Regulation and Economic Efficiency

Unregulated, profit maximizing monopolies result in economic inefficiency. In most countries, monopolies are subject to government regulation. For example, public utilities require government approval before instituting a price change. Or economic efficiency might be achieved by replacing a monopolist with competitive firms. In an industry without economies of scale, monopoly price will be higher and quantity will be lower than if the industry were composed of many competitive firms. Thus in industries without economies of scale, the government could achieve economic efficiency by splitting the monopoly into many competitive firms.

Where substantial economies of scale exist, however, society will be worse off if the government splits the monopoly into many firms, because each firm’s total costs will be much higher. The total industry output will be less, and will be sold at a higher price than that charged by the monopolist. Economic efficiency will prevail but society will be worse off. Also, no individual firm will be in long run equilibrium. In the long run, there are no “existing” firms, so the long run average cost curve is the same as that of the monopolist—meaning that all the small firms will want to expand output and increase plant size in the long—eventually, if left unregulated, resulting in another monopoly.

When substantial economies of scale exist and government regulation of a monopoly is desired, the regulation must attempt to equate price with long run marginal cost. The monopoly firm’s profit maximizing behavior will then result in the short-run marginal cost also being equated with price. Under perfect competition, the price would also equal minimum ATC and minimum LRAC, because firms enter and leave the industry at will. However, there is no guarantee this would be the case under a regulated monopoly. If above-normal profit exists (ie, price is higher than LRAC), at least one factor of production will earn higher than normal returns, resulting in a desire for resources to move into the industry—although this desire may not be actionable. The government can remove the above-normal profit by applying a tax. Conversely, if LRAC is higher than price, at least one factor of production will earn a below-normal return and will therefore desire to leave the industry. The government will have to provide a subsidy if it wants resources to remain in the industry. Alternatively, the firm could be permitted to set price higher than marginal cost, although a loss of economic efficiency will result.

Regulation itself requires resources. Empirical evidence suggests that in certain major industries, regulation is worthwhile, but in many imperfectly competitive industries the costs of regulation would exceed the benefits.