Nov 11 2007
Monopoly prices - to regulate or not to regulate, that is the question!
Published by Jason Welker at 11:56 am under
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WikipediaCompetitively Priced Electricity Costs More, Studies Show - New York Times
The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry.
A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.
Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)
Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).
Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.
The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:
“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.
The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”
The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:
“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.
In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…
In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”
That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).
Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.
Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.
Discussion Questions:
- Why do governments regulate the prices in industries such as natural gas and electricity?
- Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
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About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". 
I believe that all monopolies except natural monopolies should be regulated by the government to some extent. Let’s face it, no one wants to get ripped off by monopolies who are charging outrageous prices for their product. It is never wise to regulate a natural monopoly because it is most effective if a firm has a natural monopoly and if there is a price ceiling, it will hurt both the firm and society as well because there are no other substitutes for that natural monopoly and it is not efficient for other companies to produce the same product.
Governments regulate the prices in industries such as natural gas and electricity because these natural monopolies result in allocative inefficiencies. Since these monopolies, like any other firms, seek to maximize profits, they will produce at a level were MR = MC. But because a monopoly’s MR is less than price, the MC at that level will be less than price, which means allocative inefficiency, or that consumers are demanding more than what is actually produced. In other words, an underallocation of resources will occur in the monopoly, as the monopolist will limit its supply to keep its price at the profit-maximizing level, and there will be a loss in consumer surplus, as the price will be too high for some consumers. Therefore, the government steps in to set a price ceiling where the price equals to the marginal cost, thus resulting in allocative efficiency. But because this price is usually below the monopolist’s ATC, the government resorts to the alternative of setting the price ceiling where price equals to the firm’s ATC, or the “fair-return price”, where the monopolist will earn a normal profit.
De-regulation of the electricity industry might eventually result in lower prices in the long-run because the removal of price ceilings would lead to greater economic profits, thus attracting new firms into the industry. Increased competition would then force greater productive efficiency from the firms in the industry, who with lower costs, can sell their product/service at a lower price than its competitors, thus driving the price down closer to the price where allocative efficiency is achieved.
Monopolies are not allocatively or productively efficient, meaning, they are market failures. Which is why governments set price ceilings inorder to insure efficiency and prevent market failure. This also prevents the monololist from setting so high a price, some consumers cannot or are not willing to pay.
If governments deregulate electricity, the idea is that the high profits earned would attract new firms which would increase competition, and consequently, drive prices down. This would ensure productive and allocative efficiency which is good for the market.
Well, first of all natural gas and electricity are primarily considered by most people to be inelastic goods. Even if natural gas and electricity are expensive, consumers will still buy them because they are important to have. I mean I’m pretty sure that if the price of electricity was a huge rip off, my parents would still pay for it because we need lights to see at night time and power for computers to do work. Therefore, government regulates the electricity and natural gas industries, since they would otherwise be able to charge ridiculous prices and still make a hefty profit.
In contrast, however, deregulation would allow consumers to get sick of the high prices and begin to look for alternatives. This would, therefore, open up more competition. In the end, the monopoly would either have to significantly cut down its prices, or new firms entering the industry would be able to steal consumers. However, entry into an industry with a monopoly is very difficult and that could be an explanation as to why prices of electricity have only risen.
Contrary to the general thought that government intervention in economics actually harms the economy, regulations for a monopoly actually benefits society. The price ceiling at P=MC allows for greater allocative efficiency, and also increases total surplus, and removes deadweight loss. Utilities such as water and electricity are basically inelastic, and it is completely unfair for these natural monopolies to simply charge whatever they want. Governments still act in the interests of the people, and thus regulating some monopolies serve that very just purpose.
All natural monopoly need government regulation to control a monopoly from manipulating people’s inelastic needs for utility service. But recently, state governments have been de-regulating monopolies, believing that increased competition would force firms to more productively efficient; however, the governments neglect the higher ATC when a natural monopoly dissolves into several smaller firms.
1. Governments regulate the prices in industries such as natural gas and electricity because these industries are natural monopolies. The nature of these markets, in which great economies of scale are extended over a wide range of output, leads to a natural monopoly in which the single producer who controls the entire industry is apt to set profit-maximizing price and output. However, at the monopolist’s profit-maximizing price and output, P doesn’t equal MC, and so resources are underallocated; this is why governments might regulate the prices in such industries- in order to try to push the industry into better allocative and productive efficiency.
2. A state government would think that de-regulation of the electricity industry might eventually result in lower prices in the long run because of the theory that de-regulation would leave the electricity firms free to set high prices and earn more profit. This profit would attract new firms into the market, creating more competition and thus driving the prices downwards. In reality, however, this theory has been proven wrong as the economies of scale in this naturally monopolistic market have led to increased costs as new firms attempt to enter the market, only driving prices higher than ever before.
It’s clear that the reason why the deregulation of the industry did not attract many other firms into the industry is because of high barriers to entry, mostly caused by economies of scale. Obviously, many firms would be attracted to the lucrative profits which a pure monopolist is receiving, but since the production of electricity is so costly, it would be extremely difficult for new firms to compete with the currently monopolistic firm, thus there was no drive down of price. This is the reason why governments regulate natural monopolies in the first place. If firms could so easily enter the industry, then there would be no need for regulation since the natural state of things would be for equilibrium to be restored through an influx of producers. Therefore there should be less regulation of competitive industries, but natural monopolies should certainly be regulated
1.Governments regulate the prices in industries such as natural gas and electricity because set a price ceiling where the price is equal to the firm’s average total cost, meaning the firms would be earning only a normal profit; just enough to keep the firm in business instead of charging high price to earn high profits.
2.A state government thinks that de-regulation of the electricity industry might eventually result in lower prices in the long-run because if the price is too high, less people would be willing to buy it; therefore, less profits would earned. In order to maximize profits, firms needs to lower price eventually.
Governments regulate monopolies that are crucial to everyday life (such as electricity and water) so that more consumers are able to obtain these goods. The companies that governments usually regulate are the firms that produce necessities, so the government needs to make sure that the lower-income families are also able to pay for these non-luxurious goods. If they were merely luxuries, then the government has no reason to regulate its price.
Even though in the long-run, this deregulation may lower the prices of these goods, this will take a long time since these monopolies have reached such a large economies of scale. It will be years (maybe even decades) until it’s possible. Therefore, during these years while other companies are trying to build up its size to compete, the consumers are going to be suffering.
But another way to look at it is that it’s a small price to pay for lower prices in the future.
1. Governments regulate the prices in industries such as the natural gas and electricity because the two are natural monopolies. And also the two industries listed are necessities to everyday life. As we discussed in class the other day, by regulating the price, governments can help the lower income families by providing accessible necessities.
2. Deregulation of the electricity industry might eventually result in lower prices in the long-run because it would let other companies have no restriction in setting higher prices to make more profits. In time consumers are only going to look for other alternatives.
1.Prices would be regulated by the government in order for Natural Monopolies to become allocatively efficient. By looking at the graph above, all profit maximizing firms will produce where Marginal Revenue will equal Marginal costs. The problem producing at that point is that the firm is allocatively inefficient where price does not equal marginal costs. Therefore, governments will try to regulate the price of such firms so that those firms will achieve P=MC or allocative efficiency.
2.The government believes that deregulating prices for those industries will eventually drive prices down because of increasing profits for the industry. With increasing profits, other firms will be attracted to the sweet, delicious smell of “profit pie” thus creating competition within that industry. With increasing competition, prices will be driven down to the socially optimal price thus achieving what the government wanted in the first place.
They must reach allocatively efficient areas. The government needs to have these necessities being produced at the right amount so that there won’t be shortages for something as crucial as electricity for people.
De-regulating the industry might cause other firms to come in and COMPETE with the established ones. However, this is not the case because of ECONOMIES OF SCALE. Natural monopolies are better because they are generally more efficient and cost less than if a competing firm was to enter and cause ATC to be higher for both.
1. Natural gas and electricity are natural monopolies, meaning they have extended economies of scale. Since they’re profit-maximizing, they tend to produce at a quantity where MC=MR; this is a lower quantity and higher price than would make it allocatively or productively efficient, and resources are underallocated. Governments would thus try to control the monopoly by setting a price ceiling in an attempt to produce greater efficiency. However, this usually doesn’t work either, as the socially-optimal (or allocatively efficient) output and price where P=MC often falls below the minimum ATC, causing the monopoly to operate at a loss and eventually shut down. The compromise is the fair returns point, at which P=ATC, so the firm is at least making a normal profit and is more efficient than at the profit max point.
2. Deregulation, in theory, allows monopolists to set higher prices and earn an economic profit, thereby attracting more firms into the industry and driving down the prices in the long-run. However, the nature of such natural monopolies prevents this from actually happening; the great economies of scale make it difficult for new firms to enter into the market, and would result in overall inefficiency.
A bit tangential, but is it that bad that gas prices are so high? Maybe it’ll finally push some people towards alt. energy sources..
Governments regulate the prices in such industries because they are necessities and therefore their prices should be low enough for everyone to have an access. So government can help lower income families to purchase those good by regulating the industries.
Because de-regulation will mean that the price of electricities will be really high, earning firms in that industry profit, and therefore will attract new firms to enter the industry. And profit brings down the price. But in the case of such natural monopolies, since it is hard for new firms to enter the industry, the price will remain high and the overall efficiency will drop.
The thing with natural monopolies is that most of them are bare necessities. From the people living on government aid to the millionaires, we need these utilities, thus it is the government’s role to make it affordable to everyone. For other monopolies such as De Beers’ Diamonds, it is more of a luxury good and is not necessary for our survival. Thus keeping these unregulated is not as big of an issue as the utilities.
As for de-regulation, the consumer will suffer for the period of transition until a new firm steps in to challenge/compete with the existing monopoly. However, even after deregulation it may be too difficult for other firms to enter and gain market power. The original monopoly is already so vast and branched out that the new firm may not have enough money for the overhead costs.
Governments regulate the prices in industries such as natural gas and electricity because those products are necessities. Every human beings need those products to carry on their lives. Since people know that without those products they will not be able to survive, they will pay to purchase those products even if they are sold at extremely high price. Therefore, government should restrict the firms who always try to make the most profit.
However, some state government thinks that de-regulation of the electricity industry might eventually result in lower prices in the long-run because at first the de-regulation gives high profits to the firm but eventually more firms will be interested in this market and join in. If more companies join in, the firms will compete each other and the price will eventually drop. However, this is only in a long run, at least more than 3 years.
Governments regulate industries that produce necessities such as these because they are just that, necessities. Some people cannot afford the good at the monopolistic price and therefore governments need to regulate these prices. More so, profits are evidently not producing more competition and therefore defeats the purpose of allowing free markets.
They would think de-regualtion would result in lower prices because the profits of the industry would attract new firms creating competition and consequently creating efficiency.
I think monopolies would be better if they were not regulated in the long run. Because as we can see from the fuel market that there have been no advances in technology for the last few decades and this is because companies are not willing to and possibly not able to spend money on technological advancements which would bring greater production efficiency. If monopolies were allowed to grow by themselves, in the end they would all be able to make a profit at the price where most people could afford it because of economies of scale and technological advancements.