AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/6/6-4)
Unit 6 · Topic 6.4
6.4 The Effects of Government Intervention in Different Market Structures
How a government policy affects a firm depends on whether it changes the firm's marginal cost or only its fixed cost. Per-unit taxes and subsidies change output; lump-sum ones change only profit in the short run. Governments can also regulate a monopoly's price, set a minimum wage that helps workers in a monopsony, and use antitrust laws to protect competition.
Key terms
- per-unit tax
- lump-sum tax
- price ceiling
- socially optimal price
- fair-return price
- antitrust policy
Per-unit versus lump-sum taxes and subsidies
A per-unit tax is charged on every unit produced, so it adds to the cost of each extra unit. It shifts MC, AVC and ATC up. A per-unit subsidy shifts them down.
A lump-sum tax is a fixed amount that doesn't depend on output, like a yearly license fee. It's a fixed cost, so it shifts ATC (and AFC) up but leaves MC and AVC where they were. A lump-sum subsidy shifts ATC down.
Since every firm picks output where MR = MC, only policies that move MC change quantity and price in the short run.
| Policy on a monopolist | MC | ATC | Quantity | Price | Profit |
|---|---|---|---|---|---|
| Per-unit tax | Up | Up | Falls | Rises | Falls |
| Per-unit subsidy | Down | Down | Rises | Falls | Rises |
| Lump-sum tax | No change | Up | No change | No change | Falls |
| Lump-sum subsidy | No change | Down | No change | No change | Rises |
In perfectly competitive markets
For a perfectly competitive firm, a per-unit tax raises MC, so the market supply curve shifts up (left). The market price rises and quantity falls, as in 2.8. If there's no externality, this creates deadweight loss.
A lump-sum tax doesn't change a competitive firm's output in the short run, since P and MC are unchanged. But if it pushes firms into losses, some exit in the long run, market supply shifts left and price rises until the remaining firms break even.
Regulating a monopoly's price
A price ceiling on a monopolist can raise output. For every quantity up to where the ceiling meets demand, the firm sells each unit at the ceiling price and doesn't have to cut its price to sell more, so MR equals the ceiling price over that range. As long as the ceiling is below the unregulated price but not below the socially optimal price (where demand crosses MC), the firm makes more instead of less.
The socially optimal price is where demand crosses MC. At that price, output is allocatively efficient and deadweight loss disappears. The fair-return price is where demand crosses ATC, so the firm earns zero economic profit (a normal profit).
A natural monopoly (4.2) has ATC falling across the whole market. At the socially optimal price, P = MC is below ATC, so the firm takes a loss and would leave in the long run. To keep it at the socially optimal price, government must cover the loss with a lump-sum subsidy. That's why regulators often choose the fair-return price instead: no subsidy needed, but output is lower than the efficient quantity.
Minimum wage in a monopsony
In a competitive labor market, a minimum wage above equilibrium creates a surplus of labor (unemployment). In a monopsony (5.4) it can do the opposite. The minimum wage makes the firm's MFC flat at that wage, since it no longer has to raise everyone's pay to hire one more worker. If the minimum wage is above the monopsony wage but not too high, the firm hires more workers and pays more. Set at the competitive wage, it gives the competitive outcome with no deadweight loss. Set too high, it cuts employment.
Antitrust policy
Antitrust laws aim to keep markets competitive. In the United States, the Sherman Antitrust Act (1890) outlaws agreements that restrain trade, like price-fixing cartels, and attempts to monopolize a market. The Clayton Antitrust Act (1914) lets government block mergers that would greatly reduce competition. You only need to know what antitrust policy is for, not the details of these laws, and drawing a graph of collusion and the policy response is beyond the course.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Per-unit tax or lump-sum tax on a monopolist?
A monopolist making a profit faces either (a) a $3 tax on each unit sold or (b) a $50,000 yearly license fee. For each, what happens to its MC, ATC, quantity, price and profit?
Show the solutionHide the solution
- Step 1: (a) The $3 per-unit tax raises the cost of every extra unit, so MC (and ATC) shift up by $3. MR is unchanged, so MR now meets MC at a smaller quantity. The firm cuts output and, moving up its demand curve, charges a higher price. Profit falls.
- Step 2: (b) The license fee is the same whatever the firm produces, so it's a fixed cost. ATC shifts up, but MC doesn't move. MR = MC at the same quantity, so quantity and price don't change. Profit falls by $50,000.
- Step 3: The key is which cost curve moves: only a change in MC changes the profit-maximizing quantity.
Answer: (a) MC and ATC rise, quantity falls, price rises, profit falls. (b) ATC rises; MC, quantity and price don't change; profit falls by $50,000.
- Example 2Calculator allowed
Regulating a natural monopoly
A water utility's demand curve runs from $100 at 0 units, falling $1 per unit, and its MR curve runs from $100 down to 0 at 50 units. MC is constant at $20, and fixed cost is $1,200, so ATC is $50 at 40 units, $40 at 60 units and $35 at 80 units. Find quantity, price and profit (a) with no regulation, (b) at the socially optimal price, and (c) at the fair-return price.
Show the solutionHide the solution
- Step 1: (a) Unregulated: MR = MC. MR falls $2 per unit from $100, so 100 − 2Q = 20 and Q = 40. Price from demand: 100 − 40 = $60. ATC at 40 is $50, so profit = (60 − 50) × 40 = $400.
- Step 2: (b) Socially optimal: P = MC = $20. Demand at $20: Q = 80. ATC at 80 is $35, so the firm loses (35 − 20) × 80 = $1,200 (its whole fixed cost). A lump-sum subsidy of $1,200 would be needed to keep it open.
- Step 3: (c) Fair return: P = ATC. At 60 units, demand gives P = 100 − 60 = $40 and ATC = $40. Profit = (40 − 40) × 60 = $0, a normal profit.
- Step 4: Compare: regulation raises output from 40 to 60 (fair return) or 80 (socially optimal) and lowers the price.
Answer: (a) 40 units at $60, profit $400. (b) 80 units at $20, loss $1,200, so a $1,200 lump-sum subsidy is needed. (c) 60 units at $40, zero economic profit.
- Example 3
A minimum wage in a monopsony (classic trap)
Use the monopsony from 5.4: labor supply starts at $2 and rises $1 per worker, MFC starts at $2 and rises $2 per worker, and MRP starts at $20 and falls $1 per worker. Without regulation, the firm hires 6 workers at $8. How many workers does it hire with a minimum wage of (a) $11, (b) $13, (c) $16?
Show the solutionHide the solution
- Step 1: With a minimum wage, MFC is flat at that wage for as many workers as will work for it. The firm hires the smaller of: the number willing to work at that wage (from supply) and the number whose MRP is at least that wage (from MRP).
- Step 2: (a) $11: supply gives 11 − 2 = 9 workers; MRP is at least $11 up to 20 − 11 = 9 workers. It hires 9, the competitive outcome, with no deadweight loss.
- Step 3: (b) $13: 11 workers would work, but MRP is at least $13 only up to 7 workers. It hires 7, still more than 6.
- Step 4: (c) $16: MRP is at least $16 only up to 4 workers. It hires 4, fewer than without the minimum wage.
- Step 5: The trap is saying a minimum wage always raises (or always cuts) employment. Here, any minimum wage above $8 and below $14 (the MRP of the 6th worker) raises employment above 6.
Answer: (a) 9 workers. (b) 7 workers. (c) 4 workers.
Common mistakes
- Saying a lump-sum tax raises a monopolist's price. It doesn't change MC, so quantity and price stay the same in the short run; only profit changes.
- Thinking a price ceiling on a monopoly always causes a shortage. Set at the socially optimal price, it raises output to the efficient quantity.
- Forgetting that a natural monopoly regulated at P = MC takes a loss and needs a subsidy.
- Applying the competitive-market result (a minimum wage causes unemployment) to a monopsony without checking where the minimum wage is set.
On the exam
- A free-response question may add a tax or subsidy to a firm graph and ask what happens to price, output and profit. First say whether it's per-unit or lump-sum, then say which cost curves move.
- Know the three regulated prices for a monopoly: unregulated (MR = MC), socially optimal (P = MC) and fair return (P = ATC).
Connected topics
Videos
Check yourself
5 questions on 6.4 The Effects of Government Intervention in Different Market Structures. Pick an answer to see if you got it, and why.
The graph shows a natural monopoly, such as a local water company. Price and cost in dollars are on the vertical axis, and quantity is on the horizontal axis.
The demand curve slopes downward, and the marginal revenue (MR) curve lies below it. Marginal cost (MC) is a horizontal line at $30. The average total cost (ATC) curve slopes downward across the whole range shown and stays above MC.
MR equals MC at 200 units, where the demand curve is at $60.
The demand curve crosses ATC at 300 units and a price of $45.
The demand curve crosses MC at 400 units and a price of $30. At 400 units, ATC is $35.
Hypothetical graph described in words
If the monopoly is unregulated, what quantity will it produce and what price will it charge?
Regulators want to eliminate the deadweight loss. Which price ceiling should they set, and how much will the firm produce?
At the socially optimal price, how large a lump-sum subsidy would the firm need each period to avoid an economic loss?
If regulators instead set a fair-return price, the firm will
Compared with the unregulated outcome, the fair-return price
0 of 5 answered