Cyberlecture

This chapter introduces you to the economics of public policy, and why the government intervenes in some markets. You will also learn that the solution to a market that is producing an undesirable outcome varies widely from industry to industry.

What is a natural monopoly?
Recall from Chapter 9 that a natural monopoly is a firm that experiences very large economies of scale. For this reason, its marginal cost is below its average total cost at levels of production that are suitable for its market.

• using monopoly pricing (MR=MC, P from demand), the firm earns economic profits
• using efficient pricing (P=MC), the firm earns economic losses

The government often regulates natural monopolies so that prices are reasonable and at the same time the firm does not earn economic losses.

What are the implications of public ownership of natural monopolies?
If the government owns the natural monopoly, it can use efficient pricing and cover the losses out of general tax revenues.

• efficient production requires management incentives to keep costs low
  • for example, promotion based on success with cost minimization

What are the implications of public regulation of natural monopolies?
Governments often regulate natural monopolies to keep prices reasonable. With cost-plus regulation, the government sets the price at the firm's average cost of production plus a markup to ensure a return on the firm's investment in capital.

• using cost-plus pricing, there is little incentive to minimize costs or develop cost-saving innovations

What are the implications of exclusive contracting agreements for natural monopolies?
The government can ask firms to bid on providing a service and award an exclusive contracting agreement to the firm with the lowest bid.

• competition between the bidders acts as an incentive to minimize costs.

If there are high fixed costs, exclusive contracting agreements will not be successful

• firms will be reluctant to take on high fixed costs if the contract could go to other firms next time around

Economic Naturalist My bookstore's name is MyCollege Bookstore. So why does my receipt say Chapters in the fine print?

What is predatory pricing?
A firm is engaging in predatory pricing when it prices its product below cost with the express purpose of driving out competition.

• predatory pricing is illegal in Canada
• firms can be severely fined if they are found to be using predatory pricing

What is marginal cost pricing?
The government can choose to use marginal cost pricing if it owns a natural monopoly. The government sets the price at the marginal cost of the last unit offered for sale.

• even if the marginal cost of providing the first units is low, the price should equal the marginal cost of providing the final unit of output
• marginal cost pricing maximizes economic surplus for taxpayers

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How does information affect the health care markets?
Informational asymmetry exists in a market when the seller and buyer of a product possess different amounts of information about the product. When information is asymmetric, supply and demand are not independent of each other.

• doctors induce demand for their own services by telling patients to have recommended medical procedures
  • general physicians direct demand for specialist services, pharmaceuticals and hospital services

In a private health care market, price acts as a rationing device and as a signal of quality.

• patients undergo medical procedures when they can afford to pay for them
• patients will sometimes go to the highest-priced specialist believing her to be the best
  • no incentive exists for the specialist to minimize costs

Therefore, in a private health care market, consumers want to insure themselves against the risk of needing high-cost medical procedures.

• people who expect to have health care problems want insurance the most
• people who do not expect to become ill do not want insurance as much

An adverse selection problem exists because the people who buy health care insurance are the ones who will need it the most, but may not inform the insurance company of the true state of their health. Insurance company profits suffer because not enough healthy people buy insurance to subsidize the payments made on behalf of less healthy people.

• insurers therefore offer group insurance to pool healthy and less healthy people in the same policy
  • all employees of the same company are a group
  • all members of the same club are a group

Not everyone agrees that physicians create their own demand. Find out why the Canadian Medical Association thinks otherwise at http://www.cma.ca/cmaj/vol-159/issue-6/0647a.htm.

What cost savings are associated with public health care insurance?
Public health care insurance covers all people in an economy, whether they are healthy or less healthy. Since everyone is covered, the public insurer does not have to use resources determining the risk of each insured person.

• savings in administrative costs make public health care insurance less costly than private
• overall population health is better because more people access health care

Why should pollution be taxed?
When there are many firms causing pollution, the most efficient rule for reducing pollution is to ensure each firm acts to control its emissions until its marginal cost of abatement is exactly the same as every other firm's.

• each firm's total cost of cutting pollution by a set amount is different
  • some firms can cut emissions more easily than others
• the least cost to society of cutting emissions is when each firm's marginal cost of abatement is equal

The government can impose a tax on firms that pollute. If it is cheaper to cut emissions than to pay the tax, the firm will cut emissions. However, the government must be able to determine how high to set the tax to achieve the desired level of pollution reduction.

• it is almost impossible for the government to make that determination

The advantage of taxing pollution is that the firms that can accomplish emission reduction the most cheaply will do so.

Practice Activity 1 Try answering some questions about curbing environmental pollution.

What are pollution permits?
A pollution permit gives a firm the right to pollute, and initially must be purchased from the government. Firms bid for the right to pollute, and those firms that cannot purchase permits must eliminate emissions. If it is less costly to reduce pollution than to purchase a permit, the firm will reduce its emissions.

• market solution to pollution abatement
• if the government wants less pollution, it sells fewer permits

Monitoring and enforcement of emission quotas is expensive for the government. Therefore the pollution permit system of emission reduction works well when only a few polluters are involved.

Why are workplace regulations needed?
Often the least costly method of production involves high risks for workers. Workers often cannot assess the full risks associated with a particular job. The government then has a role to regulate the workplace for safety reasons.
      Workers' compensation is a government insurance system designed to benefit workers. Instead of regulating the workplace, the government makes firms purchase injury insurance coverage for their workers. If premiums reflect the relative safety of a workplace, employers will have an incentive to make systems more safe in order to minimize insurance premiums.
      The optimal amount of safety in the workplace is achieved when the benefit of increasing safety just equals the cost.

To find out about your province's workplace safety regulations, go to Canada's National Occupational Health and Safety website at http://www.canoshweb.org/en/good_practice.html and follow the links provided.

Practice Activity 2 Try answering some questions about making optimal choices.

How can the government regulate addictive activities?
Addictive activities like smoking, drinking and gambling obliterate free choice in participants. Economic theory that says consumers can maximize their utility by comparing the costs and benefits of any particular activity breaks down when consumers are driven by addictions to ignore rational analysis.
      The federal government and the provincial governments are divided on solutions to the problems of addictive activities.

Understanding Questions Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.