Government Intervention

Control of Monopolies

This section deals with how governments can intervene in product markets to ensure markets are efficient and that consumers, employees and suppliers are not exploited by powerful companies.

A profit maximising monopoly will produce at an output that is below the level where average total cost (ATC) is at a minimum. By restricting output the monopolist earns permanent abnormal profit. There is a transfer of consumer surplus to producer surplus.The consumer is therefore exploited and the firm is productively inefficient.

A monopolist is also allocatively inefficient, because price is above marginal cost (MC). The good is under-produced. This results in a deadweight welfare loss .

There is a number of measures a government can take to correct these problems:

__breaking up the monopoly __– The firm can be forced to sell off parts of the business to create competing firms, leading to lower prices and profits. This approach is suitable in the case of multi-plant monopolies where the minimum efficient scale (MES) is small. It is not appropriate if the MES is very high, especially if it is a natural monopoly, as breaking up the firm could then result in higher average cost as economies of scale are lost.

lowering entry barriers – There is not much that can be done to address a barrier that arises from a natural cost advantage (see 3.3.4), but government can help small firms enter markets where they face difficulty in raising finance through measures such as guaranteeing bank loans. Government can also take measures against firms that engage in anti-competitive behaviour such as predatory pricing, which often deters new entrants.

de-regulation – There are legal restrictions on competition in some markets, which governments can remove to break the power of a monopoly. In the U.K. de-regulation has often accompanied the privatisation of state owned monopolies. Gas, electricty, telecoms and bus travel are examples of industries which are now open to competition. Air travel in Europe has also been de-regulated (the so called ‘open skies’ policy) enabling new competitors to fly on routes previously reserved for national ‘flag carriers’ such as BA and Air France. The result has been a huge expansion of air travel and much lower fares.

A problem with de-regulation is that it can encourage ‘cherry picking’. This means that new entrants may choose only to provide a service in the most profitable parts of the market. Private bus services, for instance may choose to opoerate on busy city and town routes, leaving rural populations with little or no service. A monopoly, by contrast can subssidise rural services rom the profits it makes on busier routes.

price controls – This is one of the main ways in which the government has regulated the privatised monopolies, such as gas, electricity and telecoms. A maximum price can be set at a level where it is equal to the firm’s marginal cost. Provided there are no external costs or benefits, this will result in allocative efficiency and lower prices for consumers. This is shown in in Fig 1 below:

Government Intervention, figure 1

Without the price control, the monopolist will charge a price of OA and produce quantity OC. This is where MC=MR and profits are maximised.

A maximum price control of OB means that at all levels of output up to OD, the firm’s AR and MR are equal at OB. The profit maximising output is therefore OD and the firm is now producing at the allocatively efficient level. It is also making less profit. Consumer surplus rises and producer suplus falls.

The main problem with price regulation is that it is difficult to know exactly what the right price is to ensure allocative efficiency. This is particularly the case with regard to externalities. If there are marginal social costs or benefits they are very hard to estimate with any accuracy.

performance and quality controls – If price controls are used, a profit maximising monopolist may seek to increase profits by reducing costs. If this is achieved by greater efficiency, that will benefit the economy as a whole (by releasing resources for another use) as well as the firm. But the monopolist may seek to cut costs by reducing the quality of the good or service. This can be addressed by setting performance and quality targets, with financial penalties if they are not achieved. Train companies are set targets for punctuality. Water companies have to meet minimum quality standards for water. Electricity suppliers have to meet time limits for restoring power when supply is interrupted.

Targets are not always easy to monitor and enforce. Train companies, for instance will seek to lay the blame for delays on Network rail, which owns the track and stations. Also, a train company may change its timetable, lengthening the ‘official’ time a train is due at its destination, thereby making it easier to achieve the punctuality target.

profit controls - The government can regulate monopolies by limiting the amount of profit they are allowed to make. A maximum rate of profit can be set equal to what the regulator thinks a firm would earn in a competitive market. This can be set by looking at the rate of return on capital that is achieved by firms in other industries that operate in competitive markets, where the level of risk is similar. If the regulator decides that an acceptable rate of return on capital is 10%, a monopolist that has £500 million of capital employed (its assets) would be allowed to earn an annual profit of £50 million.

A problem here is that the regulated monopoly would have an incentive to over-invest in machines, buildings or vehicles (ie employ more capital) in order to increase the amount of profit they are allowed to make. This would lead to an inefficient use of capital.

Another problem is that the monopolist would have little incentive to try to reduce costs and become more productively efficient, since the firm would not be allowed to make more than the maximum profit.

A third problem is that the regulator often knows less about the industry than the people running the business. It is likely therefore that the target level of profit will be too generous; the firm has an incentive to overstate the level of risk it is taking and exaggerate its costs.

This problem is called regulatory capture. It is also an example of asymmetric information.

__subsidies __– Allocative efficiency of a monopolist may be improved by paying the firm a subsidy for each unit of output (eg per passenger mile for a train company). This is shown in Fig 2 below:

Government Intervention, figure 2

Suppose the government decides that the allocatively efficient price and output is OC and OD respecively. Without a subsidy, the monopolist will produce OB and charge a price of OA. A subsidy per unit will push the MC curve downwards as shown on the diagram. The right amount of subsidy will result in a new equilibrium price and output at the allocatively efficient level.

One problem here is the political difficulty of getting the public to accept a subsidy to a monopolist. A way round this is for the government to then impose a tax on the monopolist’s profits, to recover the cost of the subsidy.

A bigger problem is once again identifying the allocatively efficient level of output. It is possible that too big a subsidy could actually worsen allocative efficiency; for instance passengers may just go for a joy ride if fares are low enough.

windfall taxes – When other forms of regulation such as price or profit controls have been judged as unsuccessful in dealing with excessive monopoly profits, a government can levy a special one-off tax to eliminate the excessive profit. This may be popular with voters, but most economists regard it as problematic. Firstly it involves a value judgement about what level of profit is excessive. Secondly, it is likely to be seen as punitive and discriminatory by the firms affected, who may challenge it in the courts. Thirdly, it may create a climate of uncertainty for the businesses affected, if they don’t know what the tax on profits is going to be. This could deter investment.

privatisation and nationalisation – In the 1980s the U.K. government privatised a number of state owned monopolies, including BT, the water supply industry, British Gas and the electricity generation and distribution. The government believed that the profit motive would encourage greater productive efficiency. At the same time, the government de-regulated these industries, creating competition.

In recent years there has been a revival of interest in re-nationalising some of these industries, particularly in the Labour Party. This reflects the view that regulation has not worked properly and that excessive profits have been made. Under public ownership it is argued that these industries can operate for the benefit of the community rather than for the shareholders.

__self-regulation __– This is sometimes seen as an acceptable alternative to government regulation. The industry concerned sets its own performance and quality standards and code of practice. Self-regulation can be reinforced by the threat of government regulation if it is considered unsatisfactory. It saves the government from having to closely monitor the industry concerned and avoids conflict between the govrenment and the industry, but many observers believe firms will not be regulated effectively when left to do it themselves; it’s a bit like ‘marking their own homework’.

Control of Mergers

As well as breaking up monopolies, they can be prevented in the first place by blocking mergers and takeovers. In the U.K the government can refer a proposed merger or takeover to the Competition and Markets Authority (CMA). The CMA can stop the merger/takeover altogether, or allow it to go through on certain conditions. For example a merger of two supermarkets might be allowed provided that some stores are sold off to rivals to ensure that there is still sufficient ccompetition.

Intervention to Promote Competition and Contestability

This can be achieved through the following measures:

help for small businesses – The creation and growth of small businesses increases maket efficiency by creating more competition. Small businesses can be helped in a number of ways, such as: exemptions from paying VAT; lower rates of corporation tax; grants for training or investment; government guarantees of bank loans (making it easier for small firms to get loans).


punishing anti-competitive practices – These include the operation of cartels, predatory pricing, bid-rigging, bundling of products and witholding supplies to competitors or retailers who sell at low prices. (see also notes on 3.3.4). The Competition and Markets Authority has the power to fine companies up to 10% of their annual revenue for anti-competitive behaviour, and it can also prosecute individual directors, leading to the possibility of prison sentences.

lowering entry barriers

competitive tendering – Many public services that are paid for by central government or local authorities are actually provided by private contractors. This includes rubbish collection, running prisons, the building of new schools and hospitals and much else. Firms are invited to bid for the right to provide these services. The contracts are awarded to the firms judged to be offering the best combination of quality of service and price. The practice of getting private firms to povie public services is called contracting out. It is part of the process of privatisation that has taken place since the 1980s. It aims to create a competitive market instead of a public sector monopoly.

The policy has been criticised as often providing poor value for money for taxpayers, because there is often only a limited number of firms bidding for the work and the promised level of service hasn’t always been kept to. Most of the contracts go to a few very large outsourcing companies such as Capita, G4S and Carillion, so the market is really an oligopoly. There have been scandals such as charging the government for work that has not been carried out. Carillion went bankrupt in 2018, leaving behind unfinished hospitals and thousands of unemployed workers.

Government Measures to Protect Employees

Profit maximising firms may have an incentive to boost profits by exploiting workers, not just by paying low wages, but neglecting health and safety and providing a poor working environment. Much of the protection of employees has come about through EU regulations which apply to all member countries, but some of it is the result of employment law made by national governments. Measures include: minimum wage laws; obligation on firms to provide a pension; regulation of maximum working hours and paid holiday entitlement; minimum redundancy pay; the right to join a trade union; legally binding employment contracts.

Firms can be fined for breach of employment laws and individual workers can sue for compensation

at an Industrial Tribunal for things like unfair dismissal, discrimination or unlawful deductions from their pay.

Government Measures to Protect Suppliers

Monopsonists have market power over their suppliers which can lead to suppliers being exploited. There is a number of measures the government can take to protect small suppliers to large business customers. These include:

  1. making some practices illegal – For example, preventing buyers from imposing unfair contracts on suppliers.
  2. giving suppliers the right to charge interest on firms that delay payment – This is often a major problem for small businesses that depend on large customers.
  3. appointing an independent regulator - The regulator can set up a code of practice for how big businesses treat their suppliers, and fine firms that don’t stick to it.

There are problems here. Small firms may be reluctant to take action against an important customer, or to inform the authorities, for fear of losing a valuable contract. A regulator may not be truly inependent and vulnerable to ‘regulatory capture’.

Identify and explain 10 ways in which a government can control monopolies.
Your answer should include: de-regulation / entry barriers / breaking up monopolies / windfall taxes / price controls / profit controls / subsidies / privatisation / performance / quality controls / self-regulation