Government Regulation and Deregulation, Mergers and Acquisitions

Objectives:

-Explain the economic theory of government and how government activity arises from market failure
and redistribution

-Define regulation and antitrust law and distinguish between the social interest and capture theories of
regulation

-Explain how regulation and deregulation affect prices, outputs, profits, and the distribution of the gains
from trade

- Explain the difference between mergers and acquisitions and their effects to the economy.

The Economic Theory of Government

The economic theory of government explains the purpose of governments, the economic choices that
governments make, and the consequences of those choices.

Governments exist for two main economic reasons:

1. To establish property rights and set the rules for the redistribution of income and wealth.

2. To provide a nonmarket mechanism for allocating scarce resources when the market economy results
in inefficiency—a situation called a market failure.

Governments and public choices deal with five economic problems:

I. Monopoly and oligopoly regulation

II. Externalities regulation

External costs and external benefits are consequences of an economic transaction between two parties
that are borne or enjoyed by a third party. A chemical factory that dumps waste into a river that kills the
fish downstream imposes an external cost. A bank that builds a beautiful office building creates an
external benefit. External costs and benefits prevent the market allocation of resources from being
efficient.

III. The provision of public goods

A public good is a good that is consumed by everyone and from which no one can be excluded

Examples are national defense, law and order, and sewage and waste disposal services.
The market economy underproduces these goods because it is impossible to exclude those who choose
not to pay from enjoying them—called the free-rider problem.

IV. The use of common resources

Some resources are owned by no one and used by everyone. Examples are fish in the ocean and the
lakes and rivers. The market economy overuses these resources because no one has an incentive to
conserve them—called the tragedy of the commons.

V. Income Redistribution

The market economy delivers an unequal distribution of income and wealth. Progressive income taxes
pay for public goods and redistribute income.

Public Choice and the Political Marketplace

Public choice theory applies the economic way of thinking to the choices that people and governments
make in a political marketplace. The political marketplace does not work as smoothly as the private
marketplace. Competitive markets can deliver an efficient resource allocation because individual
households and firms act in their own self-interest and (in the absence of externalities) receive the full
benefits and bear the full costs of their decisions. Market prices and profits send signals to consumers
and producers that coordinate their decisions. In the absence of price floors and ceilings, monopoly, and
taxes, competitive pressures determine an equilibrium price (marginal benefit) equal to marginal cost—
the efficient outcome.

Voters and firms are the “consumers” in the political marketplace. Politicians are the “entrepreneurs” of
the political marketplace. Bureaucrats are the producers, or firms, of the political marketplace.

The political marketplace does not possess the same power as the competitive market to convert self-
interest into an efficient outcome. In the political marketplace:

Individuals still act in their self-interested. As James Buchanan, the Nobel Prize winning economist once
noted, when we pull the curtain closed in the voting booth to indicate which representative we wish to
elect, we do not suddenly sprout the wings of angels and vote in the public interest. We vote our own
best interests, possibly to the detriment of the public interest.

But one person, one vote does not ensure equal political influence over the resource allocation process.
Some avenues to seek favor from politicians and bureaucrats require resources, which are unequally
distributed. Individuals no longer receive the full benefits nor bear the full costs of their actions, and so
are less motivated to act on the basis of complete information. The absence of price and profit signals
makes it difficult to coordinate the actions of self-interested individuals to generate socially beneficial
outcomes. Many political marketplace decisions are inseparable, bundled together as a package, which
decreases the competitive pressures that force individuals to respond to opportunity cost and marginal
benefit.

Voters and firms express their preferences for publicly provided goods and services by allocating their
votes, making campaign contributions, and lobbying government decision makers. They also pay the
taxes that provide the funds that pay for public goods and services. The objective of politicians is to get
elected to office and remain in office. Votes to a politician are like profits to a firm, so they propose
policies that they expect to attract enough votes to get elected. Bureaucrats produce the public goods
and services.

Government intervenes in monopoly and oligopoly markets to influence prices, quantities produced,
and the distribution of the gains from economic activity.

It intervenes in two main ways:

1. Regulation consists of rules administered by government agency to influence economic activity by

determining prices, product standards and types, and the conditions under which new firms may enter
an industry.

2. Antitrust law is law that regulates or prohibits certain kinds of market behavior, such as monopoly
and monopolistic practices.

A. The Economic Theory of Regulation

The economic theory of regulation of monopoly and oligopoly is an application of the general theory of
public choice. The Demand for Regulation

People and firms demand the regulation that makes them better off and they express their demand
through political activity and making campaign contributions.

The greater the potential benefit (consumer surplus per voter and producer surplus per firm) from
regulation, the greater is the demand for the regulation.

But numbers alone don’t translate to demand. Small well-organized groups can be more effective than
large unorganized groups.
The Demand for Regulation

People and firms demand the regulation that makes them better off and they express their demand
through political activity and making campaign contributions.

The greater the potential benefit (consumer surplus per voter and producer surplus per firm) from
regulation, the greater is the demand for the regulation.

But numbers alone don’t translate to demand. Small well-organized groups can be more effective than
large unorganized groups.

The Supply of Regulation

Politicians supply the regulations that increase their campaign funds and that gets enough votes to
achieve and maintain office. Politicians choose policies that appeal to a majority of voters. Bureaucrats
support the policies that maximize their budgets.

If a regulation benefits a large number of people by enough for it to be noticed, the regulation will
appeal to politicians and it will be supplied. If a regulation benefits a small number of people by a large
amount per person, the regulation will appeal to politicians because it will help them to get campaign
funds from those who gain.

Equilibrium Regulation

In a political equilibrium, no interest group finds it worthwhile to use additional resources to press for
changes and no group of politicians or bureaucrats wants to offer different regulations. The political
equilibrium might be in the public interest or private interest.

Theories in Regulation:

The social interest theory is that regulations are supplied to satisfy the demand of consumers and
producers to maximize the sum of consumer and producer surplus—to attain efficiency.

The capture theory is that the regulations are supplied to satisfy the demand of producers to maximize
producer surplus—to maximize economic profit. In this case, regulation seeks to maximize profits.

Because the social interest and the self-interest of the producer are in conflict, the political process
cannot satisfy both groups in any particular industry. The highest bidder gets the regulation it wants.

The Scope of Regulation

Some of the regulatory agencies here in the Philippines are Bureau of Fire Protection (of the DILG),
Department of Trade and Industry, Securities and Exchange Commission, Bureau of Food and Drugs (of
the DOH) and Department of the Environment and Natural Resources.
The Regulatory Process

Regulatory agencies differ in many detailed ways, but all have features in common:

First, each agency is run by bureaucrats who are experts in the industry it regulates (often recruited
from the industry) and who appointed by the president or by Congress and funded by Congress.

Second, each agency adopts a set of rules and practices designed to control the prices and other aspects
of economic behavior in the industry it regulates.

In a regulated industry, firms are generally free to determine the technology to use and quantities of
inputs. But firms are not free to set their own prices and sometimes, they are regulated in the quantities
they can produce and sell or the markets they can serve.

Natural Monopoly

Natural monopoly is a firm with economies of scale that enable it to supply the entire market at the
lowest possible price.

Figure 14.2 illustrates the demand for the good produced, the natural monopoly’s marginal cost and
average cost.

Regulation in the Social Interest

Regulation in the social interest is achieved by using

the marginal cost pricing rule, which sets price equal
to marginal cost: P = MC.

Total surplus (the sum of consumer surplus and

producer surplus) is maximized.

With marginal cost pricing, the firm incurs an

economic loss.

The firm might be able to cover its economic loss:

a. By price discrimination

b.) The government might pay the firm a subsidy.

But the taxes that generate the revenue for the subsidy create a deadweight loss in other
markets. The government might adopt a regulation that allows the firm to break even, allow the firm to
use the average cost pricing rule, which sets price equal to average total cost.
Figure 14.3 illustrates the average cost pricing
rule. Price is set equal to average cost. The firm
breaks even, but total surplus is reduced. A
deadweight loss arises, but it is minimized.

B. Deregulation

Deregulation occurs when there is a significant decrease or elimination of government regulation over
an industry, market, or economy.

Like most economic policy, deregulation is controversial. Most economists agree that deregulation
lowers an industry's barriers to entry and generally increases efficiency, competition, entrepreneurship,
and innovation. Established producers have less control over competitors in a deregulated environment.
Deregulation also benefits the broader economy because it no longer requires taxpayers to support the
regulatory agency's overhead.

Overall, deregulation tends to increase choices and lower prices for consumers. In some cases, however,
deregulation can be damaging to consumers, especially when natural monopolies are involved (such as
electric utilities or other situations with immense infrastructure or technical needs). Some also point out
that the elimination of weaker competitors in a deregulated environment means the loss of jobs.

Example: Airline Deregulation

In the 1960s and 1970s, the Civil Aeronautics Board set strict regulations for the airline industry. It
managed routes and set fares. In return, it guaranteed a 12 percent profit for any flight that was at least
50 percent full.

As a result of these and other controls, airline travel was prohibitively expensive. According to the
Airlines for America trade association, by 1977, only 63 percent of Americans had ever flown. It also
took a long time for the Board to approve new routes or any other changes.

On October 24, 1978, the Airline Deregulation Act solved this problem. Safety was the only part of the
industry that remained regulated. Competition rose, fares dropped, and more people took to the skies.
Over time, many companies could no longer compete. They either were merged, acquired or went
bankrupt. As a result, just four airlines control 85 percent of the U.S. market: American, Delta, United,
and Southwest. Deregulation has created a near-monopoly.
Deregulation has created new problems. First, small and even mid-sized cities, such as Pittsburgh and
Cincinnati, are under-served. It's just not cost-effective for the major airlines to keep a full schedule.
Smaller carriers serve these cities, at a higher cost and less frequently. Second, airlines charge for things
that used to be free, such as ticket changes, meals, and luggage. Third, flying itself has become a
miserable experience. Customers suffer from cramped seating, crowded flights, and long waits.

C. Mergers and Acquisitions

Mergers and acquisitions (M&A) are defined as consolidation of companies. Differentiating the
two terms, Mergers is the combination of two companies to form one, while Acquisitions is one
company taken over by the other. M&A is one of the major aspects of corporate finance world. The
reasoning behind M&A generally given is that two separate companies together create more value
compared to being on an individual stand. With the objective of wealth maximization, companies keep
evaluating different opportunities through the route of merger or acquisition.

Pros of Mergers and Acquisitions

1. Network Economies. In some industries, firms need to provide a national network. This means there
are very significant economies of scale. A national network may imply the most efficient number of firms
in the industry is one. For example, when T-Mobile merged with Orange in the UK, they justified the
merger on the grounds that:

“The ambition is to combine both the Orange and T-Mobile networks, cut out duplication, and create a
single super-network. For customers, it will mean bigger network and better coverage, while reducing
the number of stations and sites – which is good for cost reduction as well as being good for the
environment.”

2. Research and development. In some industries, it is important to invest in research and development
to discover new products/technology. A merger enables the firm to be more profitable and have greater
funds for research and development. This is important in industries such as drug research, where a firm
needs to be able to afford many failures.

3. Avoid duplication

In some industries, it makes sense to have a merger to avoid duplication. For example, two bus
companies may be competing over the same stretch of roads. Consumers could benefit from a single
firm with lower costs. Avoiding duplication would have environmental benefits and help reduce
congestion.

4. Regulation of Monopoly
Even if a firm gains monopoly power from a merger, it doesn’t have to lead to higher prices if it is
sufficiently regulated by the government. For example, in some industries, the government have price
controls to limit price increases. That enables firms to benefit from economies of scale, but consumers
don’t face monopoly prices.

Cons of Mergers and Acquisitions

1. Higher Prices

A merger can reduce competition and give the new firm monopoly power. With less competition and
greater market share, the new firm can usually increase prices for consumers. For example, there is
opposition to the merger between British Airways (parent group IAG) and BMI. (link Guardian) This
merger would give British Airways an even higher percentage of flights leaving Heathrow and therefore
much scope for setting higher prices. Richard Branson (of Virgin) states:

“This takeover would take British flying back to the dark ages. BA has a track record of dominating
routes, forcing less flying and higher prices. This move is clearly about knocking out the competition. The
regulators cannot allow British Airways to sew up UK flying and squeeze the life out of the travelling
public. It is vital that regulatory authorities, in the UK as well as in Europe, give this merger the fullest
possible scrutiny and ensure it is stopped.”

2. Less choice. A merger can lead to less choice for consumers.

A merger can lead to less choice for consumers. This is important for industries such as
retail/clothing/food where choice is as important as price.

3. Job Losses

A merger can lead to job losses. This is a particular cause for concern if it is an aggressive takeover by an
‘asset stripping’ company – A firm which seeks to merge and get rid of under-performing sectors of the
target firm.

On the other hand, other economists may argue this ‘creative destruction’ of job losses will only lead to
temporary job losses and the unemployed will find new jobs in more efficient firms.

4. Diseconomies of Scale.

The new larger firm may experience dis-economies of scale from the increased size. After a merger, the
new bigger firm may lack the same degree of control and struggle to motivate workers. If workers feel
they are just part of a big multinational they may be less motivated to try hard. Also, if the two firms had
little in common then it may be difficult to gain the synergy between the two companies.
Evaluation – The desirability of a merger and acquisition depend upon:

a. How much is competition reduced by? E.g. A merger between Tesco and Sainsburys would lead to a
significant fall in competition amongst UK supermarkets. This would lead to higher prices for basic
necessities.

b. How significant are economies of scale in the industry? A merger between Tesco and Sainsburys may
enable some economies of scale, but it would be relatively low compared to two oil drilling companies.
The fixed costs in oil exploration are much higher. Therefore, there is more justification for a merger in
oil exploration than in supermarkets.

c. How Contestable is the market? After the merger can new firms still enter or are barriers to entry
sufficiently high to deter new firms?

d. What are the objectives of mergers? – Are the firms seeking to gain efficiency or are the managers
hoping for higher salaries and more prestige in new firms?

Sources:

- https://www.thebalance.com/deregulation-definition-pros-cons-examples-3305921

- https://www.economicshelp.org/blog/5009/economics/pros-and-cons-of-mergers/

- https://globalcompliancenews.com/antitrust-and-competition/antitrust-and-competition-in-the-
philippines/