Just to recap what we said about monopoly: Why do people consider the monopolist to be the bad guy? It's because the monopolist charges more money and provides less to the market than a competitive market would. Which people consider this to be bad? Certainly not monopolist! Consumers view a monopoly is bad. Now, if it were the case that consumers lose a dollar, and the monopolist gains a dollar, the government (who's interested in NET social welfare) wouldn’t care; but the fact of the matter is that for every one dollar gained by the monopolist, many dollars are lost by consumers. So the government frowns on monopoly, as well. The problem is that not all monopolies are bad. Some types of monopoly are actually more efficient than a competitive market. Remember when we talked about natural monopolies? Natural monopolies occur when the startup costs are so large that effectively, the average total cost is always declining; if you produce more, you continue to defray the enormous fixed cost. Remember that in the case of a natural monopoly, it's actually much better to have one producer provide all the units (say, 100 units) at a very low cost per unit, than to have 10 producers provide only 10 units each, at a very high cost per unit. Let's take a closer look at a profit-maximizing natural monopolist, a producer whose cost curves are always declining. Now, add demand and marginal revenue. Where is maximum profit, and how much is earned? As always, the output is determined where MR=MC (marginal revenue equals marginal cost), and AT that level of output, the price is determined by looking at the demand curve. This monopolist earns everything above its cost per unit (average total cost), up to its price. That’s a lot of profit! Now, what happens if the government steps in and tries to make this firm behave more like a competitive industry? In a competitive market, price ends up being equal to marginal cost, and this somehow seems fair to us, because then the price tag is just equal to the additional cost on last unit produced. What happens if the government decides to subject the natural monopolist to marginal cost pricing? Start with the basic natural monopoly diagram -- I’m showing the unregulated decision, just for comparison purposes -- where is this producer forced to operate under marginal-cost pricing regulation? Remember that the demand line shows the prices, so price equals marginal cost where the demand and marginal cost intersect. Under regulation the government and consumers are very happy. For example, if this is an electricity producer, then lots of power is being provided at a very low price. Who is not happy with this scenario? The monopolist. Under marginal-cost pricing regulation, the monopolist loses the difference between its per unit cost and the price it’s allowed to charge, on every unit -- and that’s a lot of units. If you were this producer, what would you do? I know what I would do: get out at the first opportunity. A MC-pricing regulated monopoly will lose money, so it will exit the industry. But then there's no one to produce the product, and we're all left without! Again, imagine the power producer. What we do with no power being produced? What now? Well, the government is going to have to figure out some way to persuade the monopolist to stay. Now, the government wants to be careful, because it wants to cover the firm's losses, but not go so far as to give the monopoly positive profits, because this would probably anger consumers. There are a few options. 1) subsidize the monopoly to the tune of average total cost minus the regulated price on each unit, to just cover the loss. This might not go over too well with voters, because taxpayer dollars are used to pay a monopoly, but effectively what's being done is a redistribution: the wealthier pay more taxes so that everyone, especially the poor, can afford electricity. Option 2) instead of paying the monopolist, the government could just allow it a slightly higher price, such that they can just break even. This would be average-cost pricing regulation. It results in a slightly higher price and slightly less output than marginal-cost pricing, but does not cause the losses that would result in the monopolist exiting the industry. Option 3) There is a third method that the government could use: allow the monopolist to price discriminate. Price discrimination means that the producer can charge different prices to different customers for the same product. This would allow the monopolist to get more money from its customers, while no one pays more than they're willing to pay for the product. Of course, from the producer’s standpoint, perfect price discrimination would be ideal, where each customer pays exactly his/her maximum willingness to pay, but how could this be done? You can't exactly go door-to-door, asking each customer how much he/she would be willing to pay, because those customers don't have any incentive to be truthful with you. In fact, they have every incentive NOT to be truthful. Instead, producers find ways of capturing blocks of customers. For example, a producer can use peak/off-peak pricing system; when customer demand is highest and most inelastic, you can charge more; when the demand is lowest and most elastic, you charge less. This model is used for electricity, bus fare, movies, etc. It's also possible to price discriminate against the people with the highest opportunity cost of their time, by way of coupons and rebates. A very busy person doesn't bother with coupons, and often forgets to mail in, or follow up on, a rebate. Blatant price discrimination is typically illegal, but there are ways to indirectly price discriminate. NEXT TIME: Oligopoly TRANSCRIPT00(MICRO) EPISODE 28: REGULATION