Regulating a Monopolist Monopolist choose output q m,whereas the efficient output is q w. 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.

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 AC 0, the excess profit given by are abcf is relatively small, but the deadweight loss (or misallocation) given by area bem is relatively large. If bem exceeds 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 AC 1, 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.

Resource Misallocation

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.

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 q w, but greater than monopoly output q m. NO Barriers to Entry – Strong Monopoly

If we consider a weak natural monopoly in conjunction with barriers to entry. q s 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 q 0 and rising thereafter. Over the range 0 ≤ q ≤ q s, costs will be subadditive. Given demand curve and marginal cost curve, efficient pricing yields output q w, 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. NO Barriers to Entry – Weak Monopoly

Ultra-free Entry Table 2.1 Appropriate regulatory policies Monopoly typeBarriers to entryNo barriers to entry Strong natural monopoly( MC pricing creates a deficits) Enforce p =MC, and subsidize firm or Deviate from MC pricing to eliminate deficit Enforce p= MC, and subsidize firm or Do not regulate, letting threat of entry force break-even prices Weak natural monopoly (MC pricing allows nonnegative profits) Enforce p= MC, and address possible "problem" of excess profit Enforce p= MC, prevent further entry into the market, and address possible "problem" of excess profit.