right.ii) Since patent system enables the inventors to get a great part of the socialbenefit from their innovation although patent system is ineffective. Thus itencourages imitations.

Government apathy leads to flower patent theft

More than 342 species of indigenous flowering plants grow in Nepal, according to asurvey made by Ministry of Forest and Land Conservation but the government hasnot taken any initiative to register the patents of these plants. The result is peoplefrom other countries come here and take away Nepals plants and register those

under their own countries patents.

Floriculture Association of Nepal (FAN) president Ghacchadar Karki said there aremore than 342 species identified but as they are yet to be registered at theinternational level it is boosting patent theft.

We recently heard one of our local plants known as Jamuney Mandro has got itspatent registered by Japan. Actually, it is a rare plant grown in Kathmandu Valley,said Karki.


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It is useless to identify our local species if we fail to protect their identity in ourcountry.

He added that if the authorised bodies were active for patent registration of plantsavailable in our country, the floriculture business would have bloomed to

phenomenal proportions. The plants available in our forests can be used throughtissue culture for higher production. This can increase the export of Nepalsflowers, said Karki.

Though the country is rich in bio-diversity, the lack of government initiative forceFAN to import flowering and non-flowering plants from other countries.

Huge quantities of flowering and non-flowering plants are imported fromKalimpong and Kolkata while more than Rs. 1 million is spent on buying mother-plants of certain flowers from abroad, Karki said.

According to him, for festivals huge quantities of cut flowers are imported from

India during winter seasons while mother-plants are imported mainly fromCambodia.

Investigations are still on about the number of species of flowering plants and non-flowering plants available at high altitudes, according to the Ministry of Forest andLand Conservation.

We need special package programmes such as priority for investments toencourage the floriculture business in Nepal, and Karki.

Currently, there a number of nurseries involved in selling flowers that are importedfrom other countries but not those which are available in the countrys forests.

Exports of foreign plants cannot make us feel proud, at least not until we are ableto sell our own floral products in the international market, said Karki.

There is also a number of non-flowering plants which if recognized can be broughtfor business in the local market. According to Karki, about 75 percent of plants bothflowering and non-flowering plants are imported from foreign countries.

There are around 500 registered floriculturists under FAN but only 350 areparticipating actively. There are around 600 flower farms and nurseries in 35districts.

Around 4000 people are directly involved in floriculture while the number oftemporary workers getting employed during peak seasons is double that.


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Subsidies

Government also responds to external economies of production by providingsubsidies to private business firms. These subsides can be indirect, as in the case

of government construction and maintenance of highways used by the truckingindustry. They can also take the form of such direct payments as special taxtreatments and governmentprovided low-cost financing.

Investments tax credits allowed for certain types of business investments and thedepletion allowances provided to promote resources extraction industries areexamples of tax subsides given in recognition of production externalities whichprovide benefits to society. The external economies associated with locating amajor manufacturing facility in an industrial park have given rise to localgovernment financing of such facilities. The low-cost financing is thought to providecompensation for the external benefits provided.

Often market creates negative externalities. Government use taxes along withdirect operating requirement and controls to correct for the external diseconomiesin the market place.

Operating control

Just as government attempts to correct for the market failures associated withexternal economies, it also works to remedy problems associated with external dis-

economies. One of the primary tools of government policy in this area is theimposition of operating controls that limit the activities of firms.

What kind of operating controls are imposed on business firms? Controls overenvironmental pollution immediately come to mind, but businesses are also subjectto many other kinds of constraints. For example:

Federal legislation sets limits for automobiles safety standards; and firms handlingfood products, drugs and other substances that could harm consumers areconstrained under various labour laws and health regulations: Included areprovisions related to noise levels, noxious gases and chemicals, and safetystandards.

Anti-discrimination laws designed to protect minority groups and women also causesome firms to modify their hiring and promotional policies.

Wage and price controls, imposed at various times in the past in attempts toreduce high rates of inflation, restrict the freedom of firms in setting prices andaffect the usage of resources throughout the economic system.


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Numerous other constraints have been imposed on firms. Rather than attempt toenumerate all of them, it will prove more useful to specify the value of economicanalysis in determining the impact of direct controls over the activities of firms.

Operating right grant

Government exercises the following measures as operating right grant:

a) Government controls media such as radio, television broadcasting right toprovide quality services to the public.

b) Government through central bank control banking and financial institutions.

c) In order to get the operating right for higher secondary school and college, firmmust fulfil certain conditions such as minimum amount of deposits, qualifiedfaculty number physical facilities etc.

Tax policies

Taxes are used to control the negative externalities created by market. Tax policiesare designed to limit the undesirable activities of private firm. Pollution taxes,effluent charges, fines etc are common examples of tax policies. For examplegovernment fines to those who do not fallow the traffic rules such as wearing ofhelmet wearing of safety belt etc.

STRUCTURE FAILURE

Competitive market benefits society by reducing the price and improving theefficiency of resource allocation, thus, government's priority action should be toenhance competition. There should be enough sellers and buyers in the market toget the beneficial effect of competition or there should be at least the possibility ofthe easy entry of new firms. If such condition is not fulfilled, it is considered as themarket failure due the market structure. Depending on the nature of a particularindustry, for example: market of water, electricity, telephone, a monopoly oroligopoly may develop, possibly resulting in too little production and excess profits.Such condition is considered natural monopoly.

Natural Monopoly

In some industries, economies of scale operate (i.e. the long run average costcurve may fall) continuously as output expands, so that a single firm could supplythe entire market more efficiently than any number of smaller firms. Such large firmsupplying the entire market is called natural monopoly. Examples of naturalmonopolies are public utilities like electricity, gas, water, local transportationcompanies etc. The characteristic of natural monopoly is:


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that the firms' long-run average cost curve is still declining even the firmsupplies the entire market.

The monopoly is that, the natural result of such firm will have lower cost per unitthan other smaller firms. This will give the firm, market power to drive the smallerfirms out of the business.

To avoid this, governments usually exercises two methods for controllingmonopolistic situation:a) Control over market structureb) Direct control

a) Control over market structure

Anti-trust laws are design to decrease industrial concentration and to preventcollusion among oligopolistic firms.

Antitrust Law

In the late nineteenth century a movement toward industrial consolidationdeveloped in the United States. Industrial growth was rapid, and because ofeconomies of scale, an oligopolistic structure emerged in certain industries. Pricingreactions became apparent to industry leaders, who concluded that higher profitscould be attained through cooperation rather than through competition. As a result,voting trusts were formed, whereby the voting rights to the stocks of the variousfirms in an industry were turned over to a trust, which then managed the firm andsought to reach a monopoly price/output solution. The oil and the tobacco trusts of

the 1880s are well-known examples.Although profitable to the firms, the trusts were socially undesirable, and publicindignation resulted in the passage of the first significant antitrust measure in 1890,the Sherman Act. Other important legislation subsequently passed includes theClayton Act (1914) and the Federal Trade Commission Act (1914), the Robinson-Patman Act (1936), and the Celler Anti-Merger Act (1950). Each of these acts wasdesigned to prevent anticompetitive actions, actions whose impact is more likely toreduce competition than it is to lower costs by increasing operating efficiency. INthis section we present a brief chronology of major antitrust legislation.

Sherman Act

The Sherman Act of 1890 was the first federal antitrust legislation. In substance, itwas brief and to the point. Section 1 forbade contracts, combinations, orconspiracies in restraint of trade (then an offence at common law), and Section 2forbids monopolization. Both sections could be enforced by civil courts decrees orby criminal proceedings, with the guilty liable to fines or jail sentences.

Despite some landmark decisions against the tobacco, powder, and Standard Oiltrusts, enforcement proved to be sporadic. Moreover, the Sherman Act was allegedto be too vague. On the one hand, business people claimed not to know what was


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illegal; on the other, it was widely felt that the Justice Department was ignorant ofmonopoly-creating practices and did not bring suit against them until it was too lateand monopoly was a fait accompli.

In 1974 the Sherman Act was amended to make violations felonies rather thanmisdemeanours. That statue also increased the maximum penalties that could be

levied. Instead of $50,000 against a corporation and $50,000 and one year inprison against an individual, the act now provides for $1,000,000 maximum finesagainst corporations and up to $1,000,000 fines and three years imprisonment forindividuals. In addition to the criminal fines and prison sentences, firms andindividuals violating the Sherman Act face the possibility of triple-damage civil suitsfrom those injured by the antitrust violation.

Despite its shortcomings, the Sherman Act remains one of the government's mainweapons against anticompetitive behaviour. IN February of 1978 a federal judgeimposed some of the stiffest penalties in the history of U.S. anti trust actions o eightfirms and eleven of their officers who were convicted of violating the Sherman Act.These convictions for price fixing in the electrical wiring devices industries resulted

in fines totalling nearly $900,000 and jail terms for nine of the eleven officerscharged.

Clayton Act and Federal Trade Commission Act

Congress passed two measures in 1974 that were designed to further overcomeweakness in the Sherman Act the Clayton Act and the Federal TradeCommission (FTC) Act. The principal features of these are summarized below.

Enforcement The Federal Trade Commission Act established and funded theFTC for the expressed purpose of initiating actions to prevent and punish antitrust

violations.

Mergers Voting trusts that lessened competition were prohibited by theSherman Act, but interpretation of the act did not always prevent on corporationform acquiring the stock of other, competing firms and then merging them intoitself. Section 7 of the Clayton Act prohibited such mergers if they were found toreduce competition. Either the Anti-trust Division of the Justice Department or theFTC can bring suit under Section 7, or mergers can be prevented. IF they havebeen consummated prior to the suit, divestment can be ordered.

Interlocking Directorates The Clayton Act also prevented individuals formserving on the boards of directors of two competing companies. Two so-called

competitors having common directors would obviously not compete very hard.

Price Discrimination The Clayton Act made it illegal for a seller todiscriminate prices between its customers (1) unless cost differentials in servingthe various customers justified the price differentials or (2) unless the lower pricescharged in certain markets were offered to meet competition in the area. Theprimary concern was that a strong regional or nation firm might employ selectiveprice cuts in local markets to eliminate weak firms. Once the competitors in one


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market were eliminated, monopoly prices would be charged in the area and theexcessive profits could be used to subsidize cut throat competition in other areas.

Typing Contracts and Related Arrangements A firm, particularly one withthe patent on a vital process or a monopoly on a natural resource, con uselicensing or other arrangements to restrict competition. One such procedure is the

typing contract, through which a firm ties the acquisition of one item to anagreement to purchase other items. For example, the International BusinessMachines Corporation for many years refused to sell its business machines. Ifrented these machines to customers who were required to buy IBM punch cardsand related materials as well as machines maintenance from the company. Thisclearly had the effect of reducing competition in the maintenance and serviceindustry, as well as in the punch card and related products industry. After the IBMlease agreement was declared illegal under the Clayton Act, the company wasforced to offer its machines for sale and to cease leasing arrangements that tiedfirms to agreements to purchase other IBM materials and services.

IBM Case Study

In 1969, the Justice Department filed suit against IMB under section 2 of theSherman Act for monopolizing the computer market, for using exclusive and tryingcontracts, and for selling new equipments at below costs. The government soughtthe dissolution of IBM. After 13 years of litigation, more than 104,000 trialstranscript pages, $26 million cost to the government cost to the government (and$300 million incurred by IBM to defend itself), however, the Justice Departmentdropped its suit against IBM in 1982. The reason that the government decided todrop its case against IBM was that rapid technological change, increasedcompetition in the field of computers, and changed marketing methods since thefiling of the suit had so weakened the government's case that the JusticeDepartment felt it could not win. IN 1995, IBM was a struggling giant in a highlycompetitive market rather than the near monopolist it had been accused of being in1969. It was only in the second half of the 1990s that IBM seemed to find its wayagain.

The Microsoft Antitrust Case

In fall 1998, the U.S. Justice Department sued Microsoft, the world's largestsoftware company, accusing it of illegally using its Window operating system nearmonopoly to overwhelm rivals and hurt consumers. Specifically, the government

accused Microsoft of merging its Web browser into its Windows operating systemin order to crush Netscape Communication Corporation, its chief competitor in thebrowser business. By bundling the browser with Windows and using exclusionarycontracts to prevent personal computer makers form hiding or removing theMicrosoft browser, Microsoft prevented consumers from using rival browsers(particularly Netscape's) and also discouraged systems other than Windows.Furthermore, the government accused Microsoft of conducting a campaign tocurtail other potential threats form Intel, Sun Micro system, Apple Computer, andIBM that enabled Microsoft to extend its power to other areas, such as computer


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servers and Internet protocols, thus causing substantial and far-reaching harm toconsumers by stifling competition and innovation in the software industry. Theaccusation were backed in court by oral testimonies of 26 witnesses, as well asthousands of exhibits, including numerous e-mail messages and other internalcorporate records form the previous five years.

Microsoft's response was that the government's case was based on fiction andfantasy. Microsoft said that no company could have a monopoly in the fast moving, intensely competitive PC and Internet business and that it faces manycompetitive threats from the market place. According to Microsoft, bundling its Webbrowser in Windows improved the operating system and lowered prices toconsumers and, in any event, consumers had ample choices, not least of all fromNetscape, which distributed millions of copies of its browser Navigator during 1998.According to Microsoft, America Online's purchase of Netscape in early 1999 couldrestore Netscape to a leading position in the browser business. The governmentresponds that Microsoft's illegal actions shattered Netscape's browser businessand that AOL had acquired Netscape mostly for its Internet "portal" site and itsserver and e-business products.

On April 4, 2000, the federal district judge trying the case ruled that Microsoft hadviolated antitrust laws with predatory behaviour and would impose penalties andremedial action. There are three possible courses of remedial action if the judgesfind Microsoft guilty. The weakest punishment would be simply to forbid Microsoftfrom engaging in the future in exclusive dealings with providers of services on theInternet, and nothing more. This is possible in view of the fact that ProfessorStanley Fisher, the government's leading economic expert form MIT, stated in courtthat consumers "had not suffered any harm form Microsoft's actions to date." Thesecond option would be to force Microsoft to license Windows to other companies,which could develop it and sell it in competition with Microsoft. The most drasticremedy would be to break up Microsoft into two companies (along the lines of theAT&T decision of 1982), with a company controlling Windows and another sellingits applications products, including the popular Microsoft Office suite of businesssoftware. The Windows Company could develop its own applications business, andthe applications company could join a rival operating software company and pose amuch stronger challenge to Windows than existing competitors can

b) Direct control

Public utility regulation, which fixes prices at levels designed to prevent firms fromearning monopolistic profit.

Public Utility regulation

According to Lewis and Peterson public utility seems to have two general features:

i) The industry provides a product or service of particular importance either theday to day livelihood or the future growth.

ii) The nature of the production process is such that competition is seem asyielding undesirable result such as duplication of facilities.


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The most common method of monopoly regulation is through pricecontrol/regulation. The regulated price is such that monopoly recovers its fixed andvariable cost plus an allowed return on investment. The government exercisesprice control mechanism for the following results:

Sales volume of the product would increase compare to unrestrictedmonopoly condition.

Reduction of the profit of the firm Level of rate of return on owner's investment will reduce.

The actual output, however, will be determined by the actual demand at the priceset by the regulatory commission.

In order to restrict the firm to operate in an unconstrained monopolist condition,government/policy maker can exercise several alternatives. Some alternatives arediscussed below:

a) Price at marginal cost;b) Compromise solution; andc) Undue price discrimination

Price at marginal cost

One of the measures to control monopoly price is by fixing the price of the product.In this method, policy makers lets the firms maintain the existing monopoly positionand make them fix price equal to marginal cost. But, for retaining price level atmarginal cost for long time government should either compensate for loss orprovide subsidy to the firm. This situation can be explained with the help of figurebelow:

The existence of natural monopoly poses something of a dilemma fro public policy.One alternative is to let the firm operate as a monopoly. If the firm faced the


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demand curve DD, as shown in the Figure, the monopoly price would be P M andthe quantity, QM. The firm would then earn economic profit, as indicated by thearea of the rectangle PMABC. Compared to marginal cost pricing (i.e., setting theprice equal to marginal cost), the monopoly-pricing scheme would result in adeadweight loss and also transfer of consumer surplus form consumers toproducers.

If the firm is allow maintaining its monopoly position but regulated to set the price atmarginal cost, it would result in a price of PC and a quantity of QC. At this level ofproduction there is no deadweight loss because production is increased until thecost of producing the last unit is equal to the value of that unit. There is also notransfer of surplus form consumers to producers. In fact, the problem is quite thereverse. Because the monopolist is producing in a region of decreasing cost, itsmarginal cost is less than its average cost. Being required at marginal cost, themonopolist is unable to earn a normal return on capital. This is easily seen byobserving that at the output rate QC, the average revenue as shown by the demandcurve is less than the average cost.

Compromise Solution

The most common method for pricing the products of a natural monopoly is thecompromise solution. The nature of the compromise is depicted by the abovefigure. A simple description of public utility price regulation is that price is set equalto average cost. That is, the firm is allowed to charge a price that allows it to earnno more than a normal return on its capital. This is shown in the figure by the price,PR, and the quantity, QR. The regulatory approach is compromise because theprice is less than if the firm were allowed to act as a monopolist. Because the firmearns a normal profit, there is no need for the subsidy that would be required withmarginal cost pricing. Thus, this mechanism achieves some of the gains formmarginal cost pricing without requiring a subsidy.

Undue Price discrimination

Price discrimination occurs when consumers are charged different prices for aproduct and the differences in price cannot be accounted for by cost differentials.The three requirements for successful price discrimination are: that consumers have different demand elasticity, that markets be separable, and that the firm has some power over price.

The telephone industry provides an example of successful price discriminationpolicies by a public utility. Rates for basic telephone services are higher forbusiness users than they are for residential users. There is no particular reason toassume that the cost of installing and maintaining a phone in an office is differentform putting one in a kitchen. There are, however, possible differences in demandelasticity for business versus home phone customers. Consider the case of astockbroker. The vast majority of orders for the purchase or sale of stock come tothe broker by phone. There is no way the business could be conducted without a


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phone. In contrast, if there is a neighbour's phone that can be used in anemergency, it is quite possible to get along without a telephone in one's home. Ineconomic terms, the stockbroker is said to have more inelastic demand fortelephone service than does the residential customer.

The other conditions for price discrimination are also met in the telephone industry.

Because there is a physical connection between the customer and the phonecompany, there is no way low-cost home telephone service can be resold to abusiness customer. Also, is the stockbroker does not interconnect with the localphone company; there is no practical way to have access to customers calling inorders.

The consequence of price discrimination provides an argument for regulation.Perhaps government should intervene to protect the commercial user from anunfair situation. The issue is not one of efficiency, but of fairness. The presumptionis that the monopolist should not be allowed to use its power to unduly discriminateagainst some consumers. Although some discrimination may be acceptable,government intervention may be necessary when that discrimination becomes

excessive. There is no clear definition of the distinction between due and unduediscrimination. In the end, undue price discrimination is whatever the regulatorycommissions or the courts determine it to be.

Problems of Direct Regulation

a) UncertaintyAlthough the concept of price regulation is simple, serious problem exist in itsapplication to actual regulation of public utilities. First, it is impossible to determineexactly the cost and the demand scheduled, as well as the asset base necessary

to support a specified level of output. Utilities also serve several classes ofcustomers, which means that a number of different demand scheduled with varyingprice elasticity are involved; therefore, any number of different rate schedules canbe used to produce the desired profit level. If telephone company profits are toolow, should rates be raised on local calls or on long distance calls? If electricutilities need more profits, should industrial, commercial, or residential users bearthe burden? An appeal to cost considerations for a solution to this problem of noavail, because all the services mentioned are joined products, a factor that makes itextremely difficult, if not impossible, to separate costs and allocate them to specificclasses of customers.

b) Optimal Output

A second problem with price regulation is that regulators can make mistakes withregards to the optimal output, growth, and service levels. For example, a telephoneutility is permitted to charge excessively high rates, more funds will be allocated tosystem expansion, and communication services will grow at a faster than optimalrate. Similarly, if prices allowed to natural gas producers are too low, consumerswill be encouraged to use gas at a high rate, producers will not seek new gassupplies, and a shortage of gas will occur. Too low price structure for electricity willlikewise encourage the use of power but discourage the additional of newgenerating equipment.


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c) InefficiencyPrice regulation can also lead to inefficiency. If the regulated companies areguaranteed a minimum return on their invested capital, then, provided demandconditions permit, operating inefficiencies can be offset by higher prices. This isillustrated in the figure below:

A regulated utility faces the demand curve AR and the marginal revenue curve MR.If the utility operates at peak efficiency, the average cost curves AC1 will apply. At aregulated price P1, Q1 units will be demanded; cost per unit will be C1; and profitsequal to the rectangle P1P1'C1'C1 will be earned. These profits are, lets us assume,just sufficient to provide a reasonable return on invested capital.

Now assume that another company, one with less capable managers, is operatingunder similar conditions. Because this management is less efficient than that of the

first company, its cost curve is represented by AC2. If its price is set at P1, it too willsell Q1 units, but its average cost will be C2; its profits will be only P1P1'C2'C2; andthe company will be earning less than a reasonable rate of return. In the absenceof regulation, inefficiency and low profits go together, but under regulation theinefficient company can request - and probably be granted - a rate increase to P2.Here it can sell Q2 units of output, incur an average cost of C3 per unit, and earnprofits of P2P2'C3'C3, resulting in a rate of return on investment approximately equalto that of the efficient company. We see, then, that regulation can reduce if noteliminate the profit incentive for efficiency.

Investment Levels

A fourth problem with regulation is that it can lead to over investment or underinvestment in fixed assets. The allowed profits are calculated as a percentage ofthe rate base, which is approximately equal to fixed assets. If the allowed rate ofreturn exceeds the cost of capital, it will benefit the firm to expand fixed assets andto shift to capital intensive methods of production. Conversely, if the allowed rateof return is less than the cost of capital; the firm will not expand capacity rapidlyenough and will produce by methods that require relatively little capital. This is


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related to the issue of determining the optimal output, growth, and service levelsdiscussed above.

Regulatory Lag and Political Problems

A related problem is that of regulatory lag, which is defined as the period between

the times it is recognized that a price increases (or decrease) is appropriate andthe effective date of the price change. Because of the often lengthy legalproceedings involved in these price change decisions, long periods can passbetween the times when they are implemented.

The problem of regulatory lag is particularly acute during periods of rapidly risingprices. During the late 1960s and the 1970s, for example, inflationary pressuresexerted a constant upward thrust on coasts. If normal profits and a fair rate ofreturn on capital are to be maintained in such a time, expeditious price increaseshave to be implemented.

However, public utility commissioners are either political appointees or elected

officials, and either those who appoint them or the commissioners themselves mustperiodically stand for election. Further, most voters are consumers of utilityservices and naturally dislike price increases, whether these increases are justifiedor not. Unlike consumers of unregulated goods and services, however, utilitycustomers can do exert great pressure on public utility commissioners to deny or atleast delay rate increases.

Cost of Regulation

By this time the sixth problem with price regulation should be obvious. A great dealof careful and costly analysis must be conducted before regulatory decisions canbe made. Maintaining public utility commission staffs is expensive, but an evenmore important cost element maintaining required records and processing ratecases is borne directly by the company. Ultimately activities are borne byconsumers.

It should be pointed out that we emphatically favour utility regulation. Indeed, wecan see no other reasonable alternative to such regulation for electric, gastelephone, and private water companies. If is clear, however, that serious problemsarise form efforts to regulate industry through price determination. The marketsystem, if competition is present, is a much more efficient allocator of goods andservices, and it is for this reason that efforts are made to maintain a workable levelof competition in the economy.


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Regulation of Environmental Pollution

Having argued in general that there is a role for government when externalitiesdistort the workings of competitive markets, we now turn to the most persuasiveexample-the problem of what to do in the face of environment pollution.

Many of our streams and lakeshave historically served asdepositories of chemical wastegenerated by industrial plants andmines. Some are cleaner now, butmany still suffer damage formearlier discharges of chemicals,like PCBs whose "half-lives" aremeasured in hundreds of years.Many pesticides, fertilizers, anddetergents used by farms andhomes find their way into ourlakes and waterways, where theyhave damaged commercial andrecreational fishing. Automobilesare primary source of many airpollutants. The residue of theiremission can foul both the air thatwe breathe and the land locatedclose to the road that we drive on.Factories generate particles ofvarious kinds, often through the

combustion of fossil fuels; thesepollute the air and fall onto theground-both near and far. Someof our pollution has even been

shown to cause damage on a global scale. Theproduction and emission of chlorofluorocarbons

has damaged the ozone layer and exposed much of the planet to increasedultraviolet (UV-B) radiation from the sun; the emission of carbon dioxide and othergreenhouse gases has begun to warm the planet at rates that many find alarming.

Why does our economy tolerate any pollution of the environment? We now knowthat an externality occurs when one person (or firm's) use or abuse of a resource

damages other people who cannot obtain proper compensation. When this occurs,a competitive economy is unlikely to function properly. For market prices toproduce an efficient allocation of resources, it is necessary that the full cost ofusing each resource be borne by the person or a firm that uses it. If this is not thecase, so that the user bears only part of the full costs, then the resource is notlikely to be directed by the price system into the socially optimal use. And why dopeople use resources like the environment? This is because; pollution is a by-product of activities that add to their welfare. These activities bring economic gainto producers and utility gain to consumers. We do not pollute the planet just for fun;

Fig: Waste dumped into water source


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we do it as part of activities that improve our welfare. The economist's view of thisis that pollution creates another trade-off of cost and benefit that must be weighedon a case by case basis.

Resources are used most efficiently in a perfectly competitive economy becausethey are allocated to the people and firms that find it worthwhile to bid the most for

them. Underlying this scheme is the notion that the resulting prices of all resourceswould reflect their true social costs. Suppose, however, that the presence ofexternal diseconomies made it possible that people and firms did not pay the truesocial cost for certain resources. Suppose that some firms or people were usingwater or air for free even though other firms or people were incurring some costfrom this use. Suppose, to be quite specific, that some firms were polluting the airor water and those others were suffering economic losses as a result. In this case,the private costs of using air and water would vary form the social costs. The pricespaid by the user of water and air would be guided in their decisions by the privatecosts of water and air-costs that would be reflected by the prices that they had topay. Faced with this difference between private and social cost, these firms would"use" too much air and water form society point of view, because the prices that

they would pay for air and water would be too low.

Note that the divergence between private and social costs occurs if and only if theuse of water or air by one firm or person imposes costs on other firms or otherpeople. A paper mill that uses water and then restores it to its original quality wouldnot be responsible for creating a divergence between private and social costs; itwould be paying the full social cost of using the water in the (presumably minimum)cost of running the restoration process. But if the same mill dumped untreatedwastes into a stream so that firms and towns downstream had to pay to restore thequality of the water, then it would be responsible for creating a divergence betweenprivate and social costs. The same is true of air pollution. If an electric power plantused the atmosphere as a cheap and convenient place to dispose of waste butpeople living and working nearby incurred some cost (including poorer health andthe more frequent need to paint their houses) as a result, then there would be adivergence between private and social costs.

Fig: Smoke coming out from a factory


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Efficient Pollution Control

Any industry should, in general, be able to vary the amount of pollution that itgenerates at each level of output, especially in the long run. A representative firmmay, for example, install pollution control devices like scrubbers or electrostaticprecipitators to reduce the amount of pollution that it generates at each level of

output.

The figure below shows why, untreated waste of the industry dumps into theenvironment increase the level of total social costs. The figure also shows the costsof pollution control at each level of discharge of the industry's wastes. Just asclearly, the more the industry cuts down on the amount of wastes it discharges, thehigher are its costs of pollution control. In addition, the figure shows the sum ofthese two costs-the cost of pollution and the cost of pollution control-at each levelof discharge of the industry's wastes.

Figure A

Form the point of view of society as a whole, the industry should reduce itsdischarge of pollution to the point where the sum of these costs is minimized.Specifically, the efficient level of pollution in the industry is R in the Figure A Why?Because increasing pollution from a level lower than R would improve socialwelfare. Discharging one more unit of pollution would increase the cost of pollution,but it would reduce the cost of pollution control by more. Reducing pollution from alevel higher than R would also improve welfare. In this case, discharge one fewerunit of pollution would increase the cost of pollution control, but it would reduce thecost of pollution by more.


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To make this more evident, curve AA' in Figure B shows the marginal cost of anextra unit of discharge of waste at each level. Curve BB' in Figure B also shows themarginal cost of reducing the industry's discharge of waste by 1 unit. Theeconomically efficient level of pollution for the industry occurs at the point wherethe two curves intersect. At this point, the cost of an extra unit of pollution would

just equal the extra cost of reducing pollution by an extra unit. Regardless ofwhether we look at Figure A or Figure B, the answer is the same: R is theeconomically efficient level of pollution.

Figure B

Earlier we observed that the efficient level of pollution is generally not zero. Itshould now be clear why this is true. The costs of reducing pollution can exceedthe associated benefits if control is pushed beyond a certain point. In Figures A andB, this point is reached when pollution is limited to R. But, could the efficient levelof pollution be zero? Sure. Zero would be the right answer if the pollutant were sodamaging that the marginal cost of even the first unit released into the environment

exceeded the marginal cost of not allowing its release. Graphically, zero could beefficient in Figure B if marginal-cost curve AA' started form a point on the verticalaxis that was higher than S (indicating that the cost of pollution would increasefaster form zero that the cost of pollution control would fall).


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Direct Regulation, Effluent Fees, and Transferable EmissionPermits

Left to its own devices, the industry in Figure B would not necessarily reduce itspollution level to R. Why? This is because; it would not necessarily pay all of thesocial costs of its pollution. Indeed, if the industry paid no private cost for itspollution, then it would emit T units-the quantity for which the marginal cost ofcontrol would equal zero. This, of course, is the heart of the problem. How can thegovernment establish incentives that would lead industries to choose the efficientamount of pollution control in their own best interest, even if they do not face all thesocial costs of residual emissions?

Direct regulation of polluting activity (i.e., setting a legal limit for pollution)frequently comes to mind. The government could, for example, simply limit theindustry's pollution to R units by decree. Direct regulation of this sort was popular inthe United States shortly after the passage of the first Clean Air Act in the 1970s.The decree were generally associated with definitions of the "best available

technologies" for pollution control, but they were criticized frequently for being toorigid to accommodate efficiently the changing landscape of modern industry andthe diversity of the suppliers of modern markets.

Effluent fees offer governments a second approach to pollution control. An effluentfee is a unit price that a polluter must pay to the government for discharging waste.The idea behind the imposition is that they can bring the marginal private cost ofpolluting faced by firms closer to the true marginal social cost of their emissions. InFigure B, for example, an effluent fee of E per unit of pollution discharge might becharged. If it were, then the (private) marginal cost of an additional unit of pollutiondischarge to the industry would be E, and so the industry would cut back itspollution so long as the marginal cost of reducing pollution by a unit were less than

E. As you can see form Figure B, marginal cost falls short of E as long as thepollution discharge exceeds R. To maximize their profits, therefore, the firms in theindustry would reduce pollution to R units.

Effluent fees often have one major advantage over direct regulation. It is, of course,socially desirable to use the cheapest way to achieve any given reduction inpollution, and a system of effluent fees is more likely to accomplish this result thandirect regulation. To see why, first consider a particular polluter facing an effluentcharge. It would find it profitable to reduce its discharge of waste to the point wherethe (marginal) cost of reducing its emissions by 1 unit equalled the fee. The effluentfee would be the same for all polluters. And it is a simple matter to show that thetotal cost of achieving the corresponding reduction in total emissions across all of

the polluters would thereby be minimized. To that end, suppose that the cost ofreduction waste discharges by an additional unit were not the same for all polluters(as might be the case if they were given individual quantity limits). The cost ofachieving the same amount of total pollution control could then be reduced byallowing polluters whose marginal control costs were high to increase theiremissions (and lower their marginal control costs) while encouraging polluterswhose marginal control costs were low to reduce theirs (by and equal amount).


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Effluent fees do not however, guarantee the same constant level of total emissionsthat could be expected if a set of individual quantity limits were issued. Why not?Because firms will pay for the right to more or less pollution as they increase ordecrease their outputs. So, although direct regulation would restrict total emissionsregardless of business conditions, and equivalent effluent fee could, at best,guarantee that the expected value of equivalent effluent fee could, at best,

guarantee that the expected value of total emission s over along period of timewould correspond to the same total. Variation in the level of total pollution can beharmful in some cases, and not in others. The point here is that preference foreffluent fees is not quite so clear-cut when the reality of uncertainty is brought tobear on the discussions.

Governments have recently learned that they can work the trade-off between thecertainty of direct regulation and the efficiency of effluent charges by issuing afixed number of transferable emission permits-permits that allow the holder togenerate a certain amount of pollution. The total number of permits can belimited, so that total pollution can be held below any targeted level. Theeconomically efficient amount might be the pollution target, but there could be

others (especially if it was difficult to collect the information necessary to identifythe efficient level or if there were an emissions threshold beyond which damagewould be severe). In any case, allowing permits to be bought and sold wouldmean that firms whose marginal control costs were high would probably try to buysome (so that they could increase their emissions) and firms whose marginalcontrol costs were low would try to sell some (and make money even though theywould have to reduce their emissions). In fact, the market would work to bring themarginal cost of pollution control at each firm equal to the market price of permits,and so to would bring the marginal cost of pollution control at every firm in linewith the marginal cost at every other firm. Notice that this is exactly the conditionfor minimizing the cost of holding total emissions to a particular level.

Transferable Emission Permits

Government have recently learned that they can work the trade-off between thecertainty of direct regulation and the efficiency of effluent charges by issuing a fixednumber of transferable emissions permits permits that allow the holder togenerate a certain amount of pollution. The total number of permits can be limited,so that total pollution can be held below any targeted level. The economicallyefficient amount might be the pollution target, but there could be others (especiallyif it were difficult to collect the information necessary to identify the efficient level orit there were an emissions threshold beyond which damage would be severe). Inany case, allowing permits to be bought and sold would mean that firms whose

marginal control costs were high would probably try to but some (so that they couldtheir emissions) and firms whose marginal control costs were low would try to sellsome (and make money even thought they would have to reduce their emissions).In fact, the market would work to bring the marginal cost of pollution control at eachfirm equal to the market price of permits, and so it would bring the marginal cost ofpollution control at every form in line with the marginal cost at every other firm.Notice that this is exactly the condition for minimizing the cost of holding totalemissions to a particular level.

Documents

Role of Government in the Economy MBS First Year