For a natural monopoly with falling average costs, a policy of average-cost pricing will not
result in allocative efficiency because price exceeds marginal cost.On what basis do we choose between marginal-cost pricing and average-
cost pricing? Marginal-cost pricing generates allocative efficiency, but the
firm incurs losses. In this case, the firm will eventually go out of business
unless someone is prepared to cover the firm’s losses. If the government
is unwilling to do so, seeing no reason why taxpayers should subsidize
the users of the product in question, then average-cost pricing may be
preferable. It provides the lowest price that can be charged and the
largest output that can be produced, given the requirement that revenue
must cover the total cost of producing the product.
Long-Run Investment
We have seen why regulators may choose average-cost pricing rather
than marginal-cost pricing. What is the implication of this choice in the
long run? Since marginal cost for a natural monopoly is below average
cost, average-cost pricing will generally lead to inefficient patterns of
long-run investment. For example, consider the situation depicted in part
(ii) of Figure 12-8 —a natural monopoly required to set price equal to
average cost. The firm will be just breaking even. If it expanded its
capacity (and moved downward along its LRAC curve) the regulated price
would fall and so the firm would still be breaking even. Thus, it has no
incentive to undertake such investment. Note, however, that the price in
this case must exceed the marginal cost (because marginal cost must be
below average cost if average cost is falling). As a result, society would