Regulating a Monopolist

1. Regulating a Monopolist • Monopolist choose output qm ,whereas the efficient output is qw . Regulation will be needed to avoid the former result. • However, if the regulator attempts to achieve the latter result, the firm is not financially solvent since price is below average cost and a deficit occurs equal to area bfgy. • Average cost is decreasing, society may be better off if the firm is allowed to maintain monopoly status, because this market structure minimizes production costs for any output. • A deficit results if society forces the firm to price all units at marginal cost; the firm must be subsidized or else shut down. • One regulation option is to force marginal-cost pricing and subsidize the firm.

3. Resource Misallocation • Regulation is not costless, and the benefits from correcting minimal misallocations may be less than the cost of running the regulatory agency. (DWL> Regulation Costs) • With average cost AC0, the excess profit given by are abcfis relatively small, but the deadweight loss (or misallocation) given by area bemis relatively large. If bemexceeds the cost of running regulatory agency, intervention may be justified. • If there is technology change, causing fixed costs to fall dramatically, average cost drops to AC1, profit will be greater, but deadweight loss will be unchanged. (because MC is assumed unchanged in the relevant quantity range.) • Thus, the excess profit alone is not an adequate indicator of the need for regulation. The basic efficiency issue is whether or not there is much social welfare to be gained if a regulator restricts the monopolist’s pricing policy.

4. Resource Misallocation

6. Barriers to Entry • The most common barrier is an incumbent firm with large sunk costs (Baumol, Panzar and Willig, 1982). • Entrants will have to make prohibitively large investments in order to compete at able the same scale of output as the incumbent. • If the entrant is successful, expansion of market output which partly depends on the incumbent’s reaction to entry, may so reduce the price that entry will be unprofitable. • Barriers to entry have significant implications for regulation in the context of strong and weak natural monopolies.

8. NO Barriers to Entry – Strong Monopoly • Under no regulation • If a single, linear price structure is used, then the solution is to set price equal to average cost. Therefore, output will be less than the efficient output qw, but greater than monopoly output qm.

9. NO Barriers to Entry – Weak Monopoly • If we consider a weak natural monopoly in conjunction with barriers to entry. qs is the output level at which it becomes efficient for a second plant to be built and operated. Average cost for a single firm is falling up to q0 and rising thereafter. • Over the range 0 ≤ q ≤ qs, costs will be subadditive. Given demand curve and marginal cost curve, efficient pricing yields output qw , where costs are subadditive; however, average cost is increasing. • Regulatory intervention is still required to protect consumers, because the firm’s incentive still will be to set a price at which marginal revenue and marginal cost will be equal.

10. Ultra-free Entry Table 2.1 Appropriate regulatory policies