Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Monopoly: average-cost pricing
Use P = AC to show average-cost regulation of a monopoly. Compare normal profit, output and efficiency with unregulated and marginal-cost pricing.
The economic idea
A natural monopoly exists when economies of scale are so extensive that one firm can supply market demand at a lower average cost than several competing firms. High fixed network costs and relatively low marginal costs keep AC falling over the relevant range.
An unregulated natural monopolist maximises profit where MR = MC and charges the price on demand. This normally restricts output below the P = MC quantity and creates a price–marginal-cost markup.
Average-cost pricing requires the regulated firm to charge the price where demand intersects AC. At this output P = AC, so total revenue equals total economic cost and the firm earns normal profit.
Because AC normally remains above MC, the break-even price also remains above marginal cost. Average-cost pricing therefore expands output relative to unregulated monopoly but stops short of the allocatively efficient P = MC quantity.
Regulation also creates information and incentive problems. The firm may know its costs better than the regulator, overstate required revenue, reduce cost-saving effort or influence the regulatory process.
Reading the average-cost pricing outcome
“D = AR” represents price and marginal benefit, while “MR” remains relevant to the unregulated profit-maximising benchmark.
“MC” shows the cost of one more unit. “AC” includes fixed as well as variable economic cost per unit.
“E” is set where “D = AR” meets “AC”; it is not the unregulated MR = MC outcome.
The break-even price rule
“P” equals “AC” at “Q”, so total revenue covers total economic cost and the firm earns normal profit. Price remains above “MC”, so output remains below “Q*” and allocative inefficiency remains.
The current financial outcome
“P” coincides with “AC” at “Q”, so the firm earns normal profit: total revenue covers all explicit and implicit economic costs.
The policy trade-off
The firm is financially viable at normal profit, but “P” remains above “MC” and some mutually beneficial output is not supplied.
Locate the welfare loss that break-even pricing can leave
The remaining welfare-loss triangle is between “D = AR” and “MC”, from “Q” to “Q*”. Those extra units would be valued above their marginal cost, but the break-even price prevents their sale.
At P = AC, the firm’s economic profit rectangle has zero height because all economic costs, including normal profit, are covered. This is a cost-recovery result; it is not the same test as P = MC.
From unregulated monopoly to P = AC
The regulator identifies the larger output where “D = AR” meets “AC”.
The regulated price becomes “P” and the firm supplies “Q”.
Because “P” covers “AC”, an operating subsidy is not required within this simplified cost model.
Common mistakes to avoid
- Average-cost pricing is P = AC, not MR = MC and not minimum AC.
- Normal profit does not mean the firm earns nothing. Normal profit is included in AC as an opportunity cost.
- The regulated price must be read from demand at the regulated output, not from MR.
- A regulated natural monopoly is not converted into a perfectly competitive market; the cost structure and single network remain.
How to draw this diagram
- Title the diagram “Monopoly: average-cost pricing”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw D = AR first and label it clearly.
- Draw MR next and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- Regulators may not observe efficient costs and demand as accurately as the firm, creating asymmetric information.
- Guaranteed cost recovery can weaken incentives to control costs or encourage excessive capital expenditure.
- Price rules need quality standards; otherwise a firm may meet a tariff target by reducing reliability or maintenance.
- A static diagram omits investment timing, peak demand, environmental constraints and uncertainty.
- Affordability and equity may require tariff design that differs from a single uniform per-unit price.