Question

1 Many transport industries are or have been regulated due to the notion of a natural monopoly.

a.(1) What is a natural monopoly?

b.(2) What is the problem for a welfare maximizing regulator if they set P=MC?

c.(2) What are two options for regulating a natural monopoly?

d.(5) The Army Corps is looking to invest $2 billion to improve the waterways. Over time, the benefit of the investment each period is $20 million and the interest rate is 5 percent. What is the PV of the investment given the investment will last forever?

Answer 1

a. Natural monopoly is a monopoly where there is large infrastructure and fixed cost associated with the product or service it provides compare to variable cost. There is only one firm which supply the output or service to whole market. Here the average cost continuously fall with the range of output it produces. There is only one firm can utilise the economies of scale of production.

b. For welfare maximising there require to set the price equal to marginal cost. But in natural monopoly average cost curve is downward sloping i.e it continuously falls with output increase. Due to downward sloping AC the marginal cost curve always lies below the average cost curve. Because we know when AC is falling MC will lie below. So when AC curve cut the AR curve the MC will cut the AR or price below the average cost. So if we set P=MC , then natural monopolist will loose because price will be less than AC. When there will be P=MC there is MC< AC, so P=MC<AC, therefore P<AC at P=MC.

c. The natural monopoly will maximize its profit where MR= MC. To regulate the monopoly there can be taken pricing regulation. If pricing regulation are done on the the basis of public interest and set the price =marginal cost for optimal quantity of output. But if price= MC are set then monopoly will loose and there need to give subsidy equal to economic loss to the company to run the business. Another and best regulation is set the price =average cost. If price equal to average cost are set then monopoly will be no profit no loss situation and there do not need to give any subsidy. So best regulation is set the price= average cost.

d. The PW of the investment will be PW benefit minus PW cost. The PW cost is initial investment of $2 billion. Benefit of investment is $20 million at each period. Here the period is infinite because the investment will last forever. If any investment last forever then it's net present worth will be equal to -$2 billon +$20million/interest rate = -$2000 millon +$20million/0.05 = -$2000 million + $400 million =-$1600 million = -$1.6 billion. So PW or present value of of the investment is -$1.6 billion.