If a natural monopoly is regulated using the marginal cost pricing rule, how will that affect prices, outputs, profits, and the distribution of surpluses? What are the pros and cons to this method of regulation?
What will be an ideal response?
The marginal cost pricing rule sets the regulated price equal to the price where the marginal cost curve intersects the demand curve. This price is lower than the monopoly price, and results in a higher level of output. The monopoly's economic profit is eliminated; in fact, this rule results in the firm making economic losses, as marginal cost is less than average total cost for a natural monopoly. Because output increases to the point where marginal cost equals price, consumer surplus is maximized. The advantage of this method of regulation is that it results in the efficient level of output. The disadvantage of this method is that means the firm will incur an economic loss. Unless subsidized by the government, allowed to price discriminate, or allowed to use a two-part tariff, the firm will eventually exit the industry, as no firm can operate at a loss in the long run.
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