Market Failure and Government Intervention

2. Market failure due to structure or structure failure

Competitive market benefits society by reducing the price and improving the efficiency of resource allocation, thus, government’s priority action should be to enhance competition. There should be enough sellers and buyers in the market to get the beneficial effect of competition or there should be at least the possibility of the easy entry of new firms. If such condition is not fulfilled, it is considered as the market failure due the market structure. Depending on the nature of a particular industry, for example: market of water, electricity, telephone, a monopoly or oligopoly may develop, possibly resulting in too little production and excess profits. Such condition is considered natural monopoly.

Natural Monopoly: In some industries, economies of scale operate continuously as output expands, so that a single firm could supply the entire market more efficiently than any number of smaller firms. Such large firm supplying the entire market is called natural monopoly. Examples of natural monopolies are public utilities like electricity, gas, water, local transportation companies etc. The main characteristic of natural monopoly is that the firms’ long-run average cost curve is still declining even the firm supplies the entire market. The monopoly is that, the natural result of such firm will have lower cost per unit than other smaller firms. This will give the firm, market power to drive the smaller firms out of the business.

Government Responses in structure failure

Governments usually exercises two methods for controlling monopolistic situation:

1. Control over Market Structure

Anti-trust laws are design to decrease industrial concentration and to prevent collusion among oligopolistic firms. In the late nineteenth century a movement toward industrial consolidation developed around the world. Industrial growth was rapid, and because of economies of scale, an oligopolistic structure emerged in certain industries. Pricing reactions became apparent to industry leaders, who concluded that higher profits could be attained through cooperation rather than through competition. As a result, regulatory bodies were formed, which then managed the firms and sought to reach a monopoly price/output solution.

2. Direct Control

Public utility regulation, which fixes prices at levels designed to prevent firms from earning monopolistic profit. According to Lewis and Peterson public utility seems to have two general features:

  1. The industry provides a product or service of particular importance either the day to day livelihood or the future growth.
  2. The nature of the production process is such that competition is seem as yielding undesirable result such as duplication of facilities.

The most common method of monopoly regulation is through price control/regulation. The regulated price is such that monopoly recovers its fixed and variable cost plus an allowed return on investment. The government exercises price control mechanism for the following results:

  1. Sales volume of the product would increase compare to unrestricted monopoly condition.
  2. Reduction of the profit of the firm
  3. Level of rate of return on owner’s investment will reduce.

The actual output, however, will be determined by the actual demand at the price set by the regulatory commission. In order to restrict the firm to operate in an unconstrained monopolist condition, government/policy maker can exercise several alternatives. Some alternatives are discussed below:

  1. Price at marginal cost: One of the measures to control monopoly price is by fixing the price of the product. In this method, policy makers lets the firms maintain the existing monopoly position and make them fix price equal to marginal cost. But, for retaining price level at marginal cost for long time government should either compensate for loss or provide subsidy to the firm.
  2. Compromise Solution: The most common method for pricing the products of a natural monopoly is the compromise solution. A simple description of public utility price regulation is that price is set equal to average cost. That is, the firm is allowed to charge a price that allows it to earn no more than a normal return on its capital.   The regulatory approach is compromise because the price is less than if the firm were allowed to act as a monopolist. Because the firm earns a normal profit, there is no need for the subsidy that would be required with marginal cost pricing. Thus, this mechanism achieves some of the gains form marginal cost pricing without requiring a subsidy.
  3. Undue Price discrimination: Price discrimination occurs when consumers are charged different prices for a product and the differences in price cannot be accounted for by cost differentials. The telephone industry provides an example of successful price discrimination policies by a public utility. Rates for basic telephone services are higher for business users than they are for residential users. The consequence of price discrimination provides an argument for regulation. Perhaps government should intervene to protect the commercial user from an unfair situation. The issue is not one of efficiency, but of fairness. The presumption is that the monopolist should not be allowed to use its power to unduly discriminate against some consumers. Although some discrimination may be acceptable, government intervention may be necessary when that discrimination becomes excessive. There is no clear definition of the distinction between due and undue discrimination. In the end, undue price discrimination is whatever the regulatory commissions or the courts determine it to be.

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