Question

1.What is a natural monopoly? Explain with a graph how a regulated natural monopoly sets its price.   

2.Draw a graph that shows a monopoly firm making economic profit in the short run. Be sure your diagram includes the monopolist’s demand, marginal revenue, average total cost, and marginal cost curves. Be sure to indicate the profit maximizing output and price. Are these profits sustainable in the long run?   

Answer 1

A natural monopoly occurs when there are very high fixed costs and it makes sense to have only one player. Examples of natural monopolies are gas, tap water, railway and electricity. The monopolist enjoys economies of scale and the average cost curve falls. One of the ways, a government can regulate a natural monopoly is through marginal cost pricing.

A marginal cost pricing rule for a natural monopoly that sets price equal to marginal cost (where MC intersects the demand curve). There is no deadweight loss in marginal cost pricing, as P=MC.

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.

A monopolist can make positive profits in the long run as there are significant barriers to entry like high fixed costs, patents, etc.