Question

1. Assume the market demand function is D(P)=100 – P and the firm cost function is C(q)= 20q. The industry is populated by many small firms that offer identical products. In the absence of regulation, a competitive equilibrium would be achieved. However, regulation is in place and requires that a firm’s price be at least as great as 30. Derive the effect of regulation on quantity, firm profits, and social welfare.

2. Now think that the industry is deregulated. What is the price and quantity after deregulation? Does social welfare increase of decrease? What is the impact for firm’s profits? How much do you think those firms are ready to spend on political lobbying (called rent seeking activities by economic jargon) to stop deregulation? Can you think of any example similar to this situation in today’s US?

Answer 1

1.

In a competitive market without regulation, the price would be P=MC=20. However, with regulation, the price would be the minimum price allowed for the good. In this case, the regulated price is P=30. At P=30, D(P)=100-30=70. The competitive equilibrium is D(P)=100-20=80.

Therefore, regulation increases price and decreases output from the competitive equilibrium of Q=80 to Q=70. The rise in price increases the profit of the firms from a competitive equilibrium of zero profit to 10 unit profit on each unit produced. The total profit of the firms is

The social welfare will be lower than the competitive equilibrium, because, the regulation will deviate the market outcome from the efficient solution of a perfectly competitive market. The social welfare is

2.

The competitive market price is P=MC=20. The competitive quantity of the market is Q=D(P=20)=80.

As the market reaches its efficient outcome with deregulation, social welfare increases. The new social welfare is

The firm's profit reduces to zero under perfect competition. Because under deregulated market P=AC=MC. Then P=20, profit is (P-AC) x q=0.

Now the firm under regulation was earning a profit of 700 units. This reduces to zero under no regulation. Then the firms will be willing to pay as much as 700 units for political lobbying.

The one good example of rent-seeking is tariff on imported good. The free trade makes the domestic market open for global competition and the market price becomes the global competitive price. The firms in the import competing sector often lobby for tariff protection to increase global price in domestic market to earn more market share and hence profit. In 2020, the US tariff on industrial good is 2% and US imports 96% industrial good among total imports.