Explain: “An effectively regulated natural monopoly will have trouble attracting capital to sustain and modernize its facilities.”

Question

What will be an ideal response?

Answer 1

The answer to this question hinges on what is meant by the wording “effectively regulated.” If this wording means setting price equal to marginal cost, then the statement is indeed true. Marginal costs for a natural monopoly are less than average costs. A price equal to marginal cost therefore will be a price (average revenue) that is below average cost. Suffering losses, the firm will find it difficult to attract capital to sustain and modernize its facilities.
If the wording in the question means setting rates to allow for a fair return, then the statement may or may not be true. “Economic” profits do not occur under this type of “effective regulation.” However, it is the promise of “economic” profits that is most attractive to investors. Therefore, the statement may be true especially during periods of prosperity. On the other hand, despite the fact that a well-regulated monopoly promises only “normal” returns, there is little risk involved in achieving at least that amount of return. This security of investment might offset the lack of incentive that “economic” profits provide.