Key Diagrams - Monopoly Profit with a Price Cap

Without government regulation, monopolies could put prices above the competitive equilibrium. This would lead to allocative inefficiency and a decline in consumer welfare. So a price cap aims to limit the price that a monopoly can charge. To be effective, a price cap needs to be set below the normal profit maximising price for a monopolist.

Capping the price leads to an expansion of demand and an increase in consumer surplus. But the level of monopoly profit is lower. Capped prices can improve allocative efficiency but lower profits might limit how much a firm can spend on investment and research which might have consequences for dynamic efficiency in the market.