Question

Natural monopoly firms are often regulated so that they can only charge prices set by
the authorities. Under one approach, prices are based on the monopolist’s costs so that for any given quantity of sales, the monopolist can only set prices equal to its average costs.

1. Why might regulators believe that forcing the monopoly to charge a price equal to average cost is a good outcome? Does this price regulation maximise social welfare? What problems do you see with this form of price regulation?

2. Suppose the monopolist can undertake innovation that will lower its average cost. If the monopolist faces average-cost price regulation, does it face strong or weak incentives to innovate? Explain your answer.

3. An alternative to average-cost price regulation is to set a ‘price cap’ for the natural monopoly firm. With a price cap, the regulator does not adjust the regulated price as soon as monopolist’s costs change but keeps the same regulated prices for a number of years. It is argued that price- cap regulation encourages innovation. Do you agree with this and why?

Answer 1

Ans 1.: Average cost is the one tool by which monopoly firm can be regulated otherwise monopolist can charge anything they wish to charge they intentionally reduce the supply in the market to raise the demand that will lead to rise in price of goods.Therefore regulators asked them to charge where the average total cost cuts the demand curve .Average cost is the cost of production for one unit it is get by dividing total cost by the total output.therefore it is more optimum way of price charging from its customers .regulators allows monopolies to charge equal to thier Average cost for product oe services they offer some time they allow to charge little more.

Average cost pricing does not allows monopoly firm to charge more price therefore its protect customer from charging extra from them.therefore it act as a social welfare for customers.

Disadvantages of average cost pricing:

Although average cost pricing is the best technique to regulate the monopolist yet consist the disadvantages:

*It does not consider the changes in the cost at different output level ;cost may differentiate at different level of production which does not considered in average cost pricing technique.

It does not allow monopolist to charge more margin ;if sale or demand decrease in future monopolist will face the loss.