Natural monopolies give rise to a monopoly that is socially justifiable. Two tel

Question

Natural monopolies give rise to a monopoly that is socially justifiable. Two telephone companies, or gas companies, or water companies, or electricity companies in the same city would be highly inconvenient and costly as long as transmission requires wires and pipes. In such instances, it makes sense for government to grant exclusive franchises and then regulate the resulting monopoly through price to ensure the public interest is protected. A regulatory commission may attempt to establish the legal price for the monopolist that is equal to marginal cost at the quantity of output chosen. This is called the “socially optimal price.”

However, government has since deregulated the gas and electric companies. What has been the economic impact on pricing?

Explanation / Answer

After deregulation, we would expect that the firms would no longer produce an output where price is equal to average cost. In such a case, the firms will an output level where Marginal cost equals marginal revenue. According to a study by Institute of Public Utilities at Michigan State University, the average electricity prices increased by 36% in deregulated states between 2002 to 2006. Whereas the same figure for regulated states was 21% for the same time period.

This is expected since the firms will now focus on profit maximization and one way to do that would be to produce an output level where MR = MC.

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