Breaking up firms and controlling mergers

Overview

Mean to break up a monopolistic business, breaking up a firm described as a structural remedy and competition authorities examine horizontal mergers most closely.

What you need to know

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Questions from this subtopic

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1. 1

   What does it mean to break up a monopolistic business, and when might a government do it?

   Model answer

   Breaking up means requiring a firm to divide into separate independent companies, or to sell off part of its operations, so that what was one supplier becomes several. It is used where a market is dominated by a single firm, where the harm to consumers is entrenched and where less drastic remedies such as price caps or access rules have failed or would need to continue indefinitely.

2. 2

   Why is breaking up a firm described as a structural remedy, and what is the advantage of a structural remedy over a behavioural one?

   Model answer

   A structural remedy changes who owns what, so once it has been carried out the market itself generates the competitive pressure. A behavioural remedy changes what a firm is allowed to do and must be monitored and enforced for as long as it lasts. The advantage of the structural approach is that it is self-sustaining, does not require a regulator to keep guessing at the right price, and is not undermined by the firm's superior knowledge of its own costs.

3. 3

   A monopolist faces demand P = 100 - 2Q and has total cost TC = 30 + 10Q + Q squared. Calculate its price, output and profit.

   Model answer

   Marginal revenue is 100 - 4Q and marginal cost is 10 + 2Q. Setting 100 - 4Q = 10 + 2Q gives 6Q = 90, so Q = 15 and price is 100 - 30 = £70. Total revenue is 70 × 15 = £1,050 and total cost is 30 + 150 + 225 = £405, so profit is £645.

4. 4

   The monopolist facing demand P = 100 - 2Q with total cost TC = 30 + 10Q + Q squared is split into two identical firms, each with total cost TC = 15 + 10q + q squared, and each then sets price equal to its own marginal cost. Calculate the new price and output.

   Model answer

   Each firm's marginal cost is 10 + 2q, so setting price equal to it gives q = (P - 10)/2 and the two together supply Q = P - 10, which rearranges to P = Q + 10. Setting that equal to demand, 100 - 2Q = Q + 10, gives 3Q = 90 so Q = 30 and P = £40. Each firm produces 15 units.

5. 5

   Following the break-up of a monopolist into two firms that each produce 15 units and sell at £40, with each firm's total cost TC = 15 + 10q + q squared, calculate industry profit and compare it with the £645 the monopolist earned.

   Model answer

   Each firm's revenue is 40 × 15 = £600 and its total cost is 15 + 150 + 225 = £390, so each earns £210 and the industry earns £420. This is £225 less than the monopolist's £645, so the break-up has transferred a large part of producer surplus to consumers while also expanding output.

6. 6

   Compare consumer surplus and total surplus before and after a break-up in which price falls from £70 to £40 and output rises from 15 to 30 units, with demand P = 100 - 2Q, monopoly profit £645 and post-break-up industry profit £420.

   Model answer

   Consumer surplus is the triangle under the demand curve above the price. Before, it is 0.5 × 15 × (100 - 70) = £225. After, it is 0.5 × 30 × (100 - 40) = £900, so consumers gain £675. Producers lose 645 - 420 = £225. Total surplus rises from 225 + 645 = £870 to 900 + 420 = £1,320, a gain of £450. The break-up is not merely a transfer, because the extra 15 units produced are worth more to consumers than they cost to make.

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