Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 5 Firm Behavior and the Organization of Industry

Chapter 15


of 36 Monopoly

Section 29 of 32

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Figure 10 here

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Figure 10 – Marginal Cost Pricing for a Natural Monopoly

Because a natural monopoly has declining average total cost marginal cost is less than average total cost.

If regulators require a natural monopoly to charge a price equal to marginal cost price will be below average total cost and the monopoly will lose money, shaded “Loss” area.

…

Government policymakers can respond to the problem of monopoly in four ways

·1· try to make monopolized industries more competitive

·2· regulate behavior of the monopolies

·3· turn some private monopolies into public enterprises

·4· do nothing at all

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·2· Regulate behavior of the monopolies

Regulation is common in the case of natural monopolies such as water and electric utility companies.

These monopolies are not allowed to charge any price they want.

Government agencies regulate and control their prices.

What prices will regulators decide these natural monopolies can charge?

One argument is the price should equal the monopolist's marginal cost (MC).

If price equals MC customers will buy the quantity of the monopolist's output that maximizes total surplus.

…

The main problem with MC pricing is the monopolist would lose money.

Natural monopolies have declining average total cost (ATC).

Figure 10 shows a natural monopoly firm with characteristic

· large fixed cost, e.g. electric power plants

· constant MC thereafter, each additional added customer incurs same cost

If regulators were to set price equal to MC

· because the MC price does not include fixed cost payments

· the MC price must always be less than the firm's ATC

Because a monopolist’s MC is always below its ATC the firm would lose money, shaded “Loss” area in Figure 10.

With losses the monopoly firm would exit the industry.

…

Regulators can respond to MC pricing losses for the monopolist in various imperfect ways, including:

a-Subsidize the monopolist

· government pays back the monopolist for the losses resulting from MC pricing

· to pay for this subsidy, government must raise the money through taxation, itself increasing overall costs to consumers and deadweight losses

b-Allow the monopolist to charge a price equal to ATC.

In Figure 10 this is where price = ATC, at point A with high price and low quantity.

But ATC high pricing creates deadweight losses because the monopolist's price does not equal the MC of producing the good.

Regulators generally set a price between MC and ATC point A levels.

… …

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