Intervention to control monopolies

• Why do Governments intervene with monopolies?

  To prevent monopoly power.
• Why do governments want to prevent monopoly power?

  There is the potential for market failure, and loss of consumer surplus, that can result from a monopoly exploiting the market.
• What are the main ways monopolies can be prevented?

  • Price regulation
  • Profit Regulation
  • Quality Standards
  • Performance Targets
• What does Price Regulation involve?

  Monopolies aim to produce at the profit maximisation level of output, (MC=MR).

  So governments can implement price capping
• What does a price cap do?

  It limits the price. (Such as a maximum price).
• What are the different type of price caps that governments can use?

  • RPI-X
  • RPI +/- K
  • Based on RPI.
• What does Based on RPI do?

  This price cap allows firms to only increase their prices by the level of RPI inflation.

  For instance:

  If RPI was 2%, the firm would be able to increase their prices by 2%, helping to cover inflationary increases in the firm’s costs. Therefore, although a price rise may take place, in real terms, prices are unchanged.
• What does X mean in RPI-X?

  it represent a certain percentage.
• Why does the government want to use RPI-X?


   if the government want to restrict price increases by a lower percentage than that of the retail price index.
• What does RPI-X do?

  Encourages firms to increase their efficiency by restricting price increase by a lower percentage than that of the RPI.

  By doing so the firm will still make a substantial profit (given that they cut their costs by more than the value of X) despite only being able to increase their prices by a percentage below the rate of RPI.
• What does RPI+/- K mean?

  K is equal to a percentage that allows the firm to make a large enough profit for capital investment.

  As this is dependent on the profit made at the firm’s current price level, the value K can either be negative or positive
• Where is RPI+/-K seen the most?

  the water industry
• What are the advantages of RPI-X Regulation?

  1. The regulator can set price increases depending on the state of the industry and potential efficiency savings.
  2. If a firm cut costs by more than X, they can increase their profits. Arguably there is an incentive to cut costs.
  3. Surrogate competition. In the absence of competition, RPI-X is a way to increase competition and prevent the abuse of monopoly power.
• What are the disadvantage of RPI-X Regulation

  1. It is costly and difficult to decide what the level of X should be.
  2. There is a danger of regulatory capture, where regulators become too soft on the firm and allow them to increase prices and make supernormal profits.
  3. However, firms may argue regulators are too strict and don’t allow them to make enough profit for investment.
  4. If a firm becomes very efficient, it may be penalised by having higher levels of X, so it can’t keep its efficiency saving.
• Desired effect of price regulation on diagram

  The desired effect of price regulation can be seen on the diagram above.

  This shows the maximum price level at the point of allocative efficiency.

  Through price regulation the government is able to force monopolies to produce at a point at which consumer satisfaction in maximised.

  The effect of this can be seen through a lower price (PM to PQ) and an increase in the quantity of goods/services produced (QM to QC).

  A) MC

  B) AC

  C) Maximum Price

  D) D=AR

  E) MR

  
• What does profit regulation involve?

  Governments can control the profits that firms earn by ensuring they are not excessive.

  Eg. via Corporate tax
• Is corporate tax direct or indirect?

  Direct tax
• What are examples of profit regulation used?

  • Rate of return regulation
  • Profit Capping
• What is rate of return regulation?

  A form of profit regulation.

  This occurs when the government look at the profit that is made by a firm and then decide the reasonable level of profit that they should earn given the rate of return on capital employed
• What does the rate of return regulation do?

  Encourages firms to increase their capital employed.

  If a firm is making profits that are not proportionate to the size of the firm or capital employed, then the government are likely to regulate the firm and reduces the profit they make through means such as taxation.
• What are the downsides of Profit regulation?

  • Costs are difficult for the CMA to calculate
  • Firms often try to inflate their perceived costs so as to make more profit than allowed
  • Monopolies have no incentive to lower costs, so if costs are higher than they would be in perfect competition consumers still end up paying higher prices
  • Even with this policy in place, natural monopolies seem to post record profits year on year
• What does quality standards involve?

  The government often intervenes through legislative means to ensure that firms meet a minimum standard.

  E.g.

  gas and electric companies are not allowed to cut off the gas/electricity supply for pensioners in the winter months despite not paying their gas/electricity bill.
• Why should quality standards be used?

  One way firms can maximise profit is to reduce the quality of the raw materials to decrease costs. Which reduces the quality of the end good/service. If there are no substitutes then this is a likely outcome
• What does performance targets involve?

  Performance targets can be implemented in order to ensure that firms are operating in the consumer’s interest and that competitive outcomes are achieved. 
• Examples of performance targets:

  1.  in the rail industry, performance targets are often set whereby a train company is only allowed to have a certain number of delays on a daily basis. Going past this figure may result in fines being issued.
  2. The NHS, which has monopoly power, also has performance targets, such as reducing waiting times. It helps the firm to focus on increasing social welfare.
• Price Capping in marktes

  A maximum price involves a normative judgement on behalf of the government/authorities about what that price should be - designed to curb monopoly profit.

  In diagram below; At a capped price, the monopolist can make a profit but supernormal profit will be lower.

  A) Capped Price

  B) Supernormal profit

  C) MR

  D) AR

  E) AC

  F) MC

  
• Chains of Reasoning for capping the price of a monopoly:

  1. To be effective, the capped price must be set by the regulator below the normal profit maximising price.
  2. A price cap lowers the monopoly (supernormal) profit made by dominant firms in the market.
  3. This may stimulate attempts to improve cost efficiency.
  4. In theory - it leads to an improvement in allocative efficiency and consumer welfare.
  5. It may also lead to the exit of some businesses from the industry which might actually reduce competition.
• Arguments for price capping with a monopoly

  1. Capping is an appropriate way to curtail the monopoly power of natural monopolies or dominant firms preventing them from making excessive profits at the expense of consumers
  2. Cuts in the real price levels are good for household and industrial consumers (increase in consumer surplus and higher real living standards in the long run)
  3. Price capping helps to stimulate improvements in productive efficiency because lower costs are needed to increase a producer's profits
  4. The price capping system can be a tool for controlling consumer price inflation
• Arguments against price capping

  1. Price caps have led to large numbers of job losses especially in the utility industries
  2. Setting different price capping regimes for each industry distorts the working of the price mechanism
  3. The industry regulator may not have enough accurate information when setting the price caps for future years
  4. Capping prices means lower profits which in turn can lead to reduced capital investment by the utility businesses - ultimately consumers suffer if there is under-investment in utility infrastructure such as water and energy
• Profit capping methods

  1. Cost-Plus Pricing
  2. Combination of revenue-capping and cost-monitoring
• Cost-Plus Pricing method of profit capping

  this approach requires competition authorities to assess the production costs of firms, and then allow a certain price to be charged above that, thus limiting profits.

  The main advantage is that this is simple to understand for both regulator and firm. However, it does not give the monopoly firm any incentive to try and reduce production costs and become more efficient. There is also the risk of not enough profit being earned to provide finance for innovation or investment.
• Combination of revenue-capping and cost-monitoring method of profit capping:

  Easier for competition authorities to manage and regulate than profit-capping directly. Revenue-capping is arguably very similar to price- capping, as regulators may want a firm to only earn a certain amount of revenue per item sold / per customer.
• Issue with price-capping

  True profit-capping is not, as yet, a policy that is followed by any major competition authorities, probably because of the issues that are likely to arise as a result. These might include:

  • Disincentivisation of business activity
  • Reduction in corporation tax revenue
  • Ease with which firms could bypass the regulation e.g. setting up subsidiaries, or offshoring etc
  • Difficulties in monitoring