Question

Explain how price (rate) regulation may improve the performance of monopolies. In your answer distinguish between (a) socially optimal (marginal-cost) pricing and (b) fair-return (average-total-cost) pricing. What is the “dilemma of regulation”?

Answer 1

Answer - The pricing in the monopoly takes place at the maximum possible price that can be charged on the inelastic portion of the demand curve. This price is above MC in short run and above ATC in long run which allows monopoly to earn the positive economic profits.

Now , the socially optimal output is less in case of monopoly which increases the cost to society generating the loss of economic surplus. In both short and long run , socially optimal pricing does not take place because price is above MC and ATC respectively. But , due to the regulations , this price is shifted down , so as to move the monopoly to more elastic portion of demand curve. Now the price decreases and as a result the monopoly starts earning lesser profits.

The delimna is this only. As soon as the regulations come in place , the price is forced to drop down to socially optimal level. In order to achieve the allocative efficiency , the monopoly has to suffer the loss in its profit. It will not be able to increase its price , because after the price reduction , it lies more in elastic portion. If it increases the price , revenue will drop. So this will not be favourable condition for monopoly.