Government rules, regulations, and tax policy play a key role in shaping competitive forces.

By understanding the rationale for government involvement in the market economy, a better appreciation of the part played by business is gained.

• From an economic efficiency standpoint, a given mode of regulation or government control is desirable to the extent that benefits exceed costs. In terms of efficiency, the question is whether market competition by itself is adequate or if government regulation is desirable. Equity, or fairness, criteria must also be carefully weighed when social considerations bear on the regulatory decision-making process.

• Market failure is the failure of market institutions to sustain socially desirable activities or to eliminate undesirable ones. Failure by market structure occurs in markets with too few buyers and sellers for effective competition. Failure by incentive occurs when some important benefits or costs of production and consumption are not reflected in industry prices. Differences between private and social costs or benefits are called externalities. For example, air pollution is a type of negative externality.

• Competitive markets are also attractive because they are consistent with basic democratic principles. Preservation of consumer choice or consumer sovereignty is an important feature of competitive markets. A second social purpose of regulatory intervention is to limit concentration of economic and political power.

• Property rights give firms the prerogative to limit use by others of specific land, plant and equipment, and other assets. The establishment and maintenance of private property rights are essential to the workings of a competitive market. With patents, government grants an exclusive property right to produce, use, or sell an invention or innovation for a limited period (20 years in the United States). These valuable grants of legal monopoly power are intended to stimulate research and development. The tort system includes a body of law designed to provide a mechanism for victims of accidents and injury to receive just compensation for their loss. These laws create an incentive for firms and other parties to act responsibly in commerce.

• Government also responds to positive externalities by providing subsidies to private business firms. Subsidy policy can be direct or indirect, like government construction and highway maintenance grants that benefit the trucking industry. Tradable emissions permits are a new and controversial form of government subsidy that give firms the property right to pollute and to sell that right to others if they wish. Whereas subsidy policy gives firms positive incentives for desirable performance, tax policy contains penalties, or negative subsidies, designed to limit undesirable performance. Tax policy includes both regular tax payments and fines or penalties that may be assessed intermittently.

• Operating controls are regulations or standards that limit undesirable behavior by compelling certain actions while prohibiting others. The question of who pays for such regulation is seldom answered by simply referring to the point of tax collection, or point of tax incidence. The economic cost of regulation, or the tax burden, is often passed on to customers or suppliers.

• In some industries, average costs decline as output expands. The term natural monopoly describes this situation, because monopoly is a direct result of the superior efficiency of a single large producer. In such circumstances, the process of regulation is expensive in terms of administrative costs, lost operating efficiency, and the misallocation of scarce resources. Contributing to these costs is the problem of regulatory lag, or delay between the time a change in regulation is appropriate and the date it becomes effective.

• Antitrust laws are designed to promote competition and prevent unwarranted monopoly. These laws seek to improve economic efficiency by enhancing consumer sovereignty and the impartiality of resource allocation while limiting concentrations in both economic and political power.

• According to horizontal merger guidelines, mergers resulting in relatively unconcentrated markets or that result in a modest increase in market concentration are not likely to have adverse competitive effects and ordinarily will be approved. Mergers producing a large increase in market concentration, particularly those in already highly concentrated markets, are likely to create or enhance market power and would generally not be approved.

• The added value that new users add to network goods and services is called a network externality. Networks became a recent concern in antitrust policy because the Clinton Justice Department feared that if inferior networks got a decisive lead in "installed base" among consumers, switching costs might be sufficient to keep customers from switching to a superior standard. Switching costs might also constitute a barrier to entry in the industry and enable network monopolists to tie or bundle a second product in such a way as to foreclose competition in that secondary market.

• Tobin's q ratio is defined as the ratio of the market value of the firm relative to the replacement cost of tangible assets. Nobel laureate James Tobin conceived of this measure as an indicator of pending capital investment. According to Tobin, when high profits cause market values to greatly exceed replacement costs, firms have powerful incentives to expand, and capital investment should boom. Conversely, when low profits cause market values to fall below replacement costs, firms will shrink, and capital investment can be expected to wither. More recently, economists have used Tobin's q ratio as an indicator of above-normal or monopoly profits. However, given the growing importance of intangible capital in our economy, it becomes misleading to infer a simple increase in monopoly profits following an increase in Tobin's q over time.

• The capture theory of economic regulation says that the power of the state to prohibit or compel and to take or give money is often manipulated to selectively help or hurt a vast number of industries. Because of this, regulation may be actively sought by an industry. Capture theory contrasts sharply with the more traditional public interest theory view of regulation as a government-imposed means of private-market control.

• State and federal regulators have begun to address the high costs of regulation through new methods of incentive-based regulation, whereby both companies and their customers benefit through enhanced efficiency.

• In recognition that the regulatory process can sometimes harm rather than help consumer interests, a deregulation movement has sprung up and has grown to impressive dimensions. Similarly, the unnecessary costs of other forms of regulation dictate that regulatory reform is likely to remain a significant social concern.

Government regulation of the market economy is a natural by-product of public concern that unrestricted market competition has the potential to harm economic performance. As the benefits and costs of government/business interaction become better understood, the potential grows for a more constructive approach to government regulation.

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