Compare the consumer surplus, producer surplus, and deadweight loss that arise from average cost pricing with those that arise from profit-maximization pricing and marginal cost pricing

Question

What will be an ideal response?

Answer 1

For a natural monopoly, marginal cost is less than average total cost at all levels of output in the market. Compared to an average cost pricing rule a marginal cost pricing rule generates greater consumer surplus and less producer surplus because P = MC (which determines production with the marginal cost pricing rule) at a larger level of output than when P = LRAC (which determines production with an average cost pricing rule). With a marginal cost pricing rule the monopoly market will be efficient (MSB = MSC) and not experience a deadweight loss. However, the firm's average total cost exceeds its price and the monopoly suffers an economic loss. The monopoly will stay in business only if it receives a subsidy to make up for the economic loss, returning it to a normal profit. Yet this subsidy must be provided through taxing other markets, causing inefficient resource allocations in those markets. So with a marginal cost pricing rule the other markets affected by the tax will experience an increase in deadweight loss. The average cost pricing rule generates a deadweight loss in the monopoly market because MSB no longer equals MSC. This result occurs because the monopoly produces where P = LRAC and LRAC exceeds MSC at this level of output. Finally, compared to a profit-maximizing firm, a firm regulated with an average cost pricing rule has greater consumer surplus, smaller producer surplus, and smaller deadweight loss.