Question

9. Regulating a natural monopoly Consider the local telephone company, a natural monopoly. The following graph shows the monthly demand curve for phone 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.

Answer 1

Working notes:

(i) Profit is maximized at the intersection of MR and MC curves.

(ii) Profit = Output (Q) x (Price - ATC)

(iii) Firm will stay in business (exit from market) in the long run if profit is positive (negative).

(iv) In Marginal cost pricing, P = MC (Demand curve intersects MC)

(v) In Average cost pricing, P = ATC (Demand curve intersects ATC)

(1)

	Quantity	Price ($)	ATC ($)	Profit ($)	Long run decision
Profit-Maximization	6,000	50	34	6,000 x (50 - 34) = 6,000 x 16 = 96,000 (POSITIVE)	Stay in Business
Marginal cost pricing	12,000	20	27	12,000 x (20 - 27) = 12,000 x (-7) = - 84,000 (NEGATIVE)	Exit the market
Average cost pricing	10,400**	28**	28	ZERO	Stay or Exit

**Since the exact coordinates are not mentioned in graph, these are the best visual estimates

(B) TRUE

With average-cost pricing policy, Price is always equal to ATC, therefore profit will be zero even if cost increases or decreases. In this case, the firm will not have any incentive to innovate and lower costs.