64. Monopoly Regulation

• A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve.

• The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied.

• A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the

• lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency.

Efficient Regulation of a Natural Monopoly

• An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Q_m and sets a price of P_m. There is a deadweight loss.

• A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Q_mc and sets a price of P_mc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss.

• If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

• An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Q_ac and sets a price of P_ac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated.

• Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.

• Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

65. Efficient Regulation of a Natural Monopoly

An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Q_m and sets a price of P_m. There is a deadweight loss.

• A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Q_mc and sets a price of P_mc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss.

• If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

• An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Q_ac and sets a price of P_ac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated.

• Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.

• Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

• Because rate of return regulation does not give the firm the incentive to operate efficiently, price-cap regulation is now used more frequently.

66. A price-cap regulation

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

67. What Is Monopolistic Competition?

• Firms in monopolistic competition face competition from many other firms that produce a similar but differentiated product from its own.

• Firms in monopolistic competition maximize their profit by producing where MR = MC.

I. What Is Monopolistic Competition?

Monopolistic competition is a market structure in which:

• A large number of firms compete

• Each firm produces a differentiated product

• Firms compete on product quality, price, and marketing

• Firms are free to enter and exit

Large Number of Firms

• The large number of firms in a monopolistically competitive industry implies that each firm has a small market share, no firm can dictate market conditions, and collusion (conspiring to fix a higher price) is impossible.

Product Differentiation

• Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping.

Competing on Quality, Price, and Marketing

• Product differentiation allows a firm to compete with other firms in product quality, price, and marketing.

Entry and Exit

• With no barriers to entry, firms in monopolistically competitive industries make zero economic profit in the long run.

Examples of Monopolistic Competition

• Examples of a monopolistic industry include audio and video equipment, sporting goods, and jewelry.

68. Price and Output in Monopolistic Competition

Short-Run Output and Price Decision

• The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly). The downward sloping demand curve means that the firm’s marginal revenue curve also is downward sloping and lies below the demand curve.

• In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve, which, as noted, lies below the demand curve.

• The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $15 per pizza.

• The firm earns an economic profit if P > ATC (as is the case for the firm in the figure). If P = ATC, the firm earns zero economic profit, and if P < ATC, the firm incurs an economic loss.

• In the short run, profit maximizing quantity of output might be the loss minimizing quantity of output.

Long Run: Zero Economic Profit

• Unlike a monopoly, firms in monopolistic competition cannot earn economic profit in the long run. If the firms are earning an economic profit, other firms enter the market. Entry continues as long as firms in the industry earn an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward.

• Eventually the demand decreases enough so that the firms earn only a normal profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 10 pizzas per hour (where MR = MC) and sets a price of $7.50 per pizza.

Is Monopolistic Competition Efficient?

Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity

69. Product Development and Marketing

Innovation and Product Development

• Monopolistically competitive firms compete through product development and marketing. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation.

Advertising

• Advertising and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.

• Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. Advertising efforts are successful if they increase demand, which can lead to increased profit. But if all firms advertise, more firms might survive and so the demand for any one firm is less than otherwise.

• Heavy marketing and advertising expenditures are a signal to consumers of a high-quality product. A signal is an action taken by an informed person (or firm) to send a message to uninformed people.

• Advertising and brand names might be efficient if they provide consumers with information about the precise nature of product differences and about product quality. So the final verdict about the efficiency of monopolistic competition is ambiguous.