TC KEY

7.7: GOVERNMENT INTERVENTION IN

RESPONSE TO ABUSE OF MARKET POWER

Instructions: Read topic 7.7 of the textbook. Answer the questions which follow

1. Summarize the potential advantages (benefits) and disadvantages (risks) of large firms,
such as monopoly and oligopoly, with significant market power.

Advantages (benefits) Disadvantages (risks)

● Economies of scale & natural ● Allocative inefficiency & Welfare loss

monopolies ● Higher prices & Lower output
● Ability of firms to carry out R&D on ● Loss of consumer surplus to larger firm
new product and technology or firms
development ● Negative impact on distribution of
income
● Higher than necessary average costs
due to lack of competition
● Possibly less innovation

2. What is meant by the phrase “abuse of market power”? Provide examples of abuse of
market power.
Refers to situations where firms engage in activities that result in reduced competition.
Examples:
● Charging unreasonably high prices
● Depriving smaller competitors of customers by selling at artificially low prices they
cannot compete with
● Creating high barriers to entry (obstructing competitors in the market)
● Refusing to deal with certain customers or offering special discounts to customer
who buy all or most of their supplies from the dominant company
● Making sale of one product conditional on sale of another product

3. Firms facing a downward sloping demand curve (i.e. monopoly, oligopoly and
monopolistic competition) have varying degrees of market power. Do they all abuse
market power? Briefly explain

Monopolies ● Generally, have highest degree of market power

● It is abusive power due to lack of competition
● This is why private, unregulated monopolies are illegal in most
companies

Oligopolies ● May or may not abuse their market power

● Market power of collusive oligopoly is similar to that of a monopoly
 and represents a form of abuse of power → this is also why collusive
oligopolies are illegal in most countries
● Non-collusive oligopolies may or may not abuse their market power

Monopolistic ● Have less market power

Competition ● For the most part, do not abuse it because of significant competition
and because there are substitutes

4. Outline the advantages and disadvantages of the following possible government

interventions to deal with abuse of power:

Legislation to Intervention:
protect competition Legislation to prevent collusion between oligopolistic firms and
prevent anti-competitive behaviour by a single firm dominating the
market

Advantage:
● Firms found guilty of anti competitive behaviour are asked to
pay fines or may be broken into smaller firms, therefore,
maintaining free competition in the market and abuse of
market power

Disadvantages/Drawbacks:
● Difficulty interpreting legislation→ what constitutes
anti-competitive behaviour
● Laws may be vague → much room for interpretation
● Differing degrees of enforcement across countries
● If firms collude, difficult to discover evidence of collusion to
prove it (collusion usually occurs secretly)

Legislation in the Merger: agreement between two or more firms to join and become a
case of mergers single firm. May occur for different reasons other than collision.

Potential problem with merger is that there is a possibility of the

single firm created from the merger to have too much market power.

Advantage:
Legislation usually involves limits on the size of the combined firms
→ protecting free competition

Drawbacks:
● There may be uncertainty about what firms should be allowed
to merge and what firms should not merge.
● Difficulties with interpreting legislation
● Differences among governments → differing ideologies on
desirability or not of a high degree of market power
Imposition of fines Benefit:
● Often imposed if a government agency responsible for
investigating anti-competitive behaviour discovers wrongdoing.
May address abuse of market power

Drawbacks:
● Often the profits firms will gain are much more significant than
any potential fines they may have to pay if discovered. They
may be better off illegally abusing the power (cost/benefit
analysis)
● Often they are not caught at all.
● Firms may neglect ethics of wrongful behaviour if they believe
that getting caught is not as costly as compliance.

5. While most countries discourage monopoly, an exception is made if there is a natural

monopoly because it may not be in society’s interests to break it up into smaller firms.
Doing so would result in higher average costs and a waste of resources. Using the chart
below, discuss the two possible solutions to the natural monopoly that a government
might pursue. Identify the benefit(s) and possible drawbacks of each.

Government Solution: Nationalize the natural monopoly

ownership of ● Involves transferring ownership of it from private sector to public
natural sector (government)
monopolies
Benefits:
● Allows government to regulate them
● Can force them to lower prices and increase quantities produced
in interest of consumers
● This can result in reduction of allocative inefficiency and reduction
of welfare loss.

Drawbacks:
● Government ownership may lead to inefficiencies and higher than
necessary costs of production
● Unlike the private firm, government is not driven to maximize
profits

Government Governments usually regulate natural monopolies

regulation of
natural Overall Benefits:
monopolies ● This is to ensure more socially desirable price and quantity
outcomes
● This can be done even when monopoly remains under private
ownership.

Two methods (see below):

a) Marginal Government can force monopoly to charge a price equal to MC
Cost ● Since P=MC, monopolist will then achieve allocative efficiency
Pricing ● Prices will fall; quantity of output will increase to the socially
desirable level

However:
Marginal Cost Pricing can lead to losses for natural monopolies
● P=MC results in price too for the firm to be able to cover AC
● Firm will either go out of business or government will have to
subsidize it in order to cover its losses
● Therefore, this is not a popular way to regulate natural
monopolies

b) Average To avoid creating losses for natural monopolies, governments can force
Cost the firm to charge a price equal to is AC
Pricing ● P=AC, means firm earns normal profit
● Results in higher price and lower quantity than marginal cost
pricing.
● Leads to a price and quantity combination that is superior to that
of unregulated monopolist → price is lower and quantity is
greater

Allocative is not achieved, but this policy offers two important

advantages:
1. Monopolist makes normal profit and it's not in danger of having to
shut down
2. It is more efficient than the market solution

Possible disadvantages:
1. In a free, unregulated market, the monopolist faces incentives to
keep its average costs low in order to minimize profits

But, through regulation, it is guaranteed a price equal to its AC

- It loses its incentive
- Even if AC increases due to inefficiency, it will still receive a price
covering its costs

2. Regulated monopoly may continue to survive as a monopoly

even though it may stop being a natural monopoly. Continued
regulation provides protection to the firm from new competitors
that would have been able to produce more efficiently.