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Chapter 15: Problem 3

Why would it be economically efficient to require a natural monopoly to charge a price equal to marginal cost? Why do most regulatory agencies require natural monopolies to charge a price equal to average cost instead?

Short Answer

Expert verified
It would be economically efficient to set prices equal to the marginal cost because it leads to optimal resource allocation, with consumers paying the exact cost of producing an additional unit. But, due to high fixed costs in natural monopolies, marginal cost is often lesser than average cost, leading to economic losses under marginal cost pricing. Hence, regulatory agencies generally require prices to be set at average cost, ensuring that the monopoly can cover all its costs and continue operating sustainably.

Step by step solution

01

Understanding Natural Monopoly and Marginal Cost Pricing

A natural monopoly exists when a single firm can service the entire market demand at a lower cost than what it would be if there were multiple firms. Marginal cost is the added cost of producing one additional unit. If the price charged is equal to the marginal cost, then it is economically efficient because consumers are paying exactly the cost of producing an additional unit, allowing for optimal resource allocation.
02

The Predicament with Marginal Cost Pricing for Natural Monopolies

While economically efficient, the problem with a natural monopoly charging cost equal to marginal cost arises when the marginal cost is less than the average cost. This situation frequently occurs in natural monopolies due to high fixed costs and relatively low variable costs, resulting in continually decreasing average costs. If the price-setting is done at the level of marginal cost, the monopoly might not be able to fully cover its costs, leading to economic losses.
03

Reason for Regulatory Agencies favoring Average Cost Pricing

Regulatory bodies usually ask natural monopolies to price their goods or services at the level of their average cost. This ensures that monopolies can cover all their costs (fixed and variable) by balancing lower prices (due to high fixed costs) with higher ones (from variable costs). Hence, while this may not necessarily be pareto efficient as the marginal-cost pricing, it permits the firm to sustainably operate, thereby guaranteeing service provision.

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