1

Price control by Commerce Commission Justified under Monopoly- but what happens?

Previously, neoclassical view: GE under perfect competition led to (a) Price = MC

(b) Price = min. ATC and (c) markets all cleared.

And any state interference in free markets would lead to sub-optimal results unless there existed monopoly or externalities.

With monopoly, negative impacts on the economy: Price not = MC, Price > ATC

And failure of consumer efficiency; production efficiency; and allocative efficiency.

Can the State interfere to eliminate all the negative impacts?

Many countries have price regulation institutions “Prices and Incomes Board” or “Commerce Commission” etc which are legally empowered to regulate prices in the economy if it is thought that without the regulation, there are negative impacts in the economy.

Q1: what criterion should the state use to determine prices?

Q2: Is it possible for the State to eliminate all the negative consequences of monopoly?

2

Reminder: impact of monopolyOutput Qm < than under perfect competition : govt “decree” that monopolist sell more?

Price Pm > MC : could govt decree that price be reduced to MC?

Price > ATC > min ATC. (super-profits are being made): decree that price be brought down to = min. ATC?

MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G

H

3

Q: what is the primary government objective in price control?

Logically: to achieve the “good results” of Perfect Competition.

Ensure economic efficiency? ie ensure that price charged = MC?

Ensure that there are no super-profits? Price charged is the minimum of the ATC?

Ensure that all markets must be cleared: no excess supply or demand at prevailing price

What about maximising consumer surplus?

Can all be satisfied together? MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G

4

Many points on the diagram: where price ceiling could be setLook at the position of the :

Where D curve is cut by MC, or by ATC

Or where MR curve cuts MC or ATC

Or where ATC is minimum.

MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G* *

** *

*

5

Profit maximising output for monopolist still determined by MR = MC rule

With a price ceiling, what does the “revised MR curve” MRp looks like?

Suppose objective is economic efficiency: want price to = MC: where on the graph?

Could be where MC cuts the Demand curve OR

Where original MR curve cuts the MC curve.

MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G

H

**

6

Price ceiling gives maximum price that can be charged:

eg if price ceiling is set at Pc (where MC curve cuts the Demand curve)

Up to the output at H, the monopolist can only charge price Pc

Which therefore becomes the MR up to that point H

MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G

H

Pc

7

New MR curve is a kinked line

Thereafter, since a lower price can be charged, the MR curve drops to the usual dotted line.

To find profit-maximising output, equate the new MRc to the MC curve-

MC

D

MR

$

q

ATCPm

C

E

F

OQm

A

G

H

Pc=MR

MRc

8

MRc intersects the MC curve at point H

Hence output under the price ceiling = Qc which is > Qm (ie output higher)

Equilibrium price = OPc which is < Pm (price is lower) i.e consumer surplus increased.

Price also = MC (hence economic efficiency: no dead-weight loss)

MC

D

MR

$

q

ATCPm

Cm

E

F

OQm

A

G

H

Pc

MRc

Qc

Cc J

9

But price and ATC?

Pc still > ATC (Cc) ie super-profits exist.

Are super-profits greater or less than before? (note price lower, but sales higher).

MUST be lower. Why? Bonus mark. Logical deduction.

Previously the monopolist was free to charge price Pc himself- if he chose Pm rather than price Pc, then profits must be higher at price Pm.

MC

D

MR

$

q

ATCPm

Cm

E

F

OQm

A

G

H

Pc

MRc

Qc

Cc J

10

Are the markets cleared at price Pc?

i.e. is equilibrium output = demand at price Pc? Yes.

Is the price being charged = min. of ATC? No.

MC

D

MR

$

q

ATCPm

Cm

E

F

OQm

A

G

H

Pc

MRc

Qc

Cc J

11

In summary, with the price ceiling at point H

Quantity consumed has increased

Price has decreased (consumer surplus has increased)

Pc = MC hence economic efficiency, and no dead-weight loss now.

Demand = Supply

Super-profits have reduced (but not zero)

and Price not equal to min. of ATC.

MC

D

MR

$

q

ATCPm

Cm

E

F

OQm

A

G

H

Pc

MRc

Qc

Cc J

12

Suppose government tries to eliminate super-profits

Brings down the price ceiling further to correspond to the point K where the ATC intersects the demand curve: where firm, if it operates there, will make “normal” profits.

But will this eliminate super-profits?

The revised MR curve is as shown: where does it intersect the MC curve? At J

Output Qc is higher than under free monopoly, but less than under the previous price ceiling.

MC

D

MR

$

q

ATCPm

Cc

E

F

OQm

A

GK

Pc

MRc

Qc

J

13

Do we have economic efficiency? Is P = MC?

Yes: Pc = MC at output Qc.

MC

D

MR

$

q

ATCPm

Cc

E

F

OQm

A

GK

Pc

MRc

Qc

J

14

Are the markets cleared? Supply? Demand?

Supply = OQc = PcJ But demand = PcK i.e unsatisfied demand = JK

Result: black markets

Result: “Twinning”

MC

D

MR

$

q

ATCPm

Cc

E

F

OQm

A

GK

Pc

MRc

Qc

J

15

And oddly enough: super-profits have not been eliminated

Super-profits = CcPcJL.

In tutorials examine where the price ceiling would have to be so that at profit maximising output level, super-profits will be eliminated. And explain other consequences.

MC

D

MR

$

q

ATCPm

Cc

E

F

OQm

A

GK

Pc

MRc

Qc

J

L

16

2 Bonus marks: the real world

How control petroleum prices?

What are the advantages and disadvantages associated with setting

Fixed Margins: dollar amounts

Percentage amounts?

Same for all items?

How control hardware merchants’ profiteering?

Fixed Margins: dollar amounts

Percentage amounts?

Same for all items?