Role of Government in a Market Economy

The goal of antitrust is to increase competition and improve the efficiency of markets. However, breaking up a monopoly is not necessarily in the interest of economic efficiency. In the provision of certain utilities such as water, it is efficient for more than one company to deliver the product to households. To provide its services, a water company must dig up the stretchy lay by water pipes, and maintain them. It would be inefficient to have to companies supply the water because that would require two sets of pipes and would be a duplication of reserves.

The natural monopoly is a single firm in an industry in which average total cost (ATC) is declining over the entire range of production and the minimum efficient scale is larger than the size of the market.

Economies of Scale and Natural Monopolies

A natural monopoly is a declining average total cost curve. ATC declines as more is produced because fixed costs are very large compared to variable costs. A large initial expenditure is necessary to lay the main water pipes at main electrical lines but therefore the cost is relatively low. The more houses that are hooked up, the less the ATC is relatively low. When the long-run average total cost curve declines, there are economies of scale. It can be shown in the figure as:
The figure shows that why one firm can always produce more cheaply than more than one firm which ATC curve is downward sloping. If two firms divide up the market than the ATC is higher than if one firm produces for the entire market. It is more costly for more firms to produce a given quantity in case of a declining ATC curve than for one firm.

Alternative Methods of Regulation

The question arises what may be the best government policy toward a natural monopoly. Having one firm is an industry lowers the cost of production, but there will be inefficiencies associated with a monopoly price will be higher than marginal cost, and there will be dead weights loss. To get both the advantages of one firm producing and competition like behavior the government can either run the firm and regulate the firm.

The monopoly price and quantity of a natural monopoly with declining ATC are shown in the figure below. The monopoly quantity occurs where MR equals MC, the profit maximizing point for the monopolist. The monopoly price is above MC. If the firm’s price was regulated, then the government could require the firm to set a lower price, thereby raising output and eliminating some of the dead-weight loss associated with the monopoly. There are three ways for the government to regulate the price as below.

a) Marginal Cost Pricing

The process of setting monopoly price equals to marginal cost is said to be marginal cost pricing. The declining ATC, the MC is lower than ATC. It is shown in the figure as below:
Where MC is constant. Thus, if price were equal to MC, the price would be less than ATC and the monopoly’s profits would be negative. Therefore would be no incentive for any firm to come into the market.

As shown in figure, two alternatives marginal cost pricing and average total cost pricing are compared with the monopoly price. Marginal cost pricing given the greatest quantity supplied, but because price is less than ATC, the firm comes negative profits. ATC pricing results in a larger growth supplied and the firm earns zero economic profits.

b) Average Total Cost Pricing (ATC)

This is the method of regulation would have the firm set the price equal to ATC. It is also represented in the above figure. When price is equal ATC, the economic profits will be equal to zero; there will be enough to pay the managers and the investors in the firm there opportunity costs. Although price is still above MC, it is less than the monopoly price and dead weight loss will be smaller.

But there are some serious problems with ATC pricing. Suppose the firm knows that whatever its ATC is, it will be allowed to change a price equal to ATC. In that situation, there is no incentive to reduce costs. With the regulatory scheme which the price equals ATC, the price would rise by any increase in cost. Inefficiencies could occur with no penalty whatever. This approach provides neither an incentive to reduce costs not a penalty to avoid increasing costs on the part of the management and the workers of the regulated firm.

c) Incentive Regulations

There is third regulation method endeavors to deal with the problem that ATC pricing provides to little incentive to keep cost low. It is a relatively new idea but it is quickly spreading and most predict it is the way of the future. The method project a regulated price out over a number of years. The price can be based on an estimated of ATC. The regulated firm is said that the projected price will not be revised upward or downward for a number of years. If the regulated firm achieves ATC lower than the price, it will be able to keep the profits, on perhaps pass on some of profits to a worker who came up with the idea for the innovation. Similarly, if supply management causes ATC to rise, then profits will fall because the regulatory agency will not revise the price.

Thus, under incentive regulation, the regulated price is only imperfectly related to ATC. The firm has a profit incentive to reduce costs. If a firm does poorly it pays the penalty in terms of lower profits or losses. Under incentive regulation, the incentives can be adjusted. Incentive regulation is sometimes made difficult by asymmetric information problems. The regulated firm knows more than the regulator about its equipment, technology and workers. Thus, the firm can mislead the regulator and say its ATC is higher than it actually is in order to get a higher price as shown in the following figure.

d) Price Discrimination

Many natural monopolies are allowed to price discriminate. Monopolists can increase their TR and profits for a given level of output by practicing price discrimination. One form of price discrimination occurs when the monopolist charges different prices for the same commodity in different markets in such a way that the last unit of the commodity sold in each market gives the same MR.

Sometimes, the government can run natural monopoly itself rather than regulate a private firm. Nepal Government has natural monopoly in utilities sectors.

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