Question

There are three main options for handling monopolies. Describe these three options.

Please put this into simple/clear words, as I am fairly new to economics. Thank you!!

Answer 1

Answer: Monopoly is an imperfectly competitive market set up where there are a large number of buyers but a single seller, and the product it sells does not have a close substitute. The monopoly firm being the only seller is the price-maker in the market. It fixes price by maximizing its own profit. So, the monopoly firm has a sufficient degree of market power in the market. It blocks the entry of new firm in the market either by strategic action or by lobbying the government to block the entrance.

To maximize its profit, the monopolist firm always charges a price (P) that is higher than its marginal cost (MC) of production. If the market were perfectly competitive, the competitive forces would have ensured that P = MC. Since in a monopoly market P>MC always, there are some social costs of monopoly which arises due to monopoly power. The monopoly equilibrium is not socially optimum, thus it is regulated and discouraged all over the world.

There are three major options to regulate a monopoly firm. The options are discussed below.

1. Price regulation

This is often used in case of natural monopolies. A natural monopoly is a firm that can produce the entire output of the market at a lower cost than the cost it would be if several firms produced the output. This happens due to strong economies of scale the firms produce, where for each unit of increase in inputs results in a higher degree of increase in output. In the figure (1), the average cost (AC), marginal cost (MC), marginal revenue (MR) and average revenue (AR) of the monopolist is shown. The AC curve is downward sloping due to economies of scale and the MC curve always lies below AC. The competitive equilibrium quantity is Qc while the monopoly equilibrium quantity is QM. A government can regulate the industry by charging a price P_r between P_M and P_C. The figure shows the regulated price Pr where AR = AC. This is also known as fair-return price as it includes a normal profit. This will induce the owners to find ways to decrease the cost and enjoy profits.

2. Regulation through the imposition of taxes

The government can regulate the monopoly through the imposition of taxes on the firm. Suppose the government imposes an ad-valorem tax on the output of the firm. So, per unit output production is now costlier for the firm. The tax can be treated as a variable cost. So, the average cost of the firm will increase. This will lead to a decrease in the output of the firms. In figure (2), due to the imposition of taxes, the AC and MC curve moves upward. Output decreases from Q_M to Q_M’. Profit decreases from AB to A’B’. However, here one disadvantage is that the seller can shift the extra burden of tax to the buyers through higher pricing. A better way is to impose a lump sum tax so that the AC curve shifts upward but the MC cost stays the same. Here, the incidence of the tax falls entirely on the firm. The firms will have the incentive to reduce output. This is shown in figure (3). Profit decreases from AB to AB’ after imposition of the tax. If the lump sum tax is very high, the profit of the firm may become negative, thus forcing it to reduce output.

The government can also regulate the firm by owning the firm and managing it efficiently and producing a socially desirable outcome.

3. Antitrust Laws

Antitrust laws are mainly rules and regulations imposed by the government that regulates actions that restrains or are likely to restrain, competition. The main intention of these laws is to maintain competition in the market and allow small companies to enter the market. Monopoly power can arise in a number of ways, which are covered in antitrust laws. Some of these are –

• agreement among producers to restrict their output and fix price above a certain level
• Parallel conduct - implicit collusion where one firm consistently follows the actions of another firm
• Predatory pricing - - to drive new entrants and competition away from the market by charging price accordingly

Antitrust laws ensure that such instances do not occur and competition is allowed in the market.