A policy of average-cost pricing will intially ______ price for a natural monopoly, but as costs increase, price will _______.
A. increase; not change
B. decrease; increase
C. decrease; not change
D. increase; decrease
Do a little research, then take a shot.
Hint: Draw a picture of a natural monopolist; (Demand and MR curves, and AC and MC curves). The defining characteristic of a natural monopolist is that AC is declining for most (all) of any likely output. If AC is declining, what does that say about the position/shape of the MC curve?. At the point when AC starts to eventually rise, what does that say about the MC curve?
In order to understand the effects of average-cost pricing on a natural monopoly, let's first explain what average-cost pricing is. Average-cost pricing is a pricing strategy where a firm sets the price of its product equal to the average cost of production per unit.
Now, in the case of a natural monopoly, where one firm has exclusive control over a particular market due to high barriers to entry, implementing average-cost pricing will initially increase the price. Here's how:
1. Determine the average cost: First, the firm calculates its average cost per unit, which is the total cost divided by the total quantity produced.
2. Set the price: The firm then sets the price equal to the average cost per unit.
Initially, when the firm sets the price equal to the average cost per unit, the price will increase because the average cost per unit is typically higher than the marginal cost (the cost of producing one additional unit). Since the average cost includes both fixed costs and variable costs, it tends to be higher than the marginal cost, which only includes the additional costs incurred to produce one more unit.
However, as costs increase, the price under average-cost pricing will eventually decrease. This is because the firm continues to set the price equal to the average cost, which is increasing due to rising costs. But since the average cost per unit includes fixed costs that do not change with changes in production levels, the price increase will be slower than the increase in average cost. Thus, the price will eventually decrease compared to the initial price set under average-cost pricing.
Therefore, the correct answer is D. increase; decrease.