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Tutorial 10: Firms With Market Power (cont.)

 

Regulating Market Power

One way for a firm to have market power is for the government to grant it monopoly status. If the firm has experienced economies of scale in the production of the good, hence has lower average total costs than new start ups, consumers could be better off. But, depending on demand, lower average costs can generate higher economic profit for the firm rather than lower prices to the consumer. So the government will often be asked to regulate the price or output of such a monopoly in the interest of consumers... So how does the government go about determining what price a regulated monopolist may charge?

The government has three basic options. First, set a price, P*, lower than the one that would maximize the firm's economic profit. Second, set the price that would prevail under competitive conditions, i.e., set price where D = MC. I'll refer to this as the "competitive price", Pc. Third, set price so that the firm just covers its opportunity cost, i.e., set price where ATC = D. I'll refer to this price as a "fair return" price, Pfr. Figures 7-9 illustrate these options.

 

A Lower Price Top of page.

Figure 7


Graph showing government regulation of a price-setting firm's price so that it is less than what would be charged under unregulated circumstances.

 

Suppose the government sets a ceiling price, the maximum the monopolist may charge, at $60 per unit, P*. The firm now takes that price as given so its demand curve becomes kinked. The demand line starts off horizontal at P* until it reaches D1 whereupon it follows D1 for the remaining quantities. (Why? Well, although the firm must charge no more than $60 per unit, it may charge less!) That means that MR will be kinked as well. MR starts off horizontal at P* because MR = P with price is constant. When P* reaches D1 the marginal revenue line drops vertically until it intersect the original MR1 and follows it thereafter. So with the new price constraint the firm sets the kinked MR1 = MC1 and produces an output of 4000 units/t at the ceiling price of $60/unit.

 

The Competitive Price Top of page.

Figure 8


Graph showing government regulation of a price-setting firm's price so that it equals a competitive market price.

 

Suppose the government requires the firm charge the competitive market price, Pc, of $55 per unit. Given this new pricing constraint, the firm sets D1 = MC1 and produces an output of 4500 units/t at the ceiling price of $55/unit.

Note that, under this pricing scheme, if fixed costs were to rise, for example, this firm could quickly find itself with economic losses! Yet it would be unable to raise its price above the competitive market price of $55... Even monopolists would not stay in business in the long run if they couldn't at least cover their opportunity costs. This potential problem with the competitive pricing approach leads to the third alternative.

 

The "Fair Return" Price Top of page.

Figure 9


Graph showing government regulation of a price-setting firm's price so that it leaves the firm with zero economic profit.

 

Suppose the government allows the firm to charge a price that gives it a fair return on its investment, i.e., allows it to earn zero economic profit. Zero economic profit occurs at an output level where P = ATC. Given this new pricing constraint, the firm sets D1 = ATC1 and produces an output of 4914.85 units/t at fair return price, Pfr, of $50.85/unit.

While this approach generates a price that is not as efficient as the competitive market price (that requires P = MC), it does guarantee that the firm will not earn economic losses and leave the industry (or ask for a subsidy from the government...).

 

This is a good time to start, or review, GFE 25.

 

This ends our discussion of firms with market power. You should walk away from this lesson remembering that there are costs and benefits to having firms with market power produce goods and services. Firms with market power charge a higher price and produce a lower output making social surplus smaller. But, because each firm in the market produces a similar, or at least differentiated, product, consumers have more choices.

In Tutorial 11 we turn our attention from modeling the market for goods to developing models of the market for inputs.