REGULATION

Another way the govemment deals with the problem of monopoly is by regulating the behavior of monopolists. This solution is common in the case of natural monopolies, such as water and electric companies. These companies are not allowed to charge any price they want. Instead, government agencies regulate their prices.

What price should toe government set for a natural monopoly? This question is not as easy as it might at first appear. One might conclude that the price should equal the monopolist’s marginal cost. If price equals marginal cost, customers will buy the quantity of the monopolist’s output that maximizes total surplus, and the allocation of resources will be efficient.

There are, however, two practical problems with marginal-cost pricing as a regulatory system. The first arises from the inexorable logic of cost curves. By definition, natural monopolies have declining average total cost. As we first discussed in Chapter 13, when average total cost is declining, marginal cost is less than average total cost. This situation is illustrated in Figure 9, which shows a firm with a large fixed cost and then constant marginal cost thereafter. If regulators were to set price equal to marginal cost, that price
would be less than the firm’s average total cost, and the firm would lose money. Instead of charging such a low price, the monopoly firm would just exit the industry.

Regulators an respond to this problem in various ways, none of. which is perfect.’ One way is to subsidize the monopolist. In essence, the government picks up the losses inherent in marginal-cost pricing. Yet to pay for the subsidy, the government needs to raise money through taxation, which involves its own deadweight losses. Alternatively, the regulators can allow the monopolist to charge a price higher than marginal cost. If the regulated price equals average total cost, the monopolist earns exactly zero economic profit. Yet average-cost pricing leads to deadweight losses because the monopolist’s price no longer reflects the marginal cost of producing the good. In essence, average-cost pricing is like a tax on the good the monopolist is selling.

Figure 9 Marginal-Cost Pricing for a Natural Monopoly

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