Production inefficiencies as rationnals for government interventions
In deciding when and how to intervene in a market, a democratic government is motivated by public opinion with regard to the market outcomes that will occur in the absence of such intervention. Members of the public may come to feel that market outcomes are not appropriate and so may seek to change those outcomes through the creation of interest groups that lobby for specific legislation. Government intervention may take a wide variety offorms, including regulation of prices or of any other aspect of production and product features. Consequently, the study of industry structure in chapter 7 is intimately linked with the study of government intervention to alter industry structures. For managers, the nature of government regulations and the ways that these regalations may impact profits can become a cention aspect of decision making. Here, game theory may be useful in analyzing the ways in which a firm may influence government policies.
Chapter 7 points to several types of market failure that, in practice, interfere with the attainment of efficiency. The production conditions of some goods and services may be such that the marginal cost declines over the relevant output range. In such cases, a single supplier may be able to produce at an average cost that will be lower than that of any potential new entrant. The creation of a new product or process can also be the cause of monopoly. Not threatened with competition, the solitary producer will be able to set prices above the marginal cost. Less than the socially optimal amount will be produced and consumed, and society would be better off if it shifted more resources into the production of such items. From society's perspective, this distortion of the production pattern creates inefficiency. In addition, monopoly profits transfer income from consumers of the product to the monopolist.
Some government believe that these distortions and failures are commonplace in free markets. In many industries, only one or perhaps a few producers supply the bulk of the product. Galbraith (1967), in his book (The New Industrail State), has presented this view forcefully. Price collusion need not involve verbal or written communication among competitors; price collusion can be achieved simply by observing the pricing decisions of competitors and reacting to these decisions. A price increase by one firm may be observed and copied by another firm. As long as all competytors follow a price leader, implicit collusion will raise prices. How much market consolidation will create the possibility of price collusion? Traditionally economists used a Hirschman-Herfindahl Index(HHI) to answer this question. The HHI is calculated by summing the squares of the market shares of the competitors in a specific market. For example, if there are five competitors, each with a market share of 20%, then the HHI is 2,000. if there are four competitors, each with a market share of 25%, then the HHI is 2,500. generally, it is believed that if the HHI for a market is greater than 2,000, then market power is substantial and regulatory authorities should consider intervening in the market.
The threat of potential competition may create “contestable market” and so can limit these distortions. The existing firms, although few in number, are aware that if they set prices too high, other will see this profit opportunity and enter the market. This view is strengthened by the new opportunities created by international trade and investment agreements. Foreign firms may be able to export to any economy where monopolists or oligopolists are charging excessive prices. Furthermore, it can be argued that modern technology is able to create substitutes for most products and that excessively high prices will stimulate this. Monopoly or oligopoly situations are constrained in that the dominance of a few firms will be only temporary, with substitute products always a possibility. Faced with this, a monopolist will be restrained in its price-setting decisions.
The production, consumption, and investment decisions of any particular individual can impact other economic activities. It is true that in some situations, private contracts may be developed to deal with such impacts. However, in other situations, contracts may be too complex; interrelationships may be too numerous, and their quantification mat be too difficult. The individual whose decision is causing the third-party effects, or “externalities,” will then have no incentive to include these impacts in his or her decision making. Pollution, for example, may severely affect the well-being of others who, without collective regulation through government, may not be able to influence the polluting activity. Positive impacts may occur, as well as negative impacts. Expenditures on research and development for new products or processes may provide benefits to others than the originator. Yet the inability to capture these third-party benefits may limit these expenditures to lower amounts than would be socially desirable. Only subsidies or direct government operation of research facilities may be able to maximize social welfare.
The significance of such third-party effects and the degree to which they can be captured by the private contract process vary among economic activities and over time. Futhermore, people disagree about the ability of government to deal with such situations, and about the most appropriate techniques for collective intervention. Consequently, as with consumption inefficiencies, production inefficiencies have led to very different patterns of government intervention in different countries. Here as well, political risks include the possibility that a nation may suddenly alter its previous decisions.