Question

The Pacific Gas and Electric Company (PG&E) is an investor-owned electric utility. PG&E provides electricity to most of the northern two-thirds of California, from Bakersfield almost to the Oregon border which represents 5.2 million households.

1. In this question we will look specifically at the market for electricity in Bakersfield, where PG&E is the sole provider of electricity. Suppose PG&E is a natural monopoly with very high fixed costs, but a constant low marginal cost. Draw the ATC and MC curves for PG&E on a single diagram.

2. Still focusing on Bakersfield, draw a generic downward-slopping demand curve and the associated marginal revenue (MR) curve.

3. Now let’s combine these two graphs. Assume PG&E is a single-price profit-maximizing monopoly. On a single diagram draw the MC, ATC, demand curve (D) and marginal revenue MR curve such that PG&E is making a profit in Bakersfield. Find the equilibrium price and quantity.

4. Now suppose that the California Public Utilities Commission is concerned over PG&E's monopoly status in Bakersfield. It considers making PG&E set the price such that it equals the marginal cost.

a. Draw a diagram of PG&E in Bakersfield under this regulation.

b. Would the firm shut down in the short run?

c. Would the firm exit in the long run?

5. Now suppose that the California Public Utilities Commission wants to set the lowest possible price such that PG&E will operate in the long run. Assume also that subsidies are not available; only the price can be regulated.

a. Draw a diagram of PG&E in Bakersfield under this regulation.

b. What would be the profit?

Answer 1

1) Because marginal cost is constant,so average variable cost will be equal to marginal cost.

So average total cost will be downward sloping but never touch the marginal cost.

2)

3)

4) a)

b) No, firm will be indifferent between shutdown and operating.

Because profit with operating=- fixed cost

With shut down=- fixed cost.

In both cases firm is making loss equal to fixed cost.

C) Yes, firm should exit in long run because with this regulation firm still make loss in long run equal to fixed cost . By exiting it can reduce loss to zero.( No, fixed cost avoidable in long run)