Discuss the difference between first-best and second-best price regulation. In your answer, you should address why governments regulate markets and the difficulties faced when doing so.
What will be an ideal response?
Monopolies create deadweight losses. Compared to a competitive market, less is produced and a higher price is charged. Additionally, monopolies may create a good of lesser quality than that produced in a competitive market. Due to the social welfare losses created by monopolies, governments often regulate them. In principle, if the government is going to regulate a market it should set the price at the perfectly competitive level in order to maximize aggregate surplus. Setting the price at the perfectly competitive level is referred to as first-best pricing. First-best pricing can be difficult to achieve due to lack of knowledge of a firm's marginal cost. Second-best pricing is an alternative, in which the regulator sets the price so as to make aggregate surplus as large as possible.
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