This is called overcapitalization,īecause the firm may overinvest in capital equipment since it Type of (average cost) pricing is that it may create an incentiveįor the firm to inflate its fixed costs. While the natural monopolist is able to make zero profits, therebyĮnsuring that the firm will stay in business, some deadweight loss reoccurs - the very thing that government involvement was trying to eliminate.Īnother potential problem with government imposing this In the graph below, these values are given, as are the corresponding shaded areasįor consumer surplus and deadweight loss (remember that profitsĪre zero here since P = AC, but there will be some deadweight Plugging Q* into the Demand equation, we can solveĬonsequently, setting P = AC means setting P* = $20, and getting 80 units of output. Using the quadratic formula, we can solve for Q: To algebraically find the price that would equal average cost, we first set Demand (Price) equal to Average Cost (AC), then solve for Q* and lastly plug Q* into the Demand equation to get P*: This is accomplished when P = AC, an approach that is called Average Cost pricing.įiguring out (algebraically) what the price will be is a bit more involved than what we did above. To charge a slightly higher price, but make zero economic profit. One possibility is that the government regulator might want to allow the firm Another way is to give up on the idea of producing where P = MC. One way to do this is by subsidizing the monopolist the amount of her loss ($400.35). Our regulator must also allow the monopolist to cover her losses. Therefore, to prevent the firm from leaving, However, achieving this particular type of efficiency causes the firm to eventually exit the industry - leavingĬonsumers with nothing. Relates to the fact that regulators wanted to make things more efficient (in terms of allocative efficiency). The whole point of government involvement here That is, should the monopolist stay in this industry if, over the long run, the best it can ever do each year is make some type of loss? The answer would obviously be no, and so if the price were set at $15, the firm would eventually exit the industry. With profit (loss), and that there is no deadweight loss since Notice that the area of consumer surplus overlaps that corresponding On the graph below, these values and the areasįor consumer surplus and profits are illustrated. Set Demand, or P, equal to MC and solve for Q* How much will the firm produce when P = MC? In this case, that means setting P = $15. When the regulating agency forces this firm to set its price at marginal cost, we have what is called marginal cost pricing. Might step in and force the monopolist to set its price at marginal cost. To get rid of the DWL, a government regulator Under perfect competition, there is some deadweight loss (shaded blue on the graph) - which represents the value of output not produced as a result of P > MC. Is that since the natural monopolist produces less output than what is possible This high price makes consumer surplus (shaded yellow in the graph) rather small. To make these kind of profits (the area represented on the graph by the striped rectangle), the monopolist sets a price exceeding what might occur within a more competitive market. The value for AC is found by plugging Q* into the AC equation to get AC = $24.41 (i.e. Before plugging things into this equation though, we must find AC. To do that, we use the formula (P - AC)Q. Suppose we also want to find the monopolist's If allowed to decide herself, how much will this natural monopolistĪnd price, this natural monopolist will produce where MR = MC:įind price by plugging Q* into the demand equation: We'll calculate the values for P* and Q* below, and also explain the meaning of the shaded areas. In general then, for a natural monopoly, AC is said to decrease (as Q increases) through "some relevant range of market output". Remembering the relationship between marginal and average values, AC will be declining as long as MC is below it. Taking a closer look at these equations, you'll see that AC is always going to be greater than MC. The relative position of the AC and MC curves give the natural monopolist a cost advantage over its competition. The answer stems from the monopolist's natural (cost-related) barriers to entry. Assume that a certain natural monopolist has the following demand and cost related curves:
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