Question

Draw a correctly labeled graph of a natural monopoly. Use your graph to identify each of the following: A. consumer surplus if the market were somehow able to operate as a perfectly competitive market B. consumer surplus with the monopoly C. monopoly profit D. dead weight loss with the monopoly

Answer 1

Natural monopoly

a) Suppose Madison Gas and Electric (MGE) is a natural monopoly in Madison for electricity. That is

the case where one firm can produce the total quantity in a market more cheaply than multiple firms

because there is a large fixed cost or

economies of scale in this industry.

The Demand curve, Average Total Cost curve, Margin

al Cost Curve, and Marginal Revenue Curve for

this firm are shown in the picture below

.

The government decides to regulate this market using marginal cost pricing. That is, the firm is told to

produce that level of output where MC is equal to P for the last unit produced.

a) Identify in the graph the quantity (Q

MC

) and price (P

MC

) outcomes under this scheme; label it with

the letter “A”. Is this regulatory scheme allocatively efficient? Why or why not?

Under this regulatory scheme the equilibrium is when P=MC.

Q

MC

= 14 and P

MC

= $12;

The equilibrium is allocatively efficient since it maximizes the total surplus or, alternatively, because

P = MC for the last unit produced. Notice also that

when P = MC there is no deadweight loss which is

another sign that the market is allocatively efficient.

b) Compute the profit of the firm. What is the mi

nimum amount of subsidy that will be necessary in

order to keep this monopolist in business?

TR = P

MC

x Q

MC

= 12x14 = $168

TC=ATC(atQ=14)x Q

MC

= 18x14 = $252

Profit = TR – TC = -$84

Hence, the minimum amount of subsidy that will be necessary in order to keep this monopolist in

business is $84; that is when the monopolist earns zero economic profits.

Suppose the government decides to use average cost pricing regulation. That is, the government tells

the monopoly to produce that level of output

where the firm earns zero economic profit.

c) Identify in the graph the equilibrium price and quantity that corresponds to this type of regulation

label it with the letter “B”.

Under this regulatory scheme the equilibrium is when the monopolist gets zero profits. In the picture,

the equilibrium is when Demand=ATC. Hence at this point;

Q

AC

= 10 and P

AC

= $20;

d) Is this price and output combinatio

n allocatively efficient? Why or why not?

The equilibrium is NOT allocatively efficient since it does not maximize the total surplus.

Alternatively, the outcome is not allocatively efficient since P is not equal to MC for the last unit

produced. In this example P is greater than MC wh

ich tells us that consumers place a higher value on

the last unit produced than do suppliers: it tells us that the market is not producing enough of the

output. Finally, when P

≠

MC we should expect there to be a deadweight loss: when the market is not

allocatively efficient there will be a deadweight loss.