AP_Krugman_Textbook

Panel (a) illustrates a case of natural monopoly without regulation. The unregulated

natural monopolist chooses the monopoly output QMand charges the price PM.Since

the monopolist receives a price greater than average total cost, she or he earns a profit,

represented by the green-shaded rectangle in panel (a). Consumer surplus is given by

the blue-shaded triangle.

Now suppose that regulators impose a price ceiling on local gas deliveries—one that

falls below the monopoly price PMbut above average total cost, say, at PRin panel (a).

At that price the quantity demanded is QR.

Does the company have an incentive to produce that quantity? Yes. If the price the

monopolist can charge is fixed at PRby regulators, the firm can sell any quantity be-

tween zero and QRfor the same price, PR. Because it doesn’t have to lower its price to

sell more (up to QR), there is no price effect to bring marginal revenue below price, so

the regulated price becomes the marginal revenue for the monopoly just like the mar-

ket price is the marginal revenue for a perfectly competitive firm. With marginal rev-

enue being above marginal cost and price exceeding average cost, the firm expands

output to meet the quantity demanded, QR. This policy has appeal because at the regu-

lated price, the monopolist produces more at a lower price.

Of course, the monopolist will not be willing to produce at all in the long run if the reg-

ulated price means producing at a loss. That is, the price ceiling has to be set high enough

to allow the firm to cover its average total cost. Panel (b) shows a situation in which regu-

lators have pushed the price down as far as possible, at the level where the average total

cost curve crosses the demand curve. At any lower price the firm loses money. The price

here, P*R,is the best regulated price: the monopolist is just willing to operate and produces

Q*R, the quantity demanded at that price. Consumers and society gain as a result.

The welfare effects of this regulation can be seen by comparing the shaded areas in the

two panels of Figure 62.2. Consumer surplus is increased by the regulation, with the gains

coming from two sources. First, profits are eliminated and added instead to consumer sur-

plus. Second, the larger output and lower price leads to an overall welfare gain—an in-

crease in total surplus. In fact, panel (b) illustrates the largest total surplus possible.

620 section 11 Market Structures: Perfect Competition and Monopoly

(a) Total Surplus with an Unregulated

Natural Monopolist

(b) Total Surplus with a Regulated

Natural Monopolist

QM QR

PM

D

MC

MR

ATC

Quantity

Price, cost,

marginal

revenue

PR

Profit

Consumer

surplus

QM Q*R

PM

D

MC

MR

ATC

Quantity

Price, cost,

marginal

revenue

P*

Consumer

surplus

R

figure 62.2 Unregulated and Regulated Natural Monopoly

This figure shows the case of a natural monopolist. In panel (a), if

the monopolist is allowed to charge PM,it makes a profit, shown

by the green area; consumer surplus is shown by the blue area. If

it is regulated and must charge the lower price, PR,output in-

creases from QMto QRand consumer surplus increases. Panel (b)

shows what happens when the monopolist must charge a price

equal to average total cost, the price P*R.Output expands to Q*R,

and consumer surplus is now the entire blue area. The monopolist

makes zero profit. This is the greatest total surplus possible with-

out the monopoly incurring losses.