Question

It has been proposed that natural monopolists should be allowed to determine their profit-maximizing outputs and prices and then government should tax their profits away and distribute them to consumers in proportion to their purchases from the monopoly. Is this proposal as socially desirable as requiring monopolists to equate price with marginal cost or average total cost? \(L O 12.7\)

Short answer

The proposal is less socially desirable as it doesn't achieve allocative efficiency like equating price with marginal cost does.

Step-by-step solution

Understanding the Proposal

The proposal suggests that a natural monopolist sets prices and outputs to maximize its profits. The government would then impose a tax to take away those profits and redistribute them to consumers according to their purchases from the monopoly.

Analyzing the Proposal

The key feature is that the monopolist maximizes profit, meaning the price will be above marginal cost. Consumers face a higher price and lower quantity compared to a competitive market. Redistribution of profits compensates consumers but does not alter the monopoly pricing.

Comparing Proposals

Alternatively, if the monopolist is required to set price equal to marginal cost (P = MC), output and price would align more closely to what is seen in a competitive market, theoretically achieving an efficient distribution of resources. If price is set equal to average total cost (P = ATC), the firm breaks even but may not reach allocative efficiency as P still may not equal MC.

Considering Social Desirability

Setting P = MC maximizes social welfare by ensuring resources are allocated efficiently, avoiding deadweight loss. Although taxing profits and redistributing them (from the first proposal) compensates consumers, it doesn't address the inefficiency in pricing. Thus, while it helps redistribute wealth, it doesn't achieve the same efficiency as setting P = MC.

Key concepts

Profit Maximization

In a natural monopoly, profit maximization occurs when a monopolist sets prices and output levels to achieve the highest possible profit. This involves setting a price that is higher than the marginal cost of production.

• This strategy ensures that the monopolist can cover both fixed and variable costs while also securing a substantial profit margin.
• The price is often set where marginal revenue equals marginal cost, which is the typical profit-maximizing condition.

However, the downside to this approach is that consumers pay higher prices than they would in a competitive market. This results in a smaller quantity of goods being available, making it less socially desirable. Even though profits can be taxed and redistributed to consumers, the overall market inefficiency remains.

Price Regulation

Price regulation is a government intervention strategy aimed at controlling the price set by a natural monopolist. The purpose of regulation is to prevent the monopolist from setting excessively high prices that could exploit consumers.

• Regulators might impose a ceiling on the price to protect consumer interests and ensure accessibility.
• This might disturb the market mechanism and lead to inefficiencies if not carefully crafted.

Price regulation is crucial since it strives to balance between allowing the monopolist to cover costs and make some profit while ensuring prices are fair for consumers. This regulation helps in mitigating the negative effects of monopolistic practices but doesn't necessarily achieve the most efficient outcome like marginal cost pricing.

Marginal Cost Pricing

Marginal cost pricing is an economic practice where the price of a good or service is set equal to the additional cost of producing one more unit of that good or service. In terms of natural monopoly, implementing marginal cost pricing can lead to several benefits:

• By setting the price equal to the marginal cost, resources are allocated most efficiently.
• This pricing model eliminates deadweight loss and aligns the monopolist's operations closer to a competitive market outcome.

However, the primary challenge with this strategy is that it might not cover the total costs of the monopolist, especially if the average cost per unit is higher than the marginal cost. This could result in losses for the monopolist unless subsidies are provided to cover the shortfall.

Average Total Cost Pricing

Average total cost pricing involves setting the price equal to the total cost of producing each unit, averaged over all the units produced. For a natural monopolist, this method can be less efficient than marginal cost pricing, but it ensures financial viability:

• It allows the firm to break even rather than maximize profit.
• This pricing method helps in covering all economic costs, thus ensuring the sustainability of the firm.

While average total cost pricing is fairer for the consumer compared to profit maximization, it doesn't achieve the efficiency of equating price with marginal cost. Hence, it results in fewer goods being produced than under marginal cost pricing, potentially creating inefficiency in resource allocation.