Mar 04 2013

Monopoly prices – to regulate or not to regulate, that is the question!

Competitively 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.Regulated Monopoly 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”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

YouTube Preview Image

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:

  1. Why do governments regulate the prices in industries such as natural gas and electricity?
  2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
  3. Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
  4. What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

254 responses so far

254 Responses to “Monopoly prices – to regulate or not to regulate, that is the question!”

  1. jduplessison 22 Feb 2013 at 7:00 pm

    # DBharwani
    I agree.
    I believe that it is the duty of the government to serve the people.

  2. jlamunoon 22 Feb 2013 at 8:46 pm

    Why do governments regulate the prices in industries such as natural gas and electricity?

    Electricity and natural gas are necessities, which means that they are inelastic. Without a regulation in their price companies (who are monopolies) would seek to maximize profit by raising the price exponentially. In turn this would cause a very un-balanced economy

    Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?

    Because even though in the short run the profit will be very big, in the long-run other firms will attempt to get in on the action. Just like the cellphone industry, when at first phones were very expensive to buy and maintain then now a days cellphones are given away as long as you make a commitment to the company with a contract, the electricity industry would branch out into multiple major companies who would then implement competitive prices to beat the other firms.

  3. jlamunoon 22 Feb 2013 at 8:49 pm

    @jduplessis

    Very good answers. I completely agree with your points. Monopolies seek to maximize profit without a care for efficiency, and if allowed to raise the price without limit the firms currently supplying us with electricity and gas they would take away all consumer surplus without a blink of an eye

  4. mchastanet2on 13 Mar 2013 at 5:45 pm

    Why do governments regulate the prices in industries such as natural gas and electricity?

    Because companies tend to abuse from the consumers. Electricity and natural gas is primordial for most people, so people are ready to pay a lot to have those products. So firms usually increase their price since the products are inelastic( demand won’t change whatever the price is) . So if government don’t regulate companies will abuse consumers by putting high prices.

    Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?

    Because the monopoly will start to make a lot of profit, so may new firms will try enter the market seeing this great opportunity. So the price will start falling ( much more supply) until everyone makes normal profit.

  5. mchastanet2on 13 Mar 2013 at 5:49 pm

    # avonwendorff

    Hey!

    i totally agree with your answers.

    i really liked the first answer ” governements are created to fullfill the needs of its people” that just says it all. Of course it has to take a fair party between the consumers and the firms.

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