Question

Use a diagram to illustrate the “hoped for” result of natural monopoly regulation that attempts to set a price equal to average cost. What are the difficulties in achieving this outcome? Would an unregulated monopoly be preferable to a regulated natural monopoly?

Answer 1

Unregulated monopoly uses MR = MC and this results in a profit maximizing level of output at Q*. Corresponding price is P*

When price is set equal to the average cost, we have demand and AC curve meeting and this determines a higher quantity at Q** and lower price equal to AC.

Comparing the two, unregulated monopoly is able to earn economic profits while regulated one has only normal profits or fair return on the investment

The difficultly arrives when government authorities have to find out the true average cost because such a monopoly has an incentive to inflate cost to have a higher price set for them.

From social point of view, regulated monopoly is preferred as it offers a lower price, provides a greater quantity and has a lower deadweight loss.