Government Intervention
Government Intervention
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A firm with few or no rivals can charge more and let its costs rise, which is why governments intervene in some product markets.
Veltia is a country. Its water comes through one network of pipes, owned by one firm. Most of its cement comes from three large firms. In its mining towns, one company employs most of the workers. In each market, one side has market power: it faces few or no rivals, so it can raise its price without losing most of its customers.
Water is a natural monopoly, a market where one firm can supply everyone at a lower average cost than two firms could: a second set of pipes would double the cost of the network. A rival would raise costs, not lower them, so the state regulates the single network instead of adding one.
Why would a firm with market power sell less? To sell one more unit, it must charge a lower price, and that lower price applies to every unit it sells, not only to the extra one. So the extra revenue from one more unit, its marginal revenue, is less than its price. Its marginal cost is the extra cost of producing one more unit. Producing more adds to profit only while marginal revenue is above marginal cost, so the firm stops where the two are equal. It therefore sells less, at a higher price, than firms facing rivals would, and consumers pay more, buy less and have less choice.
With no rival to lose customers to, nothing forces the firm to cut its costs either, so they can rise above the lowest possible level. This is X-inefficiency.
A monopsony, a single dominant buyer, has power too: it can lower the price it pays suppliers and the wages it pays workers, who have few other buyers to turn to.
This is the case for government intervention: the government changing what firms may do, or what they are paid. Its measures fall into three groups:
Intervention can also fail. So the case for it is not that it is perfect, but that it can give a better result than the market alone.
A cap on a monopoly's price removes its reason to sell less, so it supplies more at a lower price.
Left alone, Veltia's water network produces where marginal revenue equals marginal cost (MR = MC), as any firm aiming for the highest profit does. That is 40,000 units a day, the quantity demanded at a price of $60 a unit. Its average cost, the cost of each unit, is $50, so it earns $10 a unit more than normal profit, the profit just needed to keep it in the industry: $400,000 a day. Customers cannot switch, so a regulator, a government body that sets and enforces the rules for one industry, caps the price.
Price regulation: setting a maximum price that a firm with monopoly power may charge for its product.
Put simply, the regulator sets the highest price the firm may charge, so supplying less no longer raises its price.
Why does a cap raise output? Without a cap, the network can sell more only by lowering its price on every unit. Under a $40 cap, the price is $40 however many units it sells. So one more unit no longer lowers the price of the others, and each extra unit adds $40 of revenue for $20 of marginal cost. The network therefore gains from every unit buyers will buy at $40. At $40 the quantity demanded is 60,000 units a day, against 40,000 at $60. The network therefore supplies 60,000 units: beyond that quantity there is no demand at $40.
Prices in general rise over time, and the rate at which they rise is inflation. It is measured by the consumer price index, the average change in the prices consumers pay. So many caps are allowed to rise each year with inflation.
CPI − X price cap: a price cap that allows a regulated firm's price to rise each year by the rate of inflation, measured by the consumer price index, minus an efficiency factor, X.
Put simply, X is the yearly saving the regulator expects the firm to find, so the price may rise with prices in general, less that saving.
The cap sets the price, not the profit. So if the network cuts its costs each year by more than X, its price stays at the cap while its costs fall, and it keeps the extra saving as profit. Setting X is hard: too low, and the firm earns high profit at customers' expense; too high, and it cannot afford to maintain the network.
The impact, compared with no cap: a lower price, more output, profit close to normal and a reason to cut costs. Quality is the risk, because cutting it is a cheap way to cut costs.
Exam Matters: In a Calculate on a price cap, show the allowed percentage change first, then the new price with its unit.
A regulator can limit the profit a monopoly earns on the money it has invested, which secures investment but weakens the reason to cut costs.
Veltia's gas network must replace old pipes every year, and investors pay for them only if they expect a reliable return. A regulator can give them one by limiting the network's profit instead of its price. The capital base is the value of the equipment and buildings the firm has invested in. The rate of return is profit as a percentage of that capital.
Profit regulation: a limit on the rate of return on capital that a regulated firm may earn, with its prices set to cover its costs plus that return.
Put simply, the firm is promised a fixed percentage on all it has invested, and its prices are set to cover its costs plus that amount. Profit regulation is also called rate-of-return regulation.
The attraction is certainty: investors know they will earn the allowed return, so heavy investment can be funded.
The weakness is the incentive. Prices are set to cover costs plus the allowed return. So when costs rise, prices rise too, and profit stays at the allowed return. Managers have little reason to cut costs, so costs can rise above the lowest possible level (X-inefficiency). And because allowed profit grows with the capital base, the firm has a reason to over-invest: to buy more equipment than it needs.
This is the key difference from a CPI − X cap. Under a cap, the firm keeps what it saves. Under profit regulation, its customers pay for what it spends, because its prices rise with its costs.
The impact: profit held at the allowed return and secure investment, but prices that rise with costs and lower efficiency than under a price cap.
A capped monopoly can protect its profit by cutting quality, so regulators also set the quality it must deliver.
A price cap leaves a firm one easy way to protect its profit: spend less on quality. Repairing fewer leaks or employing fewer engineers cuts costs at once. The customers of a monopoly cannot switch to a better supplier, so they live with the lower quality. Regulators therefore add two measures.
Quality standard: a minimum level of quality that a product or service must meet, set in law or in a firm's licence.
Put simply, a standard is a line the product must never fall below, written into the law or into the firm's licence, its permission to operate. An example is tap water within safe limits for lead. Falling below it at any moment is a breach, and the firm can be fined.
Performance target: a measurable level of performance that a regulated firm must reach, with a reward for beating it or a penalty for missing it.
Put simply, a target is a score the firm must reach over a period, such as repairing nine in ten leaks within a day. Missing it can mean refunds to customers or a lower cap.
The key difference is how each is measured. A standard must be met at every moment, so a single failure breaks the rule. A target is measured over a period, and the firm is rewarded or penalised by how far its result is above or below the level set.
Both have costs. Better quality needs more staff and equipment, so under a cap the firm's profit falls, unless the regulator allows a higher price. A target can also be gamed: met on paper without the real improvement it was meant to bring. A firm judged on how fast it answers calls may answer quickly and still fix nothing.
The impact: quality rises, or stops falling; price may be higher or profit lower; and customers who cannot switch get a better service than a cap alone would give them.
A firm, market or deal can be passed to a body with the power to investigate it, and the threat alone changes how firms behave.
A region's three cinema chains raise their ticket prices by the same amount in the same week. A fourth, small chain suspects that the largest of the three is cutting its prices only in the towns where the small chain has a cinema. Neither cinema-goers nor the small chain can stop this alone, but they can take the case to a competition authority, a government body that investigates and enforces competition law, the rules that keep firms competing.
Referral to regulatory authorities: passing a firm, a market or a deal to a competition authority or industry regulator, which investigates it and can order changes or impose fines.
Put simply, a referral gives the problem to a body with power to find out what happened and act. The government, another regulator, customers or rival firms can refer a case.
The authority looks for two kinds of conduct:
If it finds either, the authority can fine the firms, order the conduct to stop, or require changes to their contracts.
Why does referral matter when no one is caught? A single complaint can start an investigation, and the fine can be larger than what the firms gain. A firm that weighs the possible fine against the gain may decide that fixing prices, or cutting them to drive out a newcomer, is not worth the risk. So firms change their behaviour before anyone refers them.
The impact falls on price and choice: rivals stay, so consumers keep the lower prices and wider choice that competition brings.
Real Example: In 2021, South Korea's Fair Trade Commission fined Google 207.4 billion won, about $177 million. Google had made phone makers agree not to build modified versions of its Android system, which kept rival systems out. The commission also ordered it to stop. This is abuse of a dominant position: Google was fined for using its position to block rivals, not for being large.
A large merger is reviewed by a competition authority, because fewer rivals can mean higher prices, unless lower costs outweigh that.
Two of Veltia's three cement firms plan to join together. When two firms combine into one, it is a merger; when one firm buys another, it is a takeover. Either way, the market would go from three firms to two. Should the government allow it?
A competition authority asks whether the deal would substantially lessen competition: leave so few rivals that prices rise, choice narrows or quality falls.
Merger control: laws that require large mergers and takeovers to be reviewed by a competition authority, which can clear them, clear them with conditions, or block them.
Put simply, firms above a certain size cannot simply combine: the authority first checks whether their customers would lose.
A review usually has four stages:
Remedies are conditions that let a deal go ahead, such as selling a plant or a brand to a rival, so that enough competition remains.
Why might a merger lower prices, even though it removes a rival? A larger firm may gain economies of scale: lower average costs from producing more, for example by running one full kiln, the oven that makes cement, instead of two half-empty ones. If enough rivals remain, the firm must lower its prices to keep its customers, so part of that saving reaches them. So the authority weighs the loss of a rival against the lower costs.
The impact: a blocked or changed deal keeps price and choice where they were; a cleared deal may lower prices if the firm still faces rivals.
Real Example: In 2018 Grab bought Uber's South-East Asian business. Singapore's competition authority found that the deal had substantially lessened competition in ride-hailing, and that fares had risen by about 10-15% after it. It fined the two firms a total of S$13 million and made Grab end its exclusive deals with taxi fleets and drivers, so that new rivals could enter.
Exam Matters: In a Discuss on a merger, weigh the higher prices that fewer rivals allow against the lower costs a larger firm may reach, and say which is likely to matter more in the market in the question.
Governments can add rivals to a market by making it cheaper for new small firms and foreign firms to enter.
Suppose a market has only two or three firms, none breaking any law. How can a government add rivals? It can make entry cheaper with a tax incentive: a lower tax rate, or a tax holiday (a period with no tax to pay), for firms that do what the government wants. Or it can give a grant, money that need not be repaid.
Foreign direct investment (FDI): investment by a firm based in one country in productive assets, such as factories or offices, in another country.
Put simply, FDI is a foreign firm building or buying a business here, not just selling its goods here.
The measures are aimed at two groups:
Each new rival can win customers only by charging less or offering more, so prices fall and choice widens. To keep their customers, the firms already there must match the lower prices, and to stay profitable at those prices they must cut their costs. A foreign entrant often brings new technology too, which can lower its costs and so the prices it charges.
A grant promotes competition only if it adds a rival. A grant to the firm that already leads its market lowers that firm's costs. It does nothing about the barrier to entry, anything that stops new firms entering, that newcomers face. So the leader becomes even harder to challenge.
The costs: tax revenue given up, money spent on firms that would have come anyway, and weak firms kept alive. The impact: lower prices and more choice if new rivals arrive, lower profit for the firms already there, and a cost to taxpayers.
Removing rules that keep firms out lets new rivals enter, and even the threat of entry pushes prices down.
Suppose a country's law allows only two airlines to fly its domestic routes. A rule like this is a barrier to entry: anything that stops or discourages new firms from entering a market.
Deregulation: the removal or relaxation of rules that restrict competition or limit which firms may enter a market.
Put simply, after deregulation a firm needs no special permission to enter, only to meet the rules that every firm must meet.
Each link has a reason. A new airline wins passengers only by offering a lower fare or a better service. The existing airlines must match it or lose those passengers. At the lower fares, they stay profitable only if they also cut their costs.
Fares can fall even before a rival arrives. A market that firms can enter and leave easily is a contestable market. In such a market, a high fare would tell outside firms that there is profit to win, so a rival would enter. So the existing airlines keep their fares down to give no rival a reason to come.
Not every rule is a barrier to remove. Some rules protect safety or quality, and removing them can lower both. New firms may also serve only the profitable routes and leave the rest with fewer flights.
The impact: lower prices and more choice; lower profit for the firms already in the market; pressure to cut costs, which raises efficiency (the same output made with fewer resources); and a risk to quality where the rules removed had protected it.
Selling a state firm to private owners can cut its costs, but its price falls far only if rivals enter or a regulator caps it.
Veltia's telecoms network is the only supplier, and the state owns it. So it is in the public sector, the part of the economy the government owns and runs. Firms owned by private individuals and their investors are in the private sector.
Privatisation: the transfer of a firm or industry from the public sector to the private sector.
Put simply, the state sells the firm. It may keep the same customers, and the same monopoly, under its new owners.
The case for it: owners who want profit push managers to cut costs; the firm can raise money from investors instead of the government; and the sale brings the government money. Whether prices fall depends on what comes with the sale. Here is the demand for a monthly subscription:
With no rival, marginal cost fell by $8 but the price fell by only $4. So on each subscriber, half of the saving went to customers and half became extra profit for the owners. Why do rivals push the price down to marginal cost? While the price is above the cost of serving one more subscriber, a rival can charge a little less and still gain. Rivals keep doing this until the price equals marginal cost.
So privatisation lowers the price far only when it comes with deregulation, which lets rivals in. Where the firm stays a natural monopoly, a regulator must cap its price instead, because the sale alone adds no rival. The impact: with rivals, a lower price and more choice; without them, a small fall in price and higher profit. Costs usually fall, but quality may fall too unless a regulator sets standards.
Where only one firm can run a public service, firms can still compete to be that firm.
A city collects its own rubbish and pays for it from taxes, but it does not know whether another firm could do the job for less. Only one firm can sensibly collect from each street, so rivals cannot simply compete for households.
Competitive tendering: inviting private firms to bid for a contract to supply a service paid for by the public sector, with the contract going to the bid that offers best value.
Put simply, the city still pays for the service, but firms bid for the right to run it, and the best offer wins. A tender usually has four stages:
Why does bidding lower the cost when only one firm will supply? A rival may bid lower for the same standard, so each firm bids close to its own costs. This is called competition for the market. Firms compete to become the one supplier, instead of competing with each other for the same customers. If the city's own team bids, it must match the private bidders or lose the work.
The risks: a firm may win with a low bid and then cut the service, so contracts need penalties; bidders may secretly agree who will win; and a long contract can make the winner the only bidder with a real chance of winning next time.
The impact: a lower cost to taxpayers and higher efficiency, with a risk to quality that the contract must guard against. Choice does not change, because one firm still serves each street.
Real Example: Since 2016, Singapore's government has owned the public buses and depots. It groups bus routes into packages, and operators bid to run each package on a contract of about five years. The winners are paid a fee and can earn bonuses for good performance. This is tendering without privatisation: the state keeps the buses and sets the standards, and firms compete for the right to run them.
Lowering barriers to imports turns foreign firms into rivals, so prices fall, but some domestic firms cannot survive.
Suppose a country's makers of washing machines have long been protected from imports. A tariff, a tax on imports, makes foreign machines more expensive in its shops, and a quota, a limit on the quantity that may be imported, keeps many of them out.
Trade liberalisation: the reduction or removal of trade barriers such as tariffs and quotas.
Put simply, it opens the market to foreign firms, so their machines sit beside the local ones in the shops. Each effect follows from foreign firms becoming rivals:
Why do some firms close when consumers gain? The lower price that helps consumers is the same price the domestic makers must now accept. Average cost is the cost of making each machine. A maker whose average cost is above the new price loses money on every machine it sells, so it cannot stay in the market for long.
So the gains and losses fall on different people. Barriers to foreign firms do the reverse: they protect domestic producers, and consumers pay for it in higher prices.
The impact: lower prices and more choice; lower profit for domestic makers; and higher efficiency and quality among those that survive.
Making firms buy inputs at home protects domestic suppliers, but someone pays for the higher cost.
A country's car assembler buys most of its raw materials, such as steel and rubber, from abroad because they are cheaper there. It buys its components, parts made by other firms such as seats and wiring, abroad too. The government would like local firms to make more of them.
Local sourcing: requiring or encouraging firms to buy a set share of their raw materials and components from domestic suppliers.
Put simply, firms must buy more of what they need at home, even when it costs more. A law that sets the share is a local-content rule.
The aim is to protect domestic suppliers and their employees: local parts makers win orders they would lose to imports, their workers keep their jobs, and skills build up in the country.
Who pays? If local parts cost more than imports, the assembler's costs rise. It can charge buyers a higher price, accept a lower profit, or do some of each. Which it does depends on the price elasticity of demand for its product: how much the quantity demanded falls when the price rises. The more price elastic demand is, the more buyers would stop buying at a higher price, so the more of the cost the assembler bears in lower profit.
Protected suppliers also face less pressure to cut their costs, because the assembler must buy from them anyway (X-inefficiency). And if the rule is strict, it raises their costs, so foreign firms may choose to invest in another country.
The impact: a higher price or lower profit for the buying firm; more profit and jobs for domestic suppliers; lower efficiency; and less choice if investors go elsewhere.
Real Example: Nigeria's 2010 oil and gas content law gives Nigerian companies first consideration for oil field licences and contracts. Firms bidding for work must also submit a plan for using Nigerian firms and workers. This is a local-content rule across a whole industry: domestic suppliers win orders that foreign contractors might otherwise win.
Workers with no real alternative can be made to accept harmful terms, so the law sets the terms every employer must meet.
A migrant worker arrives to work in a factory. Her employer keeps her passport, pays her wages late and asks for fourteen-hour days. She accepts, because she cannot leave without her passport. She has almost no bargaining power: the ability to get better terms because you could work elsewhere.
Exploitation: treating workers in ways they accept only because they have no real alternative, such as unpaid wages, unsafe conditions or excessive hours.
Put simply, exploitation is more than hard work or low pay. It means terms a worker accepts only because she cannot refuse them. The workers most exposed are those with least bargaining power: migrants tied to one employer, domestic workers living in their employer's home, and workers in towns with only one large employer.
Employment legislation is the set of laws on how employers must treat their workers. Rules against exploitation include:
The impact has two sides. Workers get better conditions, and rested, safer workers are often more productive: they produce more in each hour. But each rule adds to the cost of employing someone. If that cost rises above what a worker adds to the firm's revenue, the money it earns from sales, the firm may hire fewer workers or raise its prices. It may also move work into the informal economy: work that is not registered with the government, where the law is not enforced.
Keeping foreign suppliers out raises the price, so domestic firms sell more while consumers pay more.
Veltia's cement market is open to foreign suppliers. At $24 a bag, 52,000 bags a day are bought: 28,000 from domestic firms and 24,000 imported. Veltia's cement makers ask the government to protect them.
A government can raise barriers to entry of foreign firms: rules that stop or limit foreign firms selling in its market. Examples are caps on foreign ownership, licences only for domestic firms, sectors reserved for local businesses, and tariffs and quotas on imports.
Only domestic supply, the cement Veltia's own firms supply, is left. At $24 they supply only 28,000 bags, but the quantity demanded is still 52,000, so there is a shortage (excess demand) of 24,000 bags. The shortage pushes the price up. As it rises, the quantity demanded contracts, and domestic firms supply more, because each bag now earns more. At $30 both quantities are 40,000.
Domestic firms supply more, but their own supply curve has not shifted. They supply more because the price is higher: they move along their supply curve, and their quantity supplied extends from 28,000 to 40,000 bags. Who gains and who pays?
Protected from foreign rivals, domestic cement makers also face less pressure to cut costs (X-inefficiency). The impact: a higher price, less choice, higher profit for domestic firms, and lower efficiency.
Exam Matters: In an Analyse, show the supply shift on a diagram and read off both the higher price and the larger domestic output.
A dominant buyer can pay its suppliers too little, so governments limit how it uses that power.
In a farming district, small farmers grow sugar cane but can sell it to only one mill. The mill is a monopsony, a single dominant buyer, and it has monopsony power: the power to pay its suppliers less than a competitive market would.
Because it is the only buyer, the mill pays less and buys less than a competitive market would: buying more cane would force it to raise the price on every tonne it already buys. So the farmers earn less.
Governments restrict it in several ways:
The impact: suppliers' prices and profits rise, and the buyer's profit falls. Its own customers may pay a little more. A minimum price, also called a floor, set at the right level can even raise the quantity bought.
The state can buy a firm to save its jobs or serve social aims, but without profit pressure its costs may rise.
A country's national airline is about to collapse. If it closes, thousands of its workers lose their jobs, and the firms that supply its fuel, meals and repairs lose a large customer. The government can let it fail, or buy it.
Nationalisation: the transfer of a firm or industry from the private sector to the public sector.
Put simply, the government becomes the owner, so the firm's losses and decisions become the government's too. It is the same transfer as privatisation, in the other direction. It protects suppliers and employees in two ways:
The costs fall mainly on efficiency and on taxpayers. A private firm's shareholders, the people who own its shares, press managers to cut costs, because lower costs mean more profit for them. A state firm has no shareholders pressing for profit, and often no rivals, so its costs can rise above the lowest possible level (X-inefficiency). A government may also keep prices low to win votes. If prices are below costs, the firm makes losses, and taxpayers pay for them. And its investment competes with every other claim on the government's budget, such as schools and hospitals.
The impact: jobs and suppliers may be protected, though a rescue can still cut jobs, and prices may be lower, but profit can turn into losses paid by taxpayers, and efficiency may fall unless managers face clear targets or rivals.
Real Example: In August 2014, after two air disasters and a run of losses, Khazanah, the Malaysian government's investment fund, announced that it would take Malaysia Airlines fully into state ownership. It already owned about 69% and would buy the remaining shares. It called this the first stage of a complete overhaul. This is nationalisation as a rescue: the state moved to buy out the private shareholders of a failing national airline, so that it would own all of it.
Any measure can be judged on five tests, and which test matters most depends on the market.
Veltia's water regulator caps the price of water at $40 a unit, and lets the cap rise each year by CPI − X. Is the cap a success? One number cannot answer that. Any measure in a product market can be judged on five tests:
Why can a measure that lowers the price still leave consumers worse off? Customers of a single network cannot leave it if quality falls. A cheaper but less reliable water supply may cost households more in bottled water and lost time than the cap saves them. So which test matters most depends on the market. For a single water network, quality is the weak point, so the cap works best when quality standards are added to it.
Any measure can be judged in the same way. Here is the likely direction of each test for four contrasting measures, compared with the market before the measure. "Depends" means the direction turns on the case, as quality does under a price cap, where it depends on whether standards are added:
Exam Matters: In an Evaluate, the judgement comes from weighing the five tests against each other for the market in the question, not from listing them.
A regulator can slowly come to serve the firms it regulates, usually without any bribe.
Picture an energy regulator whose staff mostly come from the power companies it oversees. Its cost figures come from the companies' own reports, and many of its staff hope to work for those companies later. No one has been bribed, yet over time its decisions start to favour the companies.
Regulatory capture: when a regulatory agency advances the commercial interests of the firms that dominate the industry it is responsible for regulating.
Put simply, the regulator comes to share the industry's view of what is reasonable, and stops asking hard questions on behalf of consumers. It happens in three main ways:
Why does relying on the firms' information shift the regulator's judgement? A regulator that cannot check a cost figure must accept it or guess. If every figure it sees comes from the firms, it comes to accept their view of what a fair cost is. Its caps then rise to cover those costs.
The results are generous price caps, rules that are rarely checked or punished, and rules that keep new rivals out, so prices stay high and the firms already in the market stay protected. Capture is a form of government failure: when intervention makes the outcome worse than it would have been.
The defences: appointments for a fixed number of years, decisions published with their reasons, limits on staff moving to the industry, and consumer representatives on the regulator's board.
Exam Matters: In an Examine on the limits of regulation, explain how capture happens in the case, then judge how far defences such as fixed terms and published decisions reduce it.
A regulated firm knows its costs better than its regulator, so it can win a cap that barely restrains it.
To cap the price of Veltia's water at average cost, the regulator needs the network's true costs. Only the network knows them for certain. This is asymmetric information: one side of a deal knows more than the other. The network gains by claiming higher costs, because a higher cost means a higher cap.
Information gap: when regulators have insufficient information to make appropriate decisions to regulate an industry.
Put simply, the regulator must decide using figures it cannot check.
Why $60, and why 40,000 units? The regulator looks for the output at which the price buyers will pay just covers the claimed average cost. At 60,000 units the claimed cost would be $50, more than the $40 buyers pay there, so the cap must be higher. At 40,000 units the claimed cost and the price buyers will pay are both $60, so that is where the cap is set. So the cap no longer restrains the network: it charges what it would charge unregulated, and keeps $400,000 a day of profit above normal.
Information gaps limit other measures too. A government setting a legal lowest wage cannot know exactly what wage employers and workers would agree in a free market. One giving grants cannot tell which firms would have started anyway.
Regulators narrow the gap by benchmarking: comparing a firm's costs with those of similar firms elsewhere. A network that claims costs well above those of similar networks must explain why.
A regulator needs enough people and money, and enough power in law, or firms find that breaking the rules pays.
A competition authority has six economists. This year it is told of two hundred mergers and takeovers, and it must also investigate complaints about cartels. It cannot study them all with care. Even a well-designed measure needs a regulator able to enforce it, and two things can stop it.
Inadequate resources: when a regulator lacks the money, staff or expertise to investigate and enforce its rules.
Put simply, the regulator may act but cannot afford to, like labour inspectors, the officials who check that employers obey the law, who cannot visit every workplace to enforce working-hours rules.
Lack of regulatory power: when the law does not give a regulator enough power to act, for example to demand documents, impose large enough fines or break up a firm.
Put simply, the regulator has the people but not the legal tools, so a firm can refuse to show its accounts and face no penalty.
The key difference is what the regulator lacks. With inadequate resources, the law lets it act, but it lacks the money or staff to do so. With a lack of regulatory power, it has the money and staff, but the law does not let it act strongly enough.
Why does a fine smaller than the gain fail to deter firms, that is, fail to stop them breaking the rule? A firm compares what it gains from breaking a rule with what it expects to pay if caught. If a cartel gains $10 million and the largest fine is $2 million, breaking the rule still pays, even if it is certain to be caught.
Either way, firms can learn that breaking the rules pays. Where they do, the measure has little impact on price, profit or quality. Governments respond with larger budgets, higher maximum fines, and cooperation between authorities in different countries, because one cartel can operate across several of them.
Labour markets can leave workers unemployed, underpaid or treated unfairly, and that is the case for government intervention.
In Veltia, a country, many workers in the north have been unemployed since the mines closed, while employers in the capital cannot fill jobs. In Galdo, a mining town in Veltia, one company employs most of the workers and sets their pay. Some workers in Veltia are also paid less than others for reasons unrelated to their work. Each is a problem in the labour market (where workers offer their time and firms hire them).
A government that intervenes, changing what employers may do or pay, has two goals. The first is efficiency, which here means using all the labour the economy has. The second is equity, which means fairness in who earns what.
The government has five types of intervention, each aimed at one of these problems:
A legal limit on pay set below the equilibrium wage makes the quantity of labour demanded greater than the quantity supplied.
Some governments limit the pay of certain workers: the bosses of state-owned firms, bankers' bonuses, or government employees. The aims are to reduce inequality, hold down government spending on pay, and reduce risky decisions, since large bonuses reward bankers for taking big risks.
Maximum wage: the maximum that firms are legally allowed to pay their workers.
Put simply, a maximum wage is a ceiling on pay: whatever the market would pay, firms may not pay more.
Take senior managers in Veltia's banks. Without a cap, the equilibrium wage is $120 an hour: at that wage the quantity of labour demanded equals the quantity supplied, and 1,600 managers are employed.
Now the government caps their pay at $100 an hour. Because $100 is below the equilibrium wage, the cap binds: it stops the wage reaching $120. At $100 the job pays less, so fewer managers are willing to do it: the quantity of labour supplied falls from 1,600 to 1,200. Each manager now costs banks less, so they want more: the quantity of labour demanded rises to 2,000. This is a shortage of labour (excess demand for labour) of 800.
How many managers are employed? Only 1,200. The quantity of labour demanded is 2,000, but only 1,200 managers are willing to work for $100, and no one can be made to work. So when the cap binds, employment equals the quantity of labour supplied, the smaller of the two quantities.
A cap above $120 changes nothing: banks already pay $120, within the limit, so it does not bind.
A binding cap has further effects:
The impact: pay at the top moves closer to pay lower down than before, and the 1,200 who stay earn $20 an hour less than before. But the banks have 800 fewer managers than they would like to employ, so each manager has more work to do, and customers may be served less well.
Real Example: Since 2014, the European Union has limited bankers' bonuses to 100% of their fixed pay, or 200% if shareholders approve. This is a maximum wage on one part of pay. Because the limit covers only the bonus, a bank can still raise fixed pay, so total pay is not capped.
Exam Matters: In an Explain on a pay cap, first compare the cap with the equilibrium wage. Then follow one effect all the way through: the shortage, workers leaving, or pay moving into benefits in kind.
A legal floor on pay set above the equilibrium wage raises pay for those in work, but leaves more workers than jobs.
Veltia's warehouse workers are hired in a competitive labour market (many employers and many workers, none able to set the wage alone). The government wants to raise their low pay.
Minimum wage: the minimum that firms are legally allowed to pay their workers.
Put simply, a minimum wage is a floor under pay, while a maximum wage is a ceiling. A floor matters only if it is above the wage the market would pay.
The warehouse workers' schedule (a table showing the quantity of labour demanded and supplied at each wage):
At $12, both quantities are 32,000, so $12 is the equilibrium wage and 32,000 workers are employed.
Now the government sets a minimum wage of $14 an hour. Because $14 is above $12, the floor binds. Each worker costs more, so the quantity of labour demanded contracts (falls along the demand curve) to 24,000. The higher pay attracts more people, so the quantity of labour supplied extends (rises along the supply curve) to 40,000. More workers are willing than firms will hire: a surplus of labour (excess supply of labour). These workers want a job and cannot get one, so the surplus is unemployment.
So half the surplus lost their jobs, and half were drawn in by the higher pay. A ceiling below the equilibrium wage creates a shortage of labour; a floor above it creates a surplus. A floor below $12 changes nothing, because firms already pay more.
How many jobs go depends on the elasticity of demand for labour: how much the quantity of labour demanded responds to a change in the wage. Demand for labour is inelastic when workers are hard to replace and wages are a small share of costs. Firms then cut few jobs when the wage rises, so a floor costs few jobs.
Exam Matters: In a Calculate on a minimum wage, read both quantities at the floor, not at the equilibrium wage. Give the answer as a number of workers.
Where one employer dominates, it hires fewer workers to keep pay down, so a wage floor can raise both pay and jobs.
Return to Galdo. Its mining company is a monopsony, a single dominant buyer, here of labour. The workers have few other employers to turn to.
The table shows, for each number of workers, the wage needed to attract them and the marginal revenue product (MRP), the value of the extra output one more worker produces.
Why does the company hire only 12,000? To attract more workers it must raise the wage, and pay the higher wage to everyone, not only to the new workers. So one more worker costs more than their own wage. This extra cost is called the marginal cost of labour (MCL): the new worker's wage plus the rise for everyone already employed.
While a worker's MRP is above the MCL, hiring them adds more to the company's revenue, the money it earns from sales, than to its costs, so profit rises. Once the MCL is above the MRP, one more worker would lower profit. So the company hires until the MCL equals the MRP, at 12,000 workers, and pays only the wage 12,000 workers need: $8 an hour, its monopsony wage.
With many competing employers, hiring one more worker does not raise anyone else's pay, so one more worker costs only the wage they need. Workers would be hired until that wage equals the MRP: 18,000 at $11.
Suppose the law then requires at least $10 an hour for every job in Galdo. Every worker must be paid $10 already, so hiring one more, up to the 16,000 willing at $10, no longer raises anyone else's pay. Each extra worker costs just $10: the MCL falls to the minimum wage.
Each of these workers adds more to the company's revenue than the $10 they cost, since even the 16,000th has an MRP of $12. So the company gains by hiring all 16,000. To hire more than 16,000, it would have to pay more than $10, and pay that to everyone, so one more worker would again cost more than their MRP. So the minimum wage raises both the wage and employment: the wage from $8 to $10, and employment from 12,000 to 16,000.
A floor raises employment only if it is set within a range. Any floor above $8 and below $14 raises employment, and the most is at $11, with 18,000 employed. A floor above $11 makes the company stop at the worker whose MRP just equals the floor. At $14, that is the 12,000th worker, so employment is back at 12,000; above $14, it falls below 12,000.
Exam Matters: In an Evaluate on the minimum wage, let the market structure carry the judgement: in a competitive market a floor above equilibrium costs jobs, but where one employer dominates, a floor in the right range adds jobs.
A tax on employing workers raises the cost of each worker, so the quantity of labour demanded falls at every wage.
Veltia's warehouse workers earn $12 an hour, and 32,000 are employed: at $12 the quantity of labour demanded equals the quantity supplied. The government can raise revenue here with a direct tax (a tax on income or profits, paid to the government by the person or firm that earns them).
Employers' national insurance contributions: a tax on the wages earned by a firm's employees.
Put simply, the firm pays the government a sum for every hour its workers work. Many countries call it a social security contribution; it pays for state pensions and benefits, the payments made to people who are ill or out of work.
Corporation tax: a tax on the profits of companies.
Put simply, it takes a share of a company's profit, so a successful investment earns its owners less. The first tax falls on each worker employed; the second reaches workers only through investment.
Suppose firms must pay $2 for every hour each warehouse worker works. The demand for labour shows the most firms will pay in total for each quantity of workers: for 32,000 workers, that is $12 an hour. With the $2 contribution, a total cost of $12 now leaves a wage of only $10 for the worker. The same holds at every quantity, so the demand for labour, drawn against the wage workers receive, shifts down by exactly $2.
Why is the $2 shared? At the old wage of $12, firms would now pay $14 in all, and at $14 the quantity of labour demanded is only 24,000, while the quantity supplied is 32,000. This surplus of labour pushes down the wage workers receive. As it falls, the quantity of labour supplied contracts and the quantity demanded extends, until both are 28,000. So firms pay $1 more ($13 against $12) and workers receive $1 less ($11 against $12).
Employees' national insurance contributions are taken from workers' pay instead. Take-home pay falls at every wage, so fewer people are willing to work at each wage: the supply of labour shifts left, and employment falls.
Corporation tax works more slowly. A higher rate leaves less profit after tax from each new investment, the money firms spend on new factories, machines and offices. So firms invest less, and some multinational firms (firms operating in many countries) locate elsewhere. Workers are hired to produce output, so fewer new factories and offices need fewer new workers, and over the years that follow, the demand for labour grows more slowly than it would have. A cut reverses each step: firms keep more profit from each new investment, so they invest more, more multinational firms locate in the country, and over the years that follow the demand for labour grows faster than it would have.
Exam Matters: In an Analyse on a direct tax, say which tax it is first. A tax on employing workers works through the cost of each worker at once; corporation tax works through investment, over years.
Some workers cannot move to where the jobs are, and the government can remove the barriers that stop them.
In Veltia's capital, firms cannot fill their jobs. In a northern region, many workers are unemployed. The jobs and the workers are in different places. This is geographical immobility of labour: workers cannot easily move to a job in another area.
Each measure removes one barrier to moving, or the need to move:
If the measures work, both regions change. Workers move from the north to the capital. In the capital, more workers are now willing to work at each wage, so the supply of labour rises and vacancies fill. In the north, the supply of labour falls, so unemployment falls. Workers who produced nothing are now employed, so output (the goods and services the economy produces) rises.
The limits are cost and family. A grant pays for the move. It cannot help a worker whose partner has a job in the north, or whose children are settled in school there. Moving would cost the family an income or a school, so the worker stays. Each measure also costs the government money.
Exam Matters: In an Explain on a measure to help workers move, follow one chain from the barrier it removes to the outcome the question names, and add the condition that limits it.
Some workers cannot switch to a job that needs skills they lack, and training can give them those skills.
In Veltia, the demand for electricians has grown, and their pay has been rising: today it is $20 an hour, with 10,000 employed. Workers from closing factories cannot take these jobs, because they lack the electrician's certificate. This is occupational immobility of labour: workers cannot easily switch to a different kind of job, because they lack its skills or qualifications.
The government can reduce it with training and education:
Suppose the government funds a two-year retraining scheme for factory workers, and nothing else in the market changes over the two years. Today nothing changes in the market, because no one has finished the course. Two years from now, 2,000 more qualified electricians are willing to work at every wage. So the supply of electricians shifts to the right (more workers are willing to work at each wage).
Why is the wage lower than it would have been? Without the scheme, the wage stays at $20, with 10,000 employed. At $18, the quantity of labour supplied would be only 9,000 against a quantity demanded of 11,000, and that shortage of 2,000 would push the wage back up to $20. With the scheme, 11,000 are willing to work at $18, so there is no shortage, the vacancies fill, and the wage is $18 with 11,000 employed. The retrained workers gain jobs.
The limits are time, cost and age. The benefit takes two years to arrive, because no one has finished the course until then. Courses cost money and may teach skills firms do not want. Older workers have fewer working years to gain from the effort, so fewer take a course.
Real Example: Since 2016, Singapore has given every citizen aged 25 and over a SkillsFuture Credit of S$500 to spend on approved courses. The credit belongs to the worker, not the employer, so workers choose the new skills they learn. It is a training credit of the kind that reduces occupational immobility.
Exam Matters: In a Discuss on retraining, weigh how long the training takes, who takes it up and whether firms want the skills, then reach a judgement.
Employers who treat a group of workers worse for reasons unrelated to work lower that group's wage and employment below what they would otherwise be.
In Veltia, many firms hire fewer women as accountants than men with the same skills, and pay them less. Nothing about the women's productivity (the output a worker produces in a given time) explains it.
Discrimination (in the labour market): treating workers differently in hiring, pay or promotion because of a characteristic unrelated to their productivity, such as sex, ethnicity, religion or age.
Put simply, discrimination judges a worker by who they are, not by what they can do. The workers lose pay and jobs. The employer loses too, because it turns away skilled workers it could have hired.
Without discrimination, the equilibrium wage for women accountants is $15 an hour, where the quantity of labour demanded equals the quantity supplied, with 30,000 employed. Discrimination lowers the demand for women's labour: at every wage, the quantity of labour demanded is 10,000 lower, so the demand curve shifts left, and at $15 only 20,000 are demanded.
Removing the discrimination reverses this. The quantity of labour demanded is again 10,000 higher at every wage, so at $13 it is 35,000, against 25,000 supplied. This excess demand for women's labour pushes the wage up. As it rises, the quantity supplied extends and the quantity demanded contracts, until both are 30,000 at $15. Because the demand curve itself has shifted, the wage and employment rise together.
The measures against discrimination:
Exploitation (treating workers in ways they accept only because they have no real alternative) is a different problem. Measures against it include enforcing employment law, protecting migrant workers (workers who have come from another country), and the right to join a trade union (a group of workers who bargain with employers together).
If the measures work, the group's wage and employment rise, and output rises as more skilled workers are used. The limits: discrimination is hard to prove, enforcement needs inspectors and courts, and informal work (jobs never declared to the government) escapes the law.
Real Example: In March 2021, Saudi Arabia changed its sponsorship rules (the rules that tied each migrant worker to one employer). Migrant workers covered by its labour law can now change employer without their current employer's consent, after a year of their contract or when it ends. Domestic workers were left out. This is a measure against exploitation: a worker who can leave has a real alternative.
Exam Matters: In an Analyse on a law against discrimination, use the demand for the group's labour: the law shifts it right, so the wage and employment rise together. Then say what the size of the effect depends on.
A firm with few or no rivals can charge more and let its costs rise, which is why governments intervene in some product markets.
A cap on a monopoly's price removes its reason to sell less, so it supplies more at a lower price.