Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Monopoly: marginal-cost pricing
Show monopoly regulation at P = MC to achieve allocative efficiency. Explain why marginal-cost pricing may leave a natural monopoly making a loss.
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.
Marginal-cost pricing requires the regulated firm to charge the price where demand intersects MC. Because demand represents marginal benefit in this model, P = MC achieves allocative efficiency and removes the monopoly deadweight loss.
For a natural monopoly, AC is commonly above MC at the efficient output because fixed costs are spread across output. P = MC can therefore leave total revenue below total cost, requiring a subsidy, a fixed charge, cross-subsidy or public funding if service is to continue.
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 marginal-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 “MC”; it is not chosen where MR meets MC.
The regulatory price rule
“P*” equals “MC” at “Q*”, which coincides with “Q*”. The displayed pricing rule therefore reaches the allocatively efficient output.
The current financial outcome
“P*” lies below “AC” at “Q*”, so the firm makes a loss, or subnormal profit. The diagram does not contain an AVC curve, so it cannot by itself determine whether the firm should shut down in the short run.
The policy trade-off
The efficiency gain is accompanied by a funding gap because “AC” exceeds “P*” at “Q*”.
Locate the funding gap after checking efficiency
The funding gap is the rectangle with width “Q*” and height equal to “AC” at that output minus “P*”. It measures revenue missing from total cost, not deadweight loss. A subsidy can cover it, but financing the subsidy has an opportunity cost.
Efficient use of the existing network does not settle how to finance it fairly. Fixed charges, taxes and cross-subsidies distribute the cost differently, and a high fixed charge may exclude low-income users.
From unregulated monopoly to P = MC
The regulator identifies where “D = AR” meets “MC” rather than allowing the firm to restrict output at MR = MC.
The regulated price becomes “P*” and output expands to “Q*”.
The regulator then compares “P*” with “AC”. “P*” lies below “AC” at “Q*”, so the firm makes a loss, or subnormal profit. The diagram does not contain an AVC curve, so it cannot by itself determine whether the firm should shut down in the short run.
Common mistakes to avoid
- Marginal-cost pricing is P = MC, not MR = MC. MR = MC is the unregulated firm’s profit-maximising rule.
- Allocative efficiency does not guarantee that the firm covers total cost; AC must be checked separately.
- 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: marginal-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.