Question

9. Regulating a natural monopoly 

Consider the local cable company, a natural monopoly. The following graph shows the monthly demand curve for cable services and the company's marginal revenue (MR), marginal cost (MC), and average total cost (ATC) curves. 

Suppose that the government has decided not to regulate this industry, and the firm is free to maximize profits, without constraints. 

Complete the first row of the following table. 

Suppose that the government forces the monopolist to set the price equal to marginal cost. 

Complete the second row of the previous table 

Suppose that the government forces the monopolist to set the price equal to average total cost. 

Complete the third row of the previous table. 

True or False: Over time, the cable company has a very strong incentive to lower costs when subject to average-cost pricing regulations. 

• True 

• False

Answer 1

The first strategy (profit maximization):

Under this, the monopolist produces the output level where the marginal revenue is equal to the marginal cost of production. Thus, the monopolist must produce 7,000 units and charges \(\$ 45\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C)\) Quantity

\(=(\$ 45-\$ 20) 7,000\)

\(=\$ 175,000\)

Thus, the profit earned by the monopolist is \(\$ 175,000 .\). Since the monopolist is making positive profits, it will STAY in the long run.

The second strategy (marginal cost pricing):

Under this, the monopolist produces the output level where the price (demand curve) equals the marginal cost of production. Thus, the monopolist must produce 14,000 units and charges \(\$ 10\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C) Q\) quantity

\(=(\$ 10-\$ 15) 14,000\)

\(=-\$ 70,000\)

Thus, the profit earned by the monopolist is -\$70,000 (negative sign denotes loss). Since the monopolist is incurring losses, it will EXIT in the long run.

Third strategy (average cost pricing):

Under this, the monopolist produces the output level where the price (demand curve) is equal to the average total cost of production. Thus, the monopolist must produce 13,000 units and charges \(\$ 15\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C)\) Quantity

\(=(\$ 15-\$ 15) 13,000\)

\(=0\)

Thus, the profit earned by the monopolist is 0 (neither profit nor loss situation). Thus, in the long run, the firm may STAY or EXIT.

Under average cost pricing policy, the natural monopoly doesn't have any incentive to cut costs. As the firm scuts down its costs, the optimal production will also change, leading to zero profits for the natural monopolist.

Thus, the given statement is TRUE; the firm has NO incentive to cut costs.