International Trade - Theory and Policy, 2010a

The standard way of correcting this type of imperfection in a domestic context is to regulate the industry.
For example, electric utilities are regulated monopolies in the United States. Power can generally be
purchased from only one company in any geographical area. To assure that these firms do not set
exorbitant prices, the government issues a set of pricing rules that the firms must follow. The purpose is to
force the firms to set prices closer, if not equal to, the marginal cost of production.
Now, in the case of utilities, determining the marginal cost of production is a rather difficult exercise, so
the pricing rules to optimally regulate the industry are relatively complicated. In the case of a foreign
monopolist with a constant marginal cost supplying a domestic market, however, the optimal policy is
simple. The domestic government could merely set a price ceiling equal to the firm’s marginal cost in
production.
To see why a price ceiling is superior to a tariff, consider Figure 9.6 "A Price Ceiling on Imports from a
Foreign Monopoly Firm". A second-best policy is the tariff. It would raise national welfare by the area
(h − a − b − c), which as mentioned will be positive for some tariffs and for a linear demand curve. The
first-best policy is a price ceiling set equal to the marginal cost at PC. The price ceiling would force the
monopolist to set the price equal to the marginal cost and induce an increase in supply to QC. Consumers
would experience an increase in consumer surplus, given by the area (d + e + f + g + h+ i + j + k), because
of the decline in price. Clearly, in this example, the consumer surplus gain with the price ceiling exceeds
the national welfare gain from a tariff.
Figure 9.6 A Price Ceiling on Imports from a Foreign Monopoly Firm
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