Question

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Suppose the government were to impose an annual license fee on a monopolist that just happened to be equal to its economic profits for a particular year. How would such a fee affect price and output? Do you think that such a fee would be appropriate? Why or why not?

Answer 1

Impact of annual license fee on a monopolist's price and output:

Price:

• The license fee equal to the monopolist's economic profit would significantly reduce its profit margins.
• To maintain profitability, the monopolist might try to raise the price of its product.
• However, the potential price increase would depend on demand elasticity (how sensitive consumers are to price changes).
• If demand is highly elastic, even a small price increase could lead to a significant drop in demand, negating the profit gains from the price hike.
• If demand is inelastic, the monopolist might be able to raise the price without a major drop in demand, partially offsetting the lost profit from the license fee.

Output:

• To maximize profits under the new fee, the monopolist might restrict output. This is because the marginal cost of producing each additional unit remains the same, but the effective price received (after paying the license fee) decreases.
• Producing fewer units, while potentially causing higher prices, could yield higher overall profit.
• Overall, the effect on price and output is uncertain and depends on various factors like demand elasticity, cost structure, and the monopolist's strategic behavior.

Appropriateness of the fee:

Arguments for:

• Reduces deadweight loss: Monopolies create deadweight loss, a welfare loss in the economy due to inefficient production and resource allocation. This fee can potentially recoup some of this loss for society.
• Controls market power: By taxing away its economic profits, the government limits the monopolist's ability to exploit its market power and generate excessive profits.
• Revenue generation: The fee can be a source of revenue for the government, which can be used for public purposes.

Arguments against:

• Distortionary effect: The fee can introduce additional distortions into the market, causing inefficiency and potentially harming consumers.
• Rent-seeking: The monopolist might lobby for lower fees or special exemptions, creating additional burdens and inefficiencies.
• Reduced innovation: The fee might decrease the monopolist's incentive to invest in research and development, potentially harming future innovation and productivity.

Ultimately, the appropriateness of the fee depends on a careful weighing of its potential benefits and drawbacks in the specific context. It's important to consider the specific characteristics of the market, the monopolist's behavior, and the potential consequences for consumers and society as a whole.