Government Intervention in

Response to Abuse of Market

Power
Unit 7 - Lesson 13
Learning outcomes:
● Define all terms in orange bold in section 7.7. (AO1)
● Discuss advantage and disadvantage to government response to abuse of
monopoly power including legislation, regulation, government ownership and
fines. (AO4)
Legislation to Reduce Monopoly Power
Legislation to Protect Competition

● Anti-trust legislation are laws that are imposed by governments to try and promote
competition and reduce/eliminate collusion.
● Firms that are shown to be in violation of these laws are usually required to pay fines.

Difficulties with Competition Policies:

● Difficulties in interpreting legislation.

○ Different people have different views
○ The laws may be vague
● Laws in different countries may be enforced to varying degrees depending on
ideological and political views.
● If firms collude it may be difficult for governments to identify or prove.
○ Both formal and tacit collusion are hard to identify and prove.
Legislation in the Case of Mergers
Legislation in the Case of Mergers
● A merger is an agreement between two or more firms to join together and
become a single firm.
○ Reasons for mergers include:
■ Economies of Scale
■ Interest in firm growth
■ Interest in acquiring monopoly power
● Mergers are an issue as the joining of two or more firms into one may result in
increased market power.
○ Legislation is introduced to limit the size and power of the firm(s).
Difficulties with Mergers:
● What firms should be allowed to merge and which firms should not be allowed?
Regulation of Natural Monopoly
If there exists a Natural Monopoly it may
not be in the interest of the government to
break the Natural Monopoly up as this
would result in higher Average Costs for
the firm resulting in higher prices for the
consumer.
● However, Natural Monopolies
produce a smaller quantity than what
is socially optimal (Qpm is less
than Qae).
● Natural Monopoly makes a Abnormal
profit of area A
Regulation of Natural Monopoly
● Governments usually regulate Natural
Monopolies to ensure socially desirable
pricing and quantity.
○ Margin Cost Pricing
○ Average Cost Pricing

Margin Cost Pricing

● Best policy is to force the Monopoly to

charge a Price (P) equal to the Marginal
Cost (MC) - Point b
○ We know that a market is
allocatively efficient if Price (P) is
equal to Marginal Cost (MC).
Margin Cost Pricing
Margin Cost Pricing
● Government response requiring Margin
Cost Pricing is beneficial as:
○ The Monopolist is Allocatively Efficient
■ Charge the Socially Optimal
Price (Pae instead of Ppm)
■ Produce the Socially Optimal
Quantity (Qae instead of Qpm).
However,
● Margin Cost Pricing leads to a loss for the
Natural Monopolist as:
○ Price (P) point b is less than Average
Total Cost (ATC) pont a at Qae.
Margin Cost Pricing
● Although Regulation by using
Margin Cost pricing will bring
about Allocative Efficiency (Price
is equal to Marginal Cost)
○ Consumers pay a lower price
(Pae instead of Ppm)
○ Consumers receive a larger
Quantity (Qae instead of Qpm)

However, it is impractical as the losses

experienced would force the Natural
Monopoly to shut-down in the
long-run.
Average Cost Pricing

● To avoid the Natural Monopolist from

experiencing losses and shutting down
in the long run, a government may require
the firm to charge a price (P) equal to
Average Total Cost (ATC).
○ This is called Average Cost Pricing
or Fair Return Pricing
○ Average Cost Pricing result in Price
(Pac) and a Quantity (Qac)
● At this point the Natural Monopolist is
making Normal (Zero Economic) Profit.
Average Cost Pricing

Average Cost Pricing results in:

● A higher Price (Pac instead of Pae)
and lower Quantity (Qac instead of
Qae) than Margin Cost Pricing.
However,
● The Natural Monopolist will no
longer be making an Economic
Loss as is the case when Margin
Cost Pricing is implemented.
● The Natural Monopolist will be
making Normal Profit.
Average Cost Pricing
Average Cost Pricing has two very
distinct advantages:

● The Natural Monopolist is making

Normal Profit and therefore will not
need to shut-down.
● Though not Allocatively Efficient
(Pae, Qae), Average Cost Pricing is
more efficient (Pac, Qac) than the
Natural Monopolist producing the
Profit Maximising Quantity of output
(Ppm, Qpm).
Average Cost Pricing
Average Cost Pricing does have
disadvantages:

● A Natural Monopolist in a free

unregulated market is incentivized
to keep their cost low in order to
maximise profits.
● If through regulation that it is
guaranteed that Price is equal to
Average Total Cost then the
Monopolist loses the incentive to
keep costs low knowing they will
always make normal profit.