Question

Sketch a natural monopoly firm under marginal cost pricing regulation. Label its price, quantity, and profit. What is the deadweight loss (loss in consumer and producer surplus) if regulation is effective?

Answer 1

Price, PMax A B P* A natural monopoly can be thought of an entity that faces a huge fixed cost and relatively lower and almost constant marginal cost. However, due to higher fixed cost, average costs (ATC and AFC) are both downward sloping and fall continuously. Demand curve and marginal revenue curve are usual downward sloping. Natural monopolist will produce a level of output determined by the interaction of marginal revenue and marginal cost. This is shown as Q* AC L - p=ACH------------- + AC P = MC – MC MR D * Q** Q*** Quantity From this level of output, it chooses a price P* which lies on the demand curve. A regulation can be imposed on this monopoly in order to reduce the price charged and make the good more affordable, in the form of P= AC or P = MC. When P = MC is applied, the quantity is Q***, price is P = MC and monopolist makes economic losses shown by area shaded with yellow. Consumer surplus is increased to an area of triangle ADP=MC. There is no deadweight loss because the market outcome is allocatively efficient when price is equal to marginal cost of production.