Question

Describe a natural monopoly. Illustrate, and explain, the three “regulatory Options” (profit maximization, marginal cost pricing and average cost pricing) we might apply to a natural monopoly. Explain which of these three options would you choose and why you would choose it.

Answer 1

A natural monopoly is a situation in which there is only one firm in a given industry. The reason behind that is the large initial costs to start a new firm. The industry is characterized by the use of some specific resource; raw material, technology or some other factors needed to operate a business. Most the natural monopolies are regulated by the government in order to ensure that the consumers get a fair deal.

1. Profit maximization: under the profit maximization, the firm charge the price at which the marginal cost of producing an additional unit is equal to the marginal revenue it produces. By this the firm makes supernormal profits but also create a deadweight loss in the economy, exploiting the consumers to an extent by providing lesser output and higher prices.

2. Marginal cost pricing: Under this, the firms are allowed to charge a price which is equal to the marginal cost of production. The price charged then is similar to what the firms in perfect competition charge. This ensures the allocative efficiency in the economy and no deadweight loss.

3. Average cost pricing: Under this, the price charged is equal to the average cost of production which is higher than what was charged under the marginal cost pricing. This pricing ensures that the firm is making zero economic profit but this creates an opportunity for capitalization wherein the firms inflate their fixed costs ensuring them normal return over the years.

Being a regulator, I think the marginal cost pricing is the best which would ensure that the allocative efficiency in maintained while in other cases the deadweight loss is generated in the economy.