Monopoly and Public Policy

Welfare Effects of Monopoly ▫By holding output below the level at which marginal cost is equal to the market price, a monopolist increases its profit but hurts the consumer. ▫To assess whether this is a net benefit or loss to society, we must compare the monopolist’s gain in profit to the consumer’s loss.  This shows that the consumers’ loss is larger than the monopolist’s gain.  Monopoly causes a net loss for society

▫Why is this loss?  Because some mutually beneficial transactions do not occur.  There are people for whom an additional unit of the good is worth more than the marginal cost of producing it but who don’t consume it because they are not willing to pay the monopoly price.  By driving a wedge between price and marginal cost, a monopoly acts much like a tax on consumers and produces the same kind of inefficiency. ▫So monopoly power detracts from the welfare of society as a whole and is a source of market failure.

Preventing Monopoly Power ▫Policy toward monopolies depends crucially on whether or not the industry in question is a natural monopoly (one in which increasing returns to scale ensure that a bigger producer has lower average total cost) ▫If the industry is not a natural monopoly, the best policy is to prevent a monopoly from arising or break it up if it already exists.

Dealing with a Natural Monopoly ▫It is not easy to decide to break up a natural monopoly because it could raise average total cost. ▫However even in the case of a natural monopoly, a profit-maximizing monopolist acts in a way that causes inefficiency.  It charges consumers a price that is higher than marginal cost and, by doing so, prevents some potentially beneficial transactions.

▫Two ways to address natural monopolies  Public Ownership  Instead of allowing private monopolists to control an industry, the government establishes a public agency to provide the good and protect consumers’ interests.  Advantage in principle is that a publicly owned natural monopoly can set prices based on the criterion of efficiency rather than profit-maximization.  Downside to public ownership is that publicly owned firms are often less eager than private companies to keep cost down or offer high-quality products  Another downside is that publicly owned companies all too often end up severing political interests.

 Regulation  In the United States, the more common answer has been to leave the industry in private hands but subject it to regulation. ▫Most local utilities are covered by price regulation that limits the prices they can charge.