3.1.6 Natural Monopoly: Regulation though Marginal Cost Pricing

[MUSIC]

One solution to the natural monopoly is to have one firm, but to regulate the firm.

So I'd like to spend a few minutes talking about two common methods for regulation.

One method of regulating the firm,

is setting what is known as marginal cost pricing.

Marginal cost pricing, as the name implies,

is setting the price equal to marginal cost.

So suppose the marginal cost is $5, the government steps in and

tells the firm you have to sell at a price of $5.

So that the price is equal to the marginal cost.

From efficiency perspective, we can see that this makes sense.

Because price, of course, is equal to marginal benefit and lo and

behold it's equal to the marginal cost and we get the efficient output.

We can see that, graphically, if the price is equal to marginal cost,

the quantity purchased by the consumers Is going to be the efficient quantity.

So we're producing, where marginal cost equals marginal benefit,

and there's no dead weight loss.

So what is the problem with this method?

The problem is then marginal cost pricing only pays for

the marginal cost which is equal to the average variable cost.

So it pays for having the extra rider ride the train but

it's not paying for putting the system in place.

It is not covering the costs of the fixed investment that's needed.

We're not covering the fixed cost of production.

So the government has to pair marginal cost pricing with the second step,

which is paying for the fixed cost of production.

How big are the fixed cost of production?

Well we know what the average fixed cost is.

The average fixed cost is always the difference

between the average variable cost, and the average total cost.

It's true for any quantity including this quantity that we're producing.

So this vertical distance between the average variable cost and

the average total cost, this vertical distance is the average fixed cost.

Times the quantity and we get that this rectangle here,

these are the fixed costs of production.

So what the government needs to do, it needs to set a marginal cost pricing rule.

But it has to add a lump sum subsidy,

a one time subsidy equal to the fixed costs.

This way, the company will be interested in entering the business.

They paid for the infrastructure, they start setting up the transportation system

and then every rider that they provide ridership for,

they cover exactly the variable cost through the marginal cost pricing rule.

So that is one method of regulation.

Let's think of a second method.

Microeconomics: When Markets Fail

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