Question

9. Regulating a natural monopoly 

Consider the local cable company, a natural monopoly. The following graph shows the monthly demand curve for cable services and the company's marginal revenue (MR), marginal cost (MC), and average total cost (ATC) curves. 

Suppose that the government has decided not to regulate this industry, and the firm is free to maximize profits, without constraints. 

Complete the first row of the following table. 

Suppose that the government forces the monopolist to set the price equal to marginal cost. 

Complete the second row of the previous table 

Suppose that the government forces the monopolist to set the price equal to average total cost. 

Complete the third row of the previous table. 

True or False: Over time, the cable company has a very strong incentive to lower costs when subject to average-cost pricing regulations. 

• True 

• False

Answer 1

The first strategy (profit maximization):

Under this, the monopolist produces the output level where the marginal revenue is equal to the marginal cost of production. Thus, the monopolist must produce 7,000 units and charges \(\$ 45\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C)\) Quantity

\(=(\$ 45-\$ 20) 7,000\)

\(=\$ 175,000\)

Thus, the profit earned by the monopolist is \(\$ 175,000 .\). Since the monopolist is making positive profits, it will STAY in the long run.

The second strategy (marginal cost pricing):

Under this, the monopolist produces the output level where the price (demand curve) equals the marginal cost of production. Thus, the monopolist must produce 14,000 units and charges \(\$ 10\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C) Q\) quantity

\(=(\$ 10-\$ 15) 14,000\)

\(=-\$ 70,000\)

Thus, the profit earned by the monopolist is -\$70,000 (negative sign denotes loss). Since the monopolist is incurring losses, it will EXIT in the long run.

Third strategy (average cost pricing):

Under this, the monopolist produces the output level where the price (demand curve) is equal to the average total cost of production. Thus, the monopolist must produce 13,000 units and charges \(\$ 15\) per unit.

Profit is the excess of revenue over cost. The calculation is as follows:

\(\pi=(P-A T C)\) Quantity

\(=(\$ 15-\$ 15) 13,000\)

\(=0\)

Thus, the profit earned by the monopolist is 0 (neither profit nor loss situation). Thus, in the long run, the firm may STAY or EXIT.

Under average cost pricing policy, the natural monopoly doesn't have any incentive to cut costs. As the firm scuts down its costs, the optimal production will also change, leading to zero profits for the natural monopolist.

Thus, the given statement is TRUE; the firm has NO incentive to cut costs.

Answer 2

From the given graph we can calculate the monopoly profit maximizing level of output as below: Under monopoly market, profit maximizing level of output is determined by equating MR with MC. MR MC P 45 ATC = 20 Calculation of total revenue: TR = P*Q TR 45+7 TR 315 Calculation of TC: TC 20*7 TC = 140

Profit = TR-TC Profit 3 1 5-1 40 Profit = 175 Thus, the firm stays in the market in the long run, because it is earning the economic profit of S175 in the short ruin Suppose that the government forces the monopolist to set the price equal to marginal cost P = MC P 10 ATC = 1 5 TR = P*Q TR 14*10 TR 1 40 TC = ATC*Q TC= 15+14 TC 210

Profit = TR-TC Profit = 140-210 Loss = 70 Thus, the firm will not stay in the market in the long run, because it is earning the loss of $70 in the short run. suppose that the goverment fores he monlss th pric equal to average total the government forces cost: P ATC Q 13 P= 15 ATC-15 Calculation of TR: TR = P*Q TR 13*15 TR 195

TC 13*15 TC 195 Profit = TR-TC Profit 195 195 Profit 0 Thus, the firm will stay in the market in the long run, because it is earning normal profits in the short run Over time, the cable company has a very strong... This statement is truel