A natural monopoly has falling long-run average costs; marginal-cost
pricing leads to losses, whereas average-cost pricing leads to allocative
inefficiency. In both parts, average costs are falling as output rises, and
thus the MC curve is below the LRAC curve.
In part (i), a policy that requires setting price equal to MC leads to output
and price This outcome is allocatively efficient but the firm cannot
cover its full unit costs of In part (ii), a policy that requires setting price
equal to average cost results in output and price The firm can cover
its full costs but the outcome is allocatively inefficient because price
exceeds marginal cost.
When a natural monopoly with falling average costs sets price equal to marginal cost, it will
suffer losses.If regulations impose marginal-cost pricing, and the firm ends up
incurring economic losses, this situation cannot be sustained for long.
This problem provides the motivation for two alternative pricing policies.
Q 1 p 1.
c 1.
Q 2 p 2.