Micro Issues


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Table of Contents



Income, Transfers and Taxes

Antitrust and Regulation









LaborLABOR FORCE BY SEX, 1920 & 2012


I. Competition and Labor: A firm that hires labor under perfectly competitive conditions hires only a minuscule proportion of all the workers who are potentially available to the firm. Thus, the supply of labor to the firm is perfectly elastic. The firm is a price taker in both the product market and labor market.

  1. Marginal Physical Product: The change in output resulting from the addition of one more worker. The MPP of the worker equals the change in total output accounted for by hiring the worker, holding all other factors of production constant. As more workers are employed each has a smaller fraction of the available non-labor factors of production with which to work.

    LABOR FORCE BY AGE, 2000 & 2012

  2. Marginal Revenue Product: MRP is the marginal physical product (MPP) times marginal revenue. The MRP represents the incremental worker’s contribution to the firm’s total revenues. In a competitive product market MRP is often called the value of marginal product (VMP) and is equal to product price times MPP.

  1. General Rule for Hiring: The firm hires workers to the point where marginal factor cost is equal to the marginal revenue product.

  2. MRP Curve: Demand for Labor: The MRP curve is a factor demand curve, assuming only one factor of production and perfect competition in both the factor and product markets.

  1. Derived Demand: Derived demand is input factor demand derived from demand for the final product being produced.


II. The Market Demand for Labor: The market demand curve for labor will slope downward. It is not a simple horizontal summation of the labor demand curves of all the individual firms. Even if labor productivity is constant, the demand for labor depends on both the wage rate and the price of the final output. If all firms increase employment due to a decrease in wages, there is an increase in the product supply curve and the price of the product must fall.

  1. Determinants of Demand Elasticity for Inputs

  1. The greater the price elasticity of demand for the final product, the greater the elasticity of demand for an input.

  2. The easier it is for a particular variable input to be substituted for by other inputs, the greater the elasticity of demand for an input.

  3. The larger the proportion of total costs accounted for by a particular variable input, the greater the elasticity of demand for that input.

  4. The longer the time period for adjustment to take place, the greater the elasticity of demand for an input.


                        LABOR MARKET EQUILIBRIUM















III. Wage Determination in a Perfectly Competitive Labor Market: The industry faces an upward sloping supply curve for labor. The intersection of the industry supply and demand curves for labor determines the market wage.

  1. Shifts in the Market Demand for and Supply of LaborJOB HUNTING

  1. Reasons for Labor Demand Curve Shifts: There are three reasons why the labor demand curve shifts: (a) Changes in Demand for Final Product: A change in the demand for the final product that labor is producing will shift the demand curve for labor in the same direction. (b) Changes in Labor Productivity: A change in labor productivity will shift the demand curve for labor in the same direction. (c) Changes in the Price of Related Factors: A change in the price of a substitute input will cause the demand for labor to change in the same direction, and a change in the price of a complementary input will cause the demand for labor in the opposite direction.

  2. Determinants of the Supply of Labor: If wage rates for factory workers in one industry remained constant while wages for factory workers in another industry go up, the supply curve of factory workers in the first industry will shift inward to the left. Changes in working conditions in an industry affect the position of the supply of labor curve. Job flexibility also determines the position of the labor supply curve.


IV. Labor Outsourcing, Wages and Employment

  1. Wage and Employment Effects of Outsourcing: The immediate economic effects of outsourcing are clear. When a home industry’s firms can employ foreign labor services that are a close substitute for home labor services, the demand for foreign labor services will increase and the demand for home labor services will decrease.

  1. US Labor Market Effects of Outsourcing by US Firms: In the US the demand for labor provided by US workers will decrease when US firms outsource jobs to foreign countries such as India. Other things constant the wage and employment of US workers will decrease. In a foreign country such as India, the demand for labor increases, and the Indian wage and employment levels increase.

  2. US Labor Market Effects of Outsourcing by Foreign Firms: In the US the demand for labor provided by US workers will increase when foreign firms outsource jobs to the US Other things constant the wage and employment of US workers will increase. In a foreign country such as Mexico, the demand for labor decreases, and the Mexican wage and employment levels decrease.

  1. Gauging the Net Effects of Outsourcing on the American Economy: Labor outsourcing by US firms tends to reduce US wages and employment. If foreign firms engage in labor outsourcing in the US, US wages and employment increase.

  1. Short-Run Versus Long-Run Effects of Outsourcing: Despite the fact that in the short term the effects of outsourcing may be lower wages and employment opportunities for some US workers it is the long-run effects on the overall levels of wages and employment that are important.

  2. The Long Term Benefits of Outsourcing for the US Economy: Increased labor outsourcing is part of a trend toward increased international trade in goods and services. Engaging in international trade allows residents of each nation that participates to specialize in producing the goods and services that they can produce most efficiently. The outcome is an increased production of goods and services and higher income levels and consumption. On balance in the long run outsourcing makes consumers in the US and other countries better off.

WatchLabor Force Participation Rate from the Federal Reserve Bank of San Francisco and video (4:15)

ReadUnemployment Rate: Measuring the Workforce from the Federal Reserve Bank of San Francisco


V. Monopoly and Labor

  1. Constructing the Monopolist’s Input Demand Curve: In constructing the demand schedule for an input, two factors must be considered: (1) the marginal physical product falls because of the law of diminishing returns as more workers are added and (2) the price (and marginal revenue) received for the product sold also falls as more product is produced and sold.

  2. Why the Monopolist Hires Fewer Workers: If an industry in which there is perfect competition in the output market could be changed to one in which there is a monopoly in the output market, the amount of employment would fall because the monopolist must take account of the declining product price that must be charged in order to sell a larger number or quantity.

WatchDetermining Job Wages



VI. Industrialization and Labor Unions: In most countries labor movements started with local craft unions, which were groups of workers in individual trades. In the 1790’s some British craft unions began to try to engage in collective bargaining in which business management engages in negotiations with union representatives about wages and hours of work. The British Combination acts in 1799 and 1800 prohibited unions but in 1825 unions were allowed to exist and engage in collective bargaining by Parliament.

  1. Unions in the US: The development of unions in the US lagged behind events in Europe. Between the Civil War and the Great Depression the Knights of Labor was formed demanding an eight-hour workday and equal pay for men and women. A dissident group from the Knights of Labor formed the American Federation of Labor (AFL).

  1. The Formation of Industrial Unions: The National Labor Relations Act, or Wagner Act, enacted in 1935, guaranteed workers the right to start labor unions, to engage in collective bargaining, and to be members in any union.

  1. Unions that have members from an entire industry. In 1938 the Congress of Industrial Organizations (CIO), composed of industrial unions, was formed by John L. Lewis.

  2. Congressional Control over Labor Unions: The Taft-Hartley Act allowed individual states to pass right-to-work laws. This makes it illegal for union membership to be a requirement for continued employment in any establishment. Jurisdictional disputes, sympathy strikes and secondary boycotts are made illegal by this act as well. The most famous aspect of the Taft-Hartley Act is its provision that the president can obtain an injunction that will last for 80 days against a strike believed to imperil national safety or health.

  1. The Current Status of Labor Unions: Different countries have differences in labor laws that complicate efforts to make inter-country comparisons of the status of labor unions. It is still possible to assess how widespread union membership is in different countries and to evaluate trends in union membership.

  1. Worldwide Trends in Unionization: Rates of unionization differ from country to country.

  2. US Unionization Trends: Union membership as a percent of US workers has been declining since the 1970s. Some of the reasons for this decline have been the decrease in manufacturing employment where unions have been strongest, deregulation, increased global competition, increased immigration, and the increased importance of social regulation.

    1. Strong unions have a long record of lifting workers’ living standards and reducing income inequality. The decline of unions, on the other hand, has contributed to slow-growing living standards for most Americans.

    2. In 2020, the percentage of Americans who say they support unions has risen to 65%, according to Gallup polls.



VII. Union Goals and Strategies: Through collective bargaining, unions establish minimum wages for union workers. Union representatives and management negotiate collective bargaining contracts. Once approved by the members, these contracts establish the length of the workday, wage rates, working conditions, fringe benefits, and other matters, usually for the next two or three years.

  1. Strike: The Ultimate Bargaining Tool: The purpose of a strike is to impose costs on management to force management’s acceptance of the union’s proposed contract terms. Workers draw no wages while on strike, but may be partly compensated out of strike funds. Strikebreakers can effectively destroy the bargaining power of the union.

  2. Union Goals with Direct Wage Setting: One of the major roles of a union that establishes a wage rate above the market-clearing price is to ration available jobs among excessive numbers of workers who wish to work unionized industries.

  1. Employing all members in the union

  2. Maximizing member income

  3. Maximizing wage rates for certain workersUNION CARTOON

  1. Union Strategies to Raise Wages Indirectly

  1. Limiting entry over time: involves freezing the number of workers in the union

  2. Altering the demand for union labor

  1. Increasing worker productivity

  2. Increasing demand for union-made goods

  3. Decreasing the demand for non-union-produced goods


VIII. Economic Effects of Labor Unions: Have unions raised wages and affected productivity? Unions have been able to raise the wages of members relative to nonunion members by about $2.25 per hour on average. When unions increase wages beyond what productivity increases permit, some union members will be laid off.

  1. Unions and Wages: Unions have been able to increase the wages of members relative to non-union workers by about $2.25 per hour. Comparisons of annual earnings show something else. Non-union workers have higher annual incomes than union workers do; though non-union workers work a slightly longer work week.

    1. range of indeterminacy: coined by economist Richard Lester to describe wage negotiationunion membership down, inequality ups between an employer and a worker. It captures the fact that wages are not a reflection simply of market forces, like a worker’s productivity or a company’s profits. In the real world, similar workers often earn different wages. Their wages fall somewhere in Lester’s range of indeterminacy. Why? Most workers don’t know exactly how valuable their contributions are and therefore what their true market wage should be. Company executives typically don’t know either, but the executives do have more information - about how much money different workers make and how productive each is. Employers also have more leverage. Companies employ many workers, and losing one of them is usually manageable. For most workers, by contrast, quitting over a pay dispute can create financial hardship. For these reasons, worker pay often settles at the low end of the range of indeterminacy. In the relationship between an employer and an individual employee, the employer has more power.

    2. When employees band together, they can reduce the power imbalance. They can share information with one another and exert some leverage of their own on the bargaining process. A business that can afford to lose one worker over a pay dispute may not be able to lose dozens. A group of workers who come together to increase their bargaining power is, of course, a labor union. Unions shift wages out of the low end of the range of indeterminacy and are a force for greater wage equality. They also help enforce the outrage constraint that used to limit executive compensation. Company executives in almost every industry claim that wages are too high. They prefer it when wages are on the low end of the range of indeterminacy - partly because it leaves more money for the executives to take home. Unions sometimes do win pay increases so large that wages exceed a reasonable range and hobble an employer. Unions can also block necessary changes in a company’s operations. However, it's beginning to look as if there may be a link between union membership and societal economic equality.

  2. Unions and Labor Productivity: The traditional view of union behavior is that unions decrease productivity by shifting the demand curve for union labor outward through featherbedding (deliberately limit production or retain excess workers in order to create jobs or prevent unemployment, typically as a result of a union contract). Another view is that unions actually increase productivity by acting as a collective voice for members. Unions can apply pressure on employers to change unsatisfactory working conditions. The individual worker has greater job security and worker turnover in unionized industries should be less, contributing to increased productivity.

  3. Economic Benefits and Costs of Labor Unions: Unions are viewed in two ways. They can be seen as restrictive monopolies that raise wages of some members at the expense of other members and non-union workers. The other view is that they can help increase labor productivity and contribute to workforce stability.

Generation Gap

The share of the US economy’s output that flows to corporate profits has almost doubled since the mid-1970s, while the share flowing to workers’ compensation has fallen. Or consider this chart:

Stock Prices and Income Compared with 1947

As you can see, stock prices and family incomes tracked each other somewhat closely in the decades after World War II - but no longer do.

ReadLabor, The Economy and Monetary Policy


Dig Deeper


Sectoral bargaining is the future of American labor unions.

Fresh Proof That Strong Unions Help Reduce Income Inequality

Test Yourself


Test Yourself: Labor














IncomeGENERAL LORENZ CURVE, Transfers and Taxes


I. Income: payment for labor services or payment for ownership of a factor of production … Labor is the most valuable resource sold by most households.

  1. Measuring Income Distribution: The Lorenz Curve: A geometric representation of the distribution of income. A Lorenz curve that is perfectly straight represents perfect income equality. The more bowed a Lorenz curve, the more unequally income is distributed.

  2. Criticisms of the Lorenz Curve:

  1. The Lorenz curve is typically presented in terms of distribution of money income only.

  2. The Lorenz curve does not account for differences in family size and effort.

  3. It does not account for age in income differences.

  4. The Lorenz curve is typically given for money income before taxes.LORENZ CURVE WITH INCOME LEVELS

  5. It does not measure unreported income from the underground economy.

Family income no longer tracks economic output.

  1. Income Distribution in the US: There have been only slight changes in the distribution of money income over time. The definition of money income used by the US Bureau of Census includes only wage and salary income, income from self-employment, interest and dividends, and such government transfer payments as Social Security and unemployment compensation. In-kind transfers from the government are excluded.

  2. Distribution of Wealth: Distribution of income (flow) is different from distribution of wealth (stock). The richest 10% of households own about 66% of all wealth.

  1. The Hidden Costs of Low Wages

    The Hidden Costs of Low Wages




















II. Determinants of Income Differences:

  1. Age: With age comes more education training and experience, which affects earnings. The Age-Earnings Cycle is the regular earnings profile of an individual throughout his or her lifetime. It usually starts with low earnings at 18 and increases to a peak at around age 50, when earnings gradually fall until they approach zero at retirement age.

  2. Marginal Productivity: Workers can expect to be paid their marginal revenue product (assuming that there are low cost information flows and the labor and product markets are competitive). In a competitive situation, workers who are being paid less than their marginal revenue product will bid away to better employment opportunities. It is likely that some persons are paid more or less than their marginal revenue product because information is costly.

  1. Determinants of Marginal Productivity:Changes in US profits and worker pay since 1960

  1. Talent: These are factors that cannot be acquired if one does not have them.

  2. Experience: Experience can be linked to the well-known learning curve that applies when the same task is done over and over. The worker repeating a task becomes more efficient.

  3. Training: Much of a person’s increased productivity is due to on-the-job training.

  1. Investment in Human Capital: Department of Labor data show that on average high school graduates make more than grade school graduates and on average college graduates make more than high school graduates. The average the rate of return to investment in human capital of a college education is between 6 and 10 percent, which is on a par with the rate of return to investment in other areas.

  1. Inheritance: An endowment can consist of an inheritance of cash, jewelry, stocks, bonds, houses, and other real estate. Only about 10 percent of inequality of income can be traced to differences in inherited wealth.

  2. Discrimination: Economic discrimination occurs whenever workers with the same marginal revenue product receive unequal pay due to some non-economic factor such as race, gender, or age. It also occurs when there is unequal access to labor markets.

  1. Access to Education: Minorities have faced discrimination in the acquisition of human capital. The amount and quality of schooling offered, has often been inferior to that offered whites.

  2. The Doctrine of Comparable Worth: The belief that women or minorities should receive the same wages as men if the levels of skill and responsibility in their jobs are equal or equivalent.


III. Theories of Desired Income Distribution: There are two normative standards for the distribution of income that have been popular with economists.

  1. Productivity: “To each according to what he produces” is a contributive standard. It is based on the principle of rewards based on the contribution to society’s total output.

  2. Equality: “To each exactly the same” means that everyone gets the same amount. The problem with this concept is that the incentive of higher rewards would be eliminated. Productivity and growth would decline.


HERB BLOCK 10/12/1966

IV.  Poverty and Attempts to Eliminate It: There are a number of welfare programs set up for the purpose of redistributing income from the better-off to the poor and for that purpose alone, but these programs have not been entirely successful.

  1. Defining Poverty: The US government defines the poverty line as income at or below three times the amount of money needed to buy basic, nutritionally sufficient food for all family members. The threshold income has been revised upward annually by the increase in the Consumer Price Index.

  2. Absolute Poverty: Because the low-income threshold as an absolute measure never changes in real terms, poverty will be reduced even if nothing is done since real income levels have been growing.

  3. Relative Poverty: Poverty has generally been defined in relative terms — in terms of the income levels of individuals relative to the rest of the population. It is based on income considerably below the average in a society. Income qualifying for poverty status in a rich country may exceed average income in a poorer country.

  4. Causes of Poverty

  1. Lack of Education: The median income of high-school dropouts in 1997 was $16,818, which was just above the poverty line for a family of four.

  2. Location: On average, people who live in the inner city earn less than people living outside the inner city.

  3. Shifts in Family Structure: Increased divorce rates result in more single-parent families and more children living in poverty.

  4. Economic Shifts: Workers without college-level skills have suffered from the ongoing decline of manufacturing, and the rise of service and high technology jobs.

  5. Racial and Gender Discrimination: Some inequality exists in wages between whites and minorities, and men and women.

  1. Transfer Payments as Income: The official poverty level is based on pretax income, including cash but no in-kind subsidies. If corrections are made for such benefits then the percentage of the population that is below the poverty line drops dramatically.

  2. Attacks on Poverty: Major Income-Maintenance Programs:

    Fewer and fewer workers are supporting the cost of entitlement programs.

    1. Social Security: For the retired, unemployed, and disabled, certain insurance programs provide income payments in prescribed situations. The best known is Social Security, which includes what has been called old-age survivors and disability insurance (OASDI).

    2. Supplemental Security Income and Temporary Assistance to Needy Families: Many poor people do not qualify for Social Security benefits. They are assisted through Supplemental Security Income, which establishes a nationwide minimum income for the aged, the blind, and the disabled. Temporary Assistance to Needy Families is a state-administered program, partly financed by federal grants. It provides temporary aid to families in need.

    1. Food Stamps: Food stamps are government issued coupons that can be used to purchase food. Food stamps are a major part of the welfare system in the US.

  1. The Earned Income Tax Credit Program: In 1975 the EITC was created to provide rebates of Social Security taxes to low-income workers. Since benefits are reduced by 17.68 cents for every dollar earned above $11,000, the incentive to make more than $11,000 is reduced. The typical EITC recipient works 1,700 hours per year compared to a standard work year of 2,000 hours.

Ratio of Social Security Beneficiary to Taxpaying Workers

WatchNickel and Dimed: On Not Getting By in America (13:58)

One view: PBS Video, Income Inequality (24:15)

ReadWhy the Rich Got Richer: Another View

What it’s like to live on $2 a day in the United States (PDF)

Dig Deeper


Try your skills at playing SPENT. (It's not easy being poor!)

Nickel and Dimed: On (Not) Getting By in America is a book written by Barbara Ehrenreich, from her perspective as an undercover journalist investigating the impact of welfare reform on the working poor in the US. If you were intrigued by the clip above, this longer and more in-depth video by Democracy Now will really make you think.

Making Ends Meet

Wealth Distribution In The United States Growing Worse

Most People Still Losing Ground In This Faltering Economy


V. Reduction in Poverty Rates: The officially defined rate of poverty in the US has shown no long-run tendency to decline. It reached its low of around 11% in 1973, peaked at over 15% in 1983, and fell steadily to 13.1% in 1990 and has since fallen no lower than 12%.




VI. Health Care: Sometimes people become poor because of inadequate (or no) health insurance. They deplete their wealth paying for the expenses of an illness. Some workers may remain in a job because of the health insurance benefits.

  1. The US Health Care Situation: Spending for health care in the US accounts for 16% of US real GDP. The US per person cost is greater than anywhere else in the world.

  2. Why Have Health Care Costs Raised So Much?

  1. The Age-Health Care Expenditure Equation: The top 5% of health care users incur over 50% of all health expenditures. The bottom 70% of users accounts for only 10%. The aging population stimulates the demand for health care and elderly make up most of the top users.

  2. New Technologies: High technology is another reason health care costs have raised dramatically. For example a CT scanner costs around $100,000, an MRI scanner can cost over $4 million, and a PET scanner costs around $4 million. Fees for using these machines can cost between $300 and $2,000.

  3. Third-Party Financing: Medicare, Medicaid and private insurance companies are third parties. When they pay for medical costs, demand for services increases. Medicare and Medicaid are the main providers of hospital and other benefits to 35 million Americans, most over 65. Medicaid, a joint state-federal program, provides long-term health care (nursing homes). There is an inverse relationship between the price and quantity demanded of medical services. Third-party payment simply decreases the net price to the consumer, thus increasing the quantity of services demanded. The more a third party pays, the greater is the likelihood that a consumer will substitute medical services for a healthier lifestyle.

  4. Price and Quantity Demanded: Because of third-party payment, the effective price facing each consumer of medical services is often zero, or close to it. Thus, at the “low” price, it is not surprising that the quantity of medical services demanded has increased greatly.

  5. Moral Hazard as it Affects Physicians and Hospitals: Because patients do not pay much, if any, of their health care costs themselves, they do not have an incentive to question the need for medical tests and procedures. Doctors and hospitals get paid by the number of services they render. They have no incentive to try to keep costs to the patient and third party payer down. Instead, their incentive is to increase the number of services and thus costs.

  1. Is National Health Insurance the Answer? Proponents argue in favor of a Canadian style system, where the government sets the fees paid to a physician, prohibits private practice, and sets a yearly income cap on the amount a doctor can receive. A specified amount of funding is provided to hospitals. Using the Canadian model, people would receive fewer health services, stay in hospitals longer, and have fewer tests and procedures.

  2. Countering the Moral Hazard Problem: A Health Savings Account: A health savings account (HSA) allows individuals to save money in a tax-exempt account that they could use to pay medical bills. Then a family or employer could buy major medical insurance with a high deductible at a relatively low price.

  1. Combating Moral Hazard: Contributors who do not use their MSAs could keep the money as a supplemental retirement account. The moral hazard problem is reduced because patients would have to pay for minor medical expenses up to the high deductible on major medical insurance. Thus they would have an incentive to live healthier lifestyles and physicians would not order expensive tests without first consulting with their patients.

  2. The Critics’ Responses: Critics say that people will avoid visits to a doctor for minor problems that could turn into major ones if left untreated. In addition HSAs would sabotage managed care plans that limit patients’ choice of physicians and hospitals in exchange for low or no deductibles.We need consumers.

WatchUS Household Incomes: A Snapshot from the Federal Reserve Bank of San Francisco and video (6:15)

ReadIncome Inequality: Measuring the Gap from the Federal Reserve Bank of San Francisco

Dig Deeper

US Census Bureau's Poverty Statistics

"Persistent poverty" exists across much of the US: "The ultimate left-behind places"

We, the Economy Films: Chapter 5: What causes inequality?

Is inequality growing? In a magical land inhabited by long lashed, multi-colored Alpacas who love lollipops, rainbows and friendship, there's a yawning divide in wealth distribution ... what's behind the inequality gap?

Why is the minimum wage important? In 2013, Seattle became ground zero for the heated national debate about increasing the minimum wage to $15 per hour. "The Value of Work" gives voice to supporters and the opponents, including the mayor, an activist city councilwoman, small business owners, and minimum-wage workers affected by the unprecedented legislation.minimum wage cartoon

Why is healthcare so expensive? "This Won't Hurt a Bit" is a short film that tells the all too familiar tale of American healthcare. A patient enters a hospital with a migraine headache, unaware of the costs his visit will incur on the path to a diagnosis. He learns much more than he bargained for in this comedy on unaffordable care.

What are the causes of inequality? In "Monkey Business," economists from across the political spectrum help explain the causes of economic inequality, with help from a couple of mammalian friends.

What happens to employment when the minimum wage is increased? Data shows that minimum wage increases can lead to short-term increases in employment for some workers.

Test Yourself


Test Yourself: Income, Transfers and Taxes














Antitrust and Regulation


I. Forms of Industry Regulation: There are two basic types of government regulation: 1) economic regulation, 2) social regulation.GOVERNMENT REGULATIONS

  1. Economic Regulation: Initially this was regulation to control prices that natural monopolies were allowed to charge. Over time federal and state governments have sought to regulate the characteristics of products or processes in industries without monopolistic characteristics.

  1. Regulation of Natural Monopolies: The regulation of natural monopolies has emphasized regulation of product prices to prevent monopoly profits that is also called rate regulation.

  2. Regulation of Non-Monopolistic Industries: All state governments regulate prices that the insurance companies can charge. Most other government regulation establishes rules that pertain to production, product features, and entry and exit within a number of specific non-monopolistic industries.

  1. Social Regulation: The aim of social regulation is to improve the quality of life through improved products, a less polluted environment, and better working conditions. Social regulation affects all firms in the economy and not just certain industries.


NATURAL MONOPOLIESII. Regulating Natural Monopolies

  1. Natural Monopolies Revisited: Whenever a single firm has the ability to produce all of the industry’s output at a lower per-unit cost than any other firm, a natural monopoly arises. The long-run average costs are falling over such a large range of production rates (relative to demand) that only one firm can survive in such an industry.

  1. The Pricing and Output Decision of the Natural Monopolist: The natural monopolist will produce to the point where marginal cost equals marginal revenue and set price on the demand curve. Price will be greater than marginal cost.

  2. Regulating the Natural Monopolist: The Problem of Marginal Cost Pricing: The government determines the price that the natural monopolist can charge. If regulation forces a natural monopolist to set price equal to marginal cost, then the monopolist would incur losses because price would be less than average cost.

  1. Practical Regulation of Natural Monopolies: Because regulators cannot force a natural monopolist to charge a price equal to marginal cost and make it stay in business, regulation has often taken the form of average cost pricing. This can take the form of only allowing prices equal to the actual cost of service called cost-of-service pricing. Rate-of-return regulation allows the firm to set a price equal to average cost where average cost includes what regulators deem a normal or competitive rate of return on investment.


III. Regulating Non-Monopolistic Industries: Protecting consumer interests has been the main rationale for government regulatory functions.

  1. Rationales for Consumer Protection in Non-Monopolistic Industries: At one time the rule of “caveat emptor,” or “let the buyer beware” was the rule in market transactions. Today federal regulations require sellers to meet certain minimum standards in their dealings with their customers.

  1. Reasons for Government-Orchestrated Consumer Protection: There are two major reasons: (1) market failure and (2) asymmetric information.INFORMATION ASYMMETRY

  2. Asymmetric Information and Product Quality: In extreme cases asymmetric information can lead to a situation where most of the products are of low quality. This is called the lemons problem with used cars.

  3. The Lemons Problem: The possibility that asymmetric information will lead to a general reduction in quality in an industry. This is particularly a potential problem with credence goods.

  4. Market Solutions to the Lemon Problem: Market solutions to the lemons problem are sellers offering warranties, setting industry standards, and seeking of external product certification.

  1. Implementing Consumer Protection Regulation: Governments implement legal remedies for consumers, licensing, and have a regulatory apparatus for overseeing all aspects of an industry’s operations when they consider private market solutions insufficient for the lemons problem and asymmetric information.

  1. Liability Laws and Government Licensing: Some liability laws specify penalties for product failures that provide consumers with protections similar to warranties. Governments also issues licenses that grant only qualifying firms the legal right to produce and sell certain products.

  2. Direct Economic and Social Regulation: A government may determine that the lemons problem is so severe in a given industry such as banking, that it establishes a regulatory apparatus to maintain public confidence in that industry.

WatchMarket Failure (PDF)


IV. Incentives and Costs of Regulation: Because abiding by regulation is costly for businesses, they engage in activities that are intended to avoid the true intent of regulations or to change established regulations.


A. Creative Response and Feedback Effects: This is a firm’s behavioral modification that allows it to comply with the letter of the law, but violate the spirit of the law, significantly lessening the law’s effects. Sometimes there is a feedback effect in which the individual’s behavior changes in undesirable ways after the regulation is implemented.


B. Explaining Regulator Behavior: The two best known explanations of regulator behavior are the capture hypothesis and the “share the gains, share the pains” theory.

  1. The Capture Hypothesis: A theory of regulatory behavior that predicts that the regulators will eventually be captured by the special interests of the industry that is being regulated.

  2. Share the Gains, Share the Pains: A theory of regulatory behavior in which regulators must take account of demands of legislators who established and oversee the regulatory agency, those in the regulated industry and consumers of the regulated industry.

  1. The Benefits and Costs of Regulation: While there are many potential benefits of regulation it is difficult to measure the actual benefits of regulation.

  1. The Direct Cost of Regulation to US Taxpayers: Currently the federal government spends $30 billion per year to fund the staff and activities of federal regulatory agencies. In addition businesses spend money complying with the regulations.

  2. The Total Social Cost of Regulation: The estimated total social cost of complying with federal regulations is estimated at $800 to $900 billion per year. When the costs of complying with state regulation are added the estimates exceed $1 trillion.

Antitrust Laws


V. Antitrust Policy: The logic behind antitrust legislation is that if the courts can prevent collusion among sellers of a product, monopoly prices will not result and there will be no restriction of output. There will be no economic profits in the long-run.

  1. Antitrust Policy: Congress has enacted four key antitrust laws.

  1. The Sherman Antitrust Act of 1890: This act was the first attempt by the federal government to control the growth of monopoly in the US. The most important provisions of the act are Section 1 (prohibits every contract, combination in the form of trust or otherwise or conspiracy, in the restraint of trade or commerce among the several states, or with foreign nations) and Section 2 (makes it illegal to monopolize, or attempt to monopolize, or combine or conspire with any other person or persons to monopolize any part of trade or commerce).

  2. Other Important Antitrust Legislation: The Sherman act was so vague that in 1914 a new law was passed —the Clayton Act of 1914. It legally prohibited a number of very specific business practices. Federal Trade Commission Act of 1914 and Its 1938 Amendment: The Federal Trade Commission Act was designed to stipulate acceptable competitive behavior. It was supposed to prevent overly aggressive competition. The Federal Trade Commission is charged with the power to investigate unfair trade practices. In 1938 the Federal Trade Commission Act was amended to allow the FTC to regulate advertising and marketing practices. The Robinson-Patman Act of 1936 was designed to protect independent retailers from specified unfair competitive acts by chain stores.

  3. Exemptions from Antitrust Laws:ANTITRUST POLICY DEBATES

  1. All labor unions

  2. Public utilities-electric, gas and telephone companies

  3. Professional sports, especially baseball

  4. Cooperative activities among American exports

  5. Schools and hospitals

  6. Public transit and water systems

  7. Suppliers of military equipment

  8. Joint publishing arrangements in a single city by two or more newspapers

  1. International Discord in Antitrust Policy: A major issue is different antitrust laws in the US and the EU. Under EU antitrust laws any business combination that “creates or strengthens a dominant position” significantly reducing or impeding competition is prohibited. It does not matter how or why competition is significantly reduced. In the US it does matter.


VI. Enforcement of the Antitrust Laws: Most antitrust enforcement today is based on the Sherman Act. The Supreme Court has defined the offense of monopolization as “(1) possession of monopoly power in the relevant market and (2) the willful acquisition or maintenance of the power as distinguished from growth, or the development as a consequence of a superior product, business acumen, or historic accident.”

  1. Monopoly Power and the Relevant Market: The Market Share Test is the primary measure of market power and is the percent of the relevant market that the firm controls. Generally a firm is considered to have monopoly power if it has a 70 percent or greater market share. The relevant market consists of (1) a relevant product market and (2) a relevant geographic market.PUBLIC POLICY TOWARD MONOPOLIES

  2. Product Packaging and Antitrust Enforcement: In US antitrust enforcement it is important to determine whether a firm has engaged in “willful acquisition or maintenance” of market power. Two actions, versioning and bundling are presented.

  1. Product Versioning: Versioning is selling an item in slightly altered forms to different groups of consumers at different prices. In the US versioning is not viewed as illegal price discrimination.

  2. Product Bundling: The joint sale of two or more products as a set. If it is only offered as a set and not individually, then US antitrust authorities view it as a form of price discrimination known as tie-in sales. Tie-in-sales requires consumers who wish to buy one of its products to purchase another item the firm sells as well.

  3. Diverging International Enforcement Perspectives: While US courts ruled that Microsoft had to unbundle Internet Explorer and Windows, the EU’s antitrust enforcers also required Microsoft to unbundle Windows and Windows Media Player as well. This action has yet to be resolved.

ReadThe Very Definition of Antitrust: AT&T and T-Mobile Deal is a Consumer Disaster

Test Yourself


Test Yourself: Antitrust and Regulation
















I. Private vs Social Costs: Private (internal) costs are costs incurred by individuals when they use scarce resources. Social costs are the full costs that society bears when a resource-using action occurs. For example, the social cost of driving a car equals all the private costs such as buying gasoline plus any additional cost that society bears, such as air pollution and traffic congestion. The air in many cities is heavily polluted from automobile exhaust fumes because when automobile drivers drive their cars they bear only the private costs of driving. They cause air pollution, which is a cost because it causes harm to other individuals. Drivers are not forced to take into account the cost of air pollution when they make the decision to drive.


II. Externalities: A situation in which a private cost or benefit diverges from a social cost or benefit, that is, the cost or benefits of an action are not fully borne by the two parties engaged in exchanges or by an individual engaging in a scarce resource-using activity.


III. Correcting for Externalities: The signals in the economy must be changed so that decision-makers will take into account all the costs of their actions.


A. The Polluter’s Choice: Faced with a cost of polluting, polluters will be induced to (1) install pollution abatement equipment or otherwise change production techniques so as to reduce the amount of pollution, (2) reduce pollution-causing activity, or (3) simply pay the price to pollute. Each polluter is faced with the full social cost of his or her actions and makes a decision accordingly.

B. Is A Uniform Tax Appropriate? The taxes imposed should be set equal to the economic damages or externalities caused by the pollution-creating activity.


IV. Pollution: The by-products of an economic activity. There is no correct answer to how much pollution should be in an economy because when the question is asked, a value judgment is being requested. There is no way to disprove a value judgment scientifically. The optimal quantity of pollution is determined when pollution is reduced up to the point where the marginal benefit from further reduction equals the marginal cost of further reduction. The optimal quantity of pollution is the level of pollution for which the marginal benefit of one additional unit of clean air equals the marginal cost of that additional unit of clean air.


 V. Common Property: Common Property is property that is owned by everyone and, therefore, owned by no one. Air and water are common property resources. Pollution occurs where there are no well-defined private property rights as in air and common bodies of water.

A. Voluntary Agreements and Transactions Costs:

1. Voluntary Agreements: Under some circumstances voluntary contracting will occur to internalize externalities.

2. Transaction Costs: One major condition for successful voluntary contracting is that the transaction costs — all costs associated with making, reaching, and enforcing agreements — must be low relative to the expected benefits of reaching an agreement.

B. Changing Property Rights: Assume that many property rights and many resources are not defined. Only when and if a use is found for a resource or the supply of a resource is inadequate to meet the quantity demanded at a zero price, does a problem develop. The problem requires that something be done about deciding property rights. If not, the resource will be wasted and possibly even destroyed. There are three ways to fill the gap between private and social costs: taxation, subsidization, and regulation.

C. Are There Alternatives to Pollution-Causing Resource Use? Some people cannot understand why we do not use non-pollution-causing sources to generate electricity, such as solar power. The fact is that generating solar power is generally more expensive relative to other alternatives. The technology does not exist yet to use solar power cost-effectively in most cases.


VI. Wild Species, Common Property and Trade-Offs: Wild species of animals are common property resources in that no one owns them and thus no one has an economic interest in protecting them. The Endangered Species Act involves restricting the use of habitats even if on private property. For example, in an attempt to save the spotted owl, logging in the Pacific Northwest was restricted and thousands of logging jobs were lost. There is thus an economic trade-off between protecting endangered species and economic activity.



VII. Recycling: The benefits of recycling are straightforward. Fewer natural resources are used. Recycling may not save total resources, however, because decreased demand for the resource (trees used for paper) may cause a decrease in supply.

A. Recycling’s Invisible Costs: Labor resources involved in recycling are often more costly than the potential savings in scarce resources. Net resource use with recycling may be greater than without it.

B. Landfills: In some areas, such as major cities, there may be a solid waste disposal crisis. In the rest of the US the data do not indicate a crisis. The disposal price per ton of city garbage has actually fallen.

C. Should We Save Scarce Resources? Virtually every natural resource has fallen in price over the last few decades, arguing against the claim that we are running out of resources.

You should conclude from this section that neither government nor markets can be asserted as a good solution to environmental problems. Of the two, government is likely the best option.

ReadPositive and Negative Externalities (PDF)

Environmental Economics and Policy (PDF)

Dig Deeper
Cap-and-Trade (PDF)

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Test Yourself: Externalities




Copyright 1996 Amy S Glenn
Last updated:   04/06/2024 0630

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