Question

What is the optimal price cap for a government to impose on a monopoly? Why?

Answer 1

Monopolies always reduce the economic wealth of society in many ways. Hence, governments regulate monopolies with the objective of benefiting societies more than would be the case if the monopolies maximized their profits. There are 3 major methods to increase the benefits of monopolies to society:

1. Removing or lowering barriers to entry through antitrust laws so that other firms can enter the market to compete

2. Regulating the prices that the monopoly can charge

3. Operating the monopoly as a public enterprise.

Monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through: Price capping – limiting price increases.

In the case of a natural monopoly, market competition will not work well and so, rather than allowing an unregulated monopoly to raise price and reduce output, the government may wish to regulate price and/or output.

Price cap regulation: when the regulator sets a price that a firm cannot exceed over the next few years.

Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.

Socially optimal is where P = MC and profit is maximized. This is because the price that consumers are willing to pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.

In order to maintain a socially optimal price for a regulated economy, the monopoly business should manufacture goods at a price which intersects the marginal cost curve. In this price, the profit will be maximum.

Hence, governments regulate monopolies with the objective of benefiting societies more than would be the case if the monopolies maximized their profits.