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.

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Effect of International Trade and Specialization on PPC (summary)

Production possibilities analysis implies that a nation is limited to the combinations of output indicated by its production possibilities curve. But we must modify this principle when international specialization and trade exist.

An economy can avoid, through international specialization and trade, the output limits imposed by its domestic production pos­sibilities curve. International specialization means directing domestic resources to out­put that a nation is highly efficient at producing. International trade involves the exchange of these goods for goods produced abroad. Specialization and trade enable a nation to get more of a desired good at less sacrifice of some other good. Specialization and trade have the same effect as having more and better resources or discovering improved production techniques; both increase the quan­tities of capital and consumer goods available to society.

Present Choices and Future Possibilities

An economy’s current position on its production possibilities curve is a basic determinant of the future location of that curve. Let’s designate the two axes of the production possibilities curve as goods for the future and goods for the resent. Goods for the future are such things as capital goods, research and edu­cation, and preventive medicine. They increase the quantity and quality of property resources, enlarge the stock of technological information, and improve the quality of human resources. Goods for the future, like industrial robots, are the ingredients of economic growth. Goods for the present are pure con­sumer goods, such as pizza, clothing, and soft drinks.

Now suppose there are two economies, Alfa and Beta, which are initially identi­cal in every respect except one: Alfa’s current choice of positions on its production possibilities curve strongly favors present goods over future goods. Point A indicates that choice. It is located quite far down the curve to the right, indicating a high priority for goods for the present, at the expense of fewer goods for the future. Beta, in contrast, makes a current choice that stresses larger amounts of future goods and smaller amounts of present goods, as shown by point B.

Other things equal, we can expect the future production possibilities curve of Beta to be farther to the right than Alfa’s curve. By currently choosing an output more favorable to technological advances and to increases in the quantity and quality of resources, Beta will achieve greater economic growth than Alfa. In terms of capital goods, Beta is choosing to make larger current additions to its “national factory”—to invest more of its current output—than Alfa. The payoff from this choice for Beta is more rapid growth—greater future production capacity. The opportunity cost is fewer consumer goods in the present for Beta to enjoy.

Is Beta’s choice thus “better” than Alfa’s? That, we cannot say. The different out­comes simply reflect different preferences and priorities in the two countries.