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 
Figure 7
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
Figure 8
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
Figure 9
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 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.
Next: Tutorial 11- Competitive
Labor Markets
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