Question

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.

 True or False: Under the average-cost pricing policy, the cable company has no incentive to cut costs. 

•  True

•  False

Answer 1

Profit maximization in monopoly situation

Monopolist is a price Maker. He will determine the quantity of output that will maximize revenue. The monopolist faces a downward sloping demand curve because he can sell more if he lowers the price. The profit maximizing price and output is where marginal revenue equals marginal cost, then it is extended to the market demand curve to determine what market price corresponds to that quantity.

The monopoly profit equals (P-ATC) x Q.

P=$60

ATC=$40

Q= where MR=MC=6

Profit =($60-$40) x 6=$120

Marginal Cost Pricing (Socially optimal outcome)

The socially optimal quantity is at the intersection of MC and demand curve.

Q= MC=D= 12

Price at MC=D=$30

ATC=$35

Profit ($35-$30) x 12=$ 60 ( Loss)

Average Cost Pricing

The fair return outcome is at the intersection of ATC and demand curve

Q= ATC=Demand curve= 11

Price at ATC=D=$35

ATC=$35

Profit=($35-$35) x 11=$0

Since P=ATC, the monopolist makes zero economic profit.

	Short run
Pricing mechanism	Quantity (Subscriptions)	Price $ (Dollars per subscription)	Profit	Long run decision
Profit maximization	6	60	Positive	Stay in business
Marginal Cost Pricing	12	30	Negative	Exit   business
Average Cost Pricing	11	35	Zero	Stay or exit business
True. The firm has no incentive to cut costs as the price equals ATC.