Question

Describe what a government can do to alter the market price in the case of a natural monopoly.

Explain implications of such interventions. Use a diagram to illustrate a natural monopoly and justify your answer. (Implications may differ depending on the level of price)

Answer 1

Natural Monopoly refers to market which is characterised by the single firm and average cost falls over the wide range of output.

It is efficient to have single firm in market as competition leads to the inefficient outcomes. For example, Water supply works under natural monopoly.

In absence of government intervention, firm tends to set higher price which does not allow it to operate at efficient level.

Hence, government can regulate market by setting price equal to AC or MC.

Following is diagram:

In above diagram, government can force monopoly to set price equal to AC or MC. Price which is set equal to the AC brings fair return to firm but price equal to MC would cause loss to monopoly. government compensate monopoly firm if price is set equal to MC.