Question

Suppose STL Electro, a monopolist that produces electricity, faces constant marginal costs of $5 and its profit-maximizing price is $8.a.What is the effect on social welfare if the government regulates this monopoly by setting a price ceiling of $6 on electricity? b.What is the effect on social welfare if the government used rate-of -return regulation instead of a price ceiling, so STL Electro could only earn zero economic profits?

Answer 1

Monopolist causes efficiency loss because it charges a price which is greater than the marginal cost of production

a) give the government is regulating the Monopoly by setting up price ceiling of $6, in a situation where the profit maximizing price for the monopolist is $8, there will be an increase in the quantity produced and sold. At the same time the prices also reduce to $6. This will increase consumer surplus and therefore reduce the efficiency loss. Therefore social welfare increases

b) if a rate of return regulation is imposed which decreases the Monopoly profits to zero, price will be equal to average cost. It is not given whether there is a fixed cost or not which means if we assume that average cost is also equal to the marginal cost which is $5, then this policy will maximize social surplus. This is because the price will now be reduced to marginal cost as well as average cost at $5, which is a competitive outcome.