Passing on the Monopoly Overcharge: A Comprehensive Policy Analysis

theorizing; virtually every empirical study of industry cost functions has found that, in most industries, marginal and average costs are equal and identical over the relevant range of output in the long run.5 In Figure 3 we have illustrated the long-run adjustments by R in response to a monopoly overcharge imposed by M. Figure 3(A) indicates both the shortand long-run supply curves of firms at level R. (We have shown an upward-sloped short-run supply curve; if the short-run supply curve were flat, 100% of APm would be passed on, so we would not need to examine the long-run results.) Note that APm, the overcharge imposed by M, shifts both the shortand long-run supply curves, but that, in the short run, the equilibrium price and output are determined by the intersection of S" and D. The rate of passing on is, in the short run, less than 100% because AP, is less than APm. That result will not continue over the long run, however. In the short run, the R firms find that at Q/', Pris less than the long-run average cost, so they are operating at a loss. In order to stop the resulting losses, the R firms will make adjustments that will bring costs into line with the market-clearing price. These adjustments may include reduction in inventory or in investment level, and hence in capacity. Exit from the industry may even be necessary if no lesser adjustment will stanch the flow of losses. The long-run equilibrium result is shown in Figure 3(B).59 In accordance with our comments regarding the time elasticity of demand, the demand curve has been shown to be more elastic in the long-run illustration. Nevertheless, when the long-run supply curve is flat, 0 the elasticity of demand is irrelevant to the rate of passing 58The classic study of industry-cost relationships is J. BAw, BAMUEns To NEw COMPETITIoN (1956). It is important to distinguish between firm and industry costs. Many observers have speculated (though little empirical substantiation has been presented) that, because of "managerial diseconomies of scale," the long-run cost curve of an individual firm may increase at some point. Our analysis depends upon the cost curve of an entire industry, to which, presumably, managerial diseconomies do not apply. 59 By showing the change in the long-run marginal-cost curve from LRMC' to LRMC" as exactly equal to the monopoly overcharge, APn, we have implicitly assumed away the possibility of factor substitution by R. It is conceivable that, by modifying the production process to use less Qr to produce a given quantity of Qr, the change in LRMC would be less than APrIn The possibility of significant factor substitution by R implies an elastic demand curve between R and M, in which case monopolistic pricing is highly improbable. Hence, it is reasonable to assume that factor substitution is relatively low in passing-on cases. 60 When the long-run supply curve is only nearly flat, the elasticity of demand is relevant to determining the rate of passing on. See part IV(A) (5) infra. [Vol. 128:269 PASSING ON THE MONOPOLY OVERCHARGE 293 COMPARISON OF SHORT-RUN AND LONG-RUN EQUILIBRIA,