Module 29 Monopoly and Public Policy

What You Will Learn The effects of the difference between perfect competition and monopoly on society’s welfare How policy makers address the problems posed by monopoly 1 2

Welfare Effects of Monopoly By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss. To avoid deadweight loss, government policy attempts to prevent monopoly behavior.

Welfare Effects of Monopoly When monopolies are devised rather than natural, governments should act to prevent them from forming and break up existing ones. The government policies used to prevent or eliminate monopolies are known as antitrust policy.

Monopoly Causes Inefficiency (a) Total Surplus with Perfect Competition (b) Total Surplus with Monopoly Price, cost Price, cost, marginal revenue Consumer surplus with perfect competition Consumer surplus with monopoly Profit PM Deadweight loss PC MC = ATC MC = ATC D D Figure 29-1: Monopoly Causes Inefficiency Panel (a) depicts a perfectly competitive industry: output is QC, and market price, PC, is equal to MC. Since price is exactly equal to each producer’s average total cost of production per unit, there is no producer surplus. So total surplus is equal to consumer surplus, the entire shaded area. Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and charges PM. Consumer surplus (blue area) has shrunk: a portion of it has been captured as profit (green area), and a portion of it has been lost to deadweight loss (yellow area), the value of mutually beneficial transactions that do not occur because of monopoly behavior. As a result, total surplus falls. MR QC Quantity QM Quantity Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and charges PM. Consumer surplus (blue triangle) has shrunk because a portion of it has been captured as profit (green area). Total surplus falls: the deadweight loss (orange area) represents the value of mutually beneficial transactions that do not occur because of monopoly behavior.

Preventing Monopoly It is not clear whether a natural monopoly should be broken up, because this would raise average total cost. 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 thereby prevents some potentially beneficial transactions.

Dealing with a Natural Monopoly What can public policy do about this? One answer is public ownership, but publicly owned companies are often poorly run. In public ownership of a monopoly, the good is supplied by the government or by a firm owned by the government. A common response in the United States is price regulation. A price ceiling imposed on a monopolist does not cause shortages as long as it is not set too low.

Unregulated and Regulated Natural Monopoly (a) Total Surplus with an Unregulated Natural Monopolist (b) Total Surplus with a Regulated Natural Monopolist Price, cost, marginal revenue Price, cost, marginal revenue Consumer surplus Consumer surplus Profit PM PM PR ATC PR * ATC MC MC Figure 29-2: Unregulated and Regulated Natural Monopoly This figure shows the case of a natural monopolist. In panel (a), if the monopolist is allowed to charge PM, it makes a profit, shown by the green area; consumer surplus is shown by the blue area. If it is regulated and must charge the lower price PR, output increases from QM to QR and consumer surplus increases. Panel (b) shows what happens when the monopolist must charge a price equal to average total cost, the price P* R. Output expands to Q* R, and consumer surplus is now the entire blue area. The monopolist makes zero profit. This is the greatest total surplus possible when the monopolist is allowed to at least break even, making P* R the best regulated price. D D MR MR QM QR Quantity QM QR * Quantity Panel (b) shows what happens when the monopolist must charge a price equal to average total cost, the price PR*. Output expands to QR*, and consumer surplus is now the entire blue area. The monopolist makes zero profit. This is the greatest consumer surplus possible when the monopolist is allowed to break even, making PR* the best regulated price.

Economics in Action Cable Dilemmas For several years, consumers have seen their cable prices increase by approximately 5% per year. At first, cable TV was subject to local price regulation, but in 1984, Congress passed a law prohibiting most local governments from regulating cable prices. Rates increased sharply, and a new law was passed to once again allow local governments to set limits on cable prices. Cable operators defend their prices, saying they must pay content providers for popular shows and do system upgrades. Critics point out the cable companies’ monopoly power.

Summary A monopoly creates deadweight losses by charging a price above marginal cost; the loss in consumer surplus exceeds the monopolist’s profit. Thus monopolies are a source of market failure and should be prevented or broken up, except in the case of natural monopolies. Natural monopolies can still cause deadweight losses. To limit these losses, governments sometimes impose public ownership and at other times impose price regulation. A price ceiling on a monopolist, as opposed to a perfectly competitive industry, need not cause shortages and can increase total surplus.