Q2. (10 marks) The figure below shows the natural monopoly of a company that sup

Question

Q2. (10 marks) The figure below shows the natural monopoly of a company that supplies electricity to a small town measured in kilowatt hours (kWh) per day. Price (S kWh) 0.60 0.50 ?? 0.20! 0.10 -ATC ?MC 400 600 900 120o Quantity (kWh '000s) Define natural monopoly and explain why this market exhibits typical characteristics of a natural monopoly? (3 marks) a) b) If the market is unregulated what price an the dead weight loss, if it exists, relative to the efficient outcome. (3 marks) d quantity would the monopolist set? Calculate the size of c) Suppose the regulator now wants to regulate zero economic profit). What price and quantity would and, if so, determine the size of this relative to the efficient outcome. (4 marks) this industry so that the firm makes a normal profit (i.e. this involve? Is there still a dead weight loss

Explanation / Answer

2.

A.

Natural monopoly is the structure that exhibits very high fixed cost or initial investment as entry barriers. In the given scenario, it can be seen that ATC is as high as $.6 per KWH in the beginning of the production, though the MC remains low at $.1 per KWH. With increase in level of production, ATC decreases. It gives the pricing advantage and economy of scale to the firm. As a result, natural monopoly is established as no other firm can produce the product at the same cost.

B.

If market is unregulated, then,

Profit maximizing output is achieved when MR = MC

At this point of MR = MC.

Output = 600 (KWH,000)

Price = $.5 per KWH

Deadweight loss = (1/2)*(.5-.1)*(1200-600) = $120 (,000)

C.

When it is a regulated monopoly,

Then,

P = ATC to earn normal profit,

At this level.

Price = $.2

Output = 900 KWH (,000)

Deadweight loss = (1/2)*(.2-.1)*(1200-900) = $15 (,000)

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