Monopolistic Competition: Price and Output

Efficiency
   Economic efficiency requires the following triple equation P=MC=minimum ATC. The equality of price and minimum ATC yields productive efficiency (and results in fair price return). The goods are produced in least costly way, and the price is just sufficient to cover average total costs (ATC), so the firm gets a normal profit. The equality of price and MC yields in allocative efficiency(and results in socially optimal price). So, the right amount of output is produced , and the scarce resources are used in the most efficient way.
   But, is monopolistic competition efficient as measure by our triple equation?

Productive and Allocative efficiency
   In monopolistic competition, neither productive nor allocative efficiency is achieved in long-run. Since in this kind of market system profit-maximizing price is slightly higher than lowest average total cost (ATC) then this results in productive inefficiency(society has to pay higher than optimal price for some goods). Also, firms in monopolistic competition have profit-maximizing prices which are higher than marginal cost (MC), that’s why monopolistic competition causes an underallocation of resources. Society values each addition unit of output higher than goods it would have to forgo to produce these items. That’s why monopolistic competition fails the allocative-efficiency test. Consumers pay higher than optimal price and get less than optimal output. Besides, monopolistic competitors must charge higher-than-optimal-price to get a normal profit.

Excess Capacity
   In monopolistic competition, the difference between the minimum average total cost (ATC) output and profit-maximizing output identifies excess capacity: underused plant or equipment because the firm produces less that minimum ATC output. If the monopolistic competitive firms produce at minimum ATC output, then the quantity supplied totally by all firms will be very high, so product will be sold at lower price. That’s why this type of market system is overcrowded by firms that produce bellow their optimal capacity. An example of this situation can be the high number of mini-markets or super-markets in each city that operates at less than their half capacity.

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Regulation of Monopoly

   Sometimes natural monopolies are subjected to price regulation (rate regulation), although more important for now is to deregulate those markets where competitions is possible. Some examples may be provincial and municipal commissions that regulate the price of gas, electricity that suppliers are charging.

   In the figure above it is presented the regulation of local monopoly, for example the distributor of electricity. In this figure there are plotted demand curve and cost curves that our supplier is facing. Because of economies of scale demand curve cuts ATC curve at a point where this curve is still falling, so it’s inefficient to have more firms in this industry because each of them would produce a smaller quantity of output, thus they will operate at a point which is much more inefficient than for just one operating firm, since in short run their ATC will be higher than for just one single firm. So in this case it’s better to have just one seller.
   We know from MR=MC rule that Q_m and P_m are profit maximizing output and price that is more likely to be chosen by monopolist. At the quantity Q_m the produce will enjoy an economic profit. Since price exceeds marginal then an underallocation of resources (allocative inefficiency) is being present. How can government regulate the price so that this will bring better results for the entire society?

Social Optimal Price P=MC
   If the regulatory commission has the task to achieve the allocative efficiency then it will attempt to set a price where P  will be equal with MC. Each point on demand curve shows a price-quantity combination. So, at point “r” we will have P_r which is equal to marginal cost.
   Confronted with price P_r monopolists will maximize profits or minimize losses by producing Q_r units of output. By making it illegal to charge a price higher than P_r , the firm won’t be able to produce other quantity of goods to increase the revenues.
   The regulatory commission can stimulate allocative efficiency to be produced by imposing the only legal price P_r and letting the monopolist to choose its profit-maximizing or loss-minimizing output. So, production will take place at point where P_r=MC, and this equality will indicate an efficient allocation of resources to this good or service. The price that achieves allocative efficiency is called socially optimal price.

Fair-Return Price P=ATC
   Social Optimal price, P_r, may be so low that the firm won’t be able to cover its average total costs (ATC). The result may be a loss for the firm. In our figure average total costs are more likely to be higher than P_r at the intersection of MR (P)=MC curve. Therefore forcing this firm to operate at social optimal price may result in short-run losses or even in bankruptcy in long-run.
   What to do in this case? One solution is to provide subsidies by government that will cover these losses. Another option for regulatory commission is to modify the allocative efficiency policy P=MC, so that firms may establish a fair-return price. In this case firms will have only a normal profit and this price is determined by intersection of ATC and demand curves (in our case point “f”). So P_f permits a fair returnfor firms. The corresponding output for this price will be Q_f. In this case the firm will realize only a normal profit.

Regulation’s Dilemma
   Comparing results given by socially optimal price (MC=P) and fair-return price (P=ATC) sometimes and dilemma, called dilemma of regulation arises. When the price is set to achieve allocative efficiency ( P=MC) regulated monopoly is more likely to suffer losses. Conversely, when the price is set for productive efficiency/ fair-return price (P=ATC) monopolists can cover its costs, but in this case underallocation of resources problem is solved only partially, since the quantity output increases from Q_m to Q_f, while the social optimal price is Q_r. Besides this dilemma regulations can improve results of monopoly from social point of view. Price regulation process reduces price, increases output, and reduces economic profit of monopolies.