Question

Question-3 [10 marks]

A local electricity company has a demand curve of P = 120 – 4Q. Average Cost = 400/Q + 4, with MC of $4 per unit.

a. Is this firm a natural monopoly? [1]

b. What is the socially optimal level of production and price? [2]

c. Redo part b if it is a monopoly. [2]

d. How much subsidy should the government give to this firm if it regulates it to charge marginal cost? [3]

e. What is a better option for the government if it wants to regulate this firm? [2]

Answer 1

A. Yes firm is a natural monopoly because average cost decreases as more quantity is produced

b. For socially optimal output, we know price has to be equal to marginal cost

Thus price=MC=4 and optimal level of quantity=120-4/4=116/4=29

c. If it act like a monopoly then MR=MC at profit maximisation

MR=120-8Q and MC=4

Thus 120-8Q=4

Quantity=116/8=14.5 and price=120-14.5(4)=62

and profit=48*14.5=696 apart from the fixed cost

D. Thus govt should provide a subsidy of 696 id it needs to regulate firm to charge marginal cost instead of monopoly pricing

e. Firm should regulate price in such a way that P=AC