Sunday, April 29, 2007

How do we correct for a Monopoly?

Another question some students had problems with is in how to correct for monopolies. First, the problem with monopoly is that we are both allocatively inefficient (P>MC ) and productively inefficient (ATC is not minimized). There are two ways we can correct for this

1) We can make the monopolist "behave" like a firm in perfect competition. That is, we can force the monopolist to set P = MC. Notice that if P=MC then we are now allocatively efficient. However, there are two problems that arise with this

a) It is often hard to estimate a firm’s Marginal Cost Curve

b) Sometimes by forcing it to behave like a perfect Competitor (P=MC), you are actually causing the firm to lose money. In the graph above, setting P=MC means that the firm loses money because P
2) To correct for this, we can adopt an alternative solution. We simply set P=ATC. If P=ATC, there is still some allocative inefficiency (on the graph above, P is still > than MC). But it is a step in the right direction.

1 comment:

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