When a natural monopoly is regulated using an average cost pricing rule, what can you say...

When a natural monopoly is regulated using an average cost pricing rule, what can you say about the firm's profit and the market's efficiency?

Expert Solution

A natural monopoly is a single firm in the market that can serve the entire market. The Average cost of the firm reduces continuously with increase in output and take advantages of economies of scale.

A monopoly firm usually produces where MR = MC in order to maximize its profit. However, this creates inefficiency in the market in the form of high deadweight loss. Also, both allocative efficiency (P = MC) and Productive Efficiency (P = Min ATC) are not achieved at the equilibrium.

To correct the situation, the government intervenes and forces the monopoly to reduce its price. Firm's profit are maximum where MR = MC. But government forces the natural monopolist to charge a price where P = minimum point of ATC. So, the firm earns normal profit in the long run. Such a price is called fair-return price.

The market becomes efficient with the regulation. However, only productive efficiency is achieved.

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Rahul Sunny answered 2 years ago

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