Question

Natural Monopoly

A. Draw a natural monopoly in an equilibrium with a profit. Clearly label the relevant areas.

B. Show how this monopoly could be regulated to produce (and price) at MC, or at AC. A part of this answer should explain/show how regulation effects the demand and MR curves.

C. Briefly mention the advantages/disadvantages of each (P=MC, P=AC).

Answer 1

A)
Natural Monopoly exists where Average cost of production falls over the wide range of output. Following is diagram:

• Equilibrium condition; MR = MC.
• Here, Gap between price and ATC is per unit profit of firm.

b)

• Since MR = MC is not efficient level of output here. thus, government can control it by forcing it to set price either equal to the ATC or MC.
• If price is set equal to MC, firm will incur loss equal to difference between ATC and price. Government has to compensate firms for loss.
• Further, if Price is set equal to ATC, it would be breakeven condition.

c)

Advantages of P=MC, P=ATC:

• It increases level of output and welfare of public.
• Price level is lower and output is enhanced.

Disadvantages:

• Forcing firms to set price equal to ATC or MC would not induce any kind of innovation.
• It might cause loss to firms if price is set equal to MC since AC is below the MC.
• Consumption of sin goods can not be discouraged if P=MC or P=ATC is pursued.