(a) Explain what is meant by the term “natural monopoly”.

(b) Construct a diagram showing the average and marginal cost curves, and the demand and marginal revenue curves for a natural monopoly. Use your diagram to explain why profit maximising behaviour by the monopolist is inefficient from society’s point of view.

(c) Suppose the government seeks to regulate the behaviour of the monopolist by price regulation. Consider the advantages and disadvantages of alternative criteria for setting the regulated price.

(a) The term "natural monopoly" refers to a market situation in which a single firm can efficiently produce and supply a good or service at a lower cost than multiple competing firms. In other words, the industry exhibits economies of scale to such an extent that it is more efficient and cost-effective for one firm to operate as a monopoly.

(b) To construct a diagram for a natural monopoly, we need to understand the cost, demand, and revenue curves. The average cost (AC) curve and the marginal cost (MC) curve represent the costs of producing each unit of output. The demand curve represents the quantity of the good or service that consumers are willing to purchase at each price level. The marginal revenue (MR) curve depicts the change in revenue resulting from the sale of one additional unit of output.

In the case of a natural monopoly, the average cost curve continuously decreases as output increases, showing economies of scale. The marginal cost curve intersects the average cost curve at its minimum point. The demand curve and the marginal revenue curve are downward sloping.

Profit-maximizing behavior for a monopolist occurs where the marginal cost (MC) intersects the marginal revenue (MR) curve, determining the level of output that maximizes profits. However, this is inefficient from society's point of view because the monopolist produces a quantity of output that is lower than the socially optimal level. The monopolist restricts output in order to charge a higher price and increase its profits, resulting in an allocative inefficiency.

(c) Government price regulation is a potential solution to address the inefficiency of profit-maximizing behavior by a monopolist. When setting the regulated price for a natural monopoly, several criteria can be considered:

1. Average total cost (ATC) pricing: The government sets the regulated price equal to the average total cost of production. This ensures that the monopolist covers its costs but does not make any profit. The advantage of this approach is that it avoids monopoly pricing and ensures affordability for consumers. However, it may not provide incentives for the monopolist to invest in innovation or efficiency improvements.

2. Fair return pricing: The government sets the regulated price at a level that allows the monopolist to earn a fair rate of return on its investment. This approach considers the costs incurred by the monopolist and provides an incentive for investment and efficiency improvements. However, determining what constitutes a fair rate of return may be subjective and open to interpretation.

3. Price caps: The government imposes a maximum price that the monopolist can charge. This approach aims to protect consumers from monopolistic pricing while allowing the firm to cover its costs and earn a reasonable profit. One advantage of price caps is that they create an incentive for the monopolist to become more efficient and reduce costs. However, if the price cap is set too low, it may discourage investment and maintenance of infrastructure.

4. Price discrimination regulation: The government prevents the monopolist from engaging in price discrimination, where different customers are charged different prices for the same product or service. This ensures fairness and prevents the monopolist from exploiting its market power. However, enforcing price discrimination regulations can be challenging, and it may limit the monopolist's ability to segment the market and offer different pricing options.

It is important to weigh the advantages and disadvantages of each criterion when setting the regulated price for a natural monopoly, taking into account factors such as efficiency, affordability, fairness, and incentives for innovation and investment.