Sometimes natural monopolies are subjected to price regulation (rate regulation), although more important for now is to deregulate those markets where competitions is possible. Some examples may be provincial and municipal commissions that regulate the price of gas, electricity that suppliers are charging.
In the figure above it is presented the regulation of local monopoly, for example the distributor of electricity. In this figure there are plotted demand curve and cost curves that our supplier is facing. Because of economies of scale demand curve cuts ATC curve at a point where this curve is still falling, so it’s inefficient to have more firms in this industry because each of them would produce a smaller quantity of output, thus they will operate at a point which is much more inefficient than for just one operating firm, since in short run their ATC will be higher than for just one single firm. So in this case it’s better to have just one seller.
We know from MR=MC rule that Qm and Pm are profit maximizing output and price that is more likely to be chosen by monopolist. At the quantity Qm the produce will enjoy an economic profit. Since price exceeds marginal then an underallocation of resources (allocative inefficiency) is being present. How can government regulate the price so that this will bring better results for the entire society?
Social Optimal Price P=MC
If the regulatory commission has the task to achieve the allocative efficiency then it will attempt to set a price where P will be equal with MC. Each point on demand curve shows a price-quantity combination. So, at point “r” we will have Pr which is equal to marginal cost.
Confronted with price Pr monopolists will maximize profits or minimize losses by producing Qr units of output. By making it illegal to charge a price higher than Pr , the firm won’t be able to produce other quantity of goods to increase the revenues.
The regulatory commission can stimulate allocative efficiency to be produced by imposing the only legal price Pr and letting the monopolist to choose its profit-maximizing or loss-minimizing output. So, production will take place at point where Pr=MC, and this equality will indicate an efficient allocation of resources to this good or service. The price that achieves allocative efficiency is called socially optimal price.
Fair-Return Price P=ATC
Social Optimal price, Pr, may be so low that the firm won’t be able to cover its average total costs (ATC). The result may be a loss for the firm. In our figure average total costs are more likely to be higher than Pr at the intersection of MR (P)=MC curve. Therefore forcing this firm to operate at social optimal price may result in short-run losses or even in bankruptcy in long-run.
What to do in this case? One solution is to provide subsidies by government that will cover these losses. Another option for regulatory commission is to modify the allocative efficiency policy P=MC, so that firms may establish a fair-return price. In this case firms will have only a normal profit and this price is determined by intersection of ATC and demand curves (in our case point “f”). So Pf permits a fair returnfor firms. The corresponding output for this price will be Qf. In this case the firm will realize only a normal profit.
Comparing results given by socially optimal price (MC=P) and fair-return price (P=ATC) sometimes and dilemma, called dilemma of regulation arises. When the price is set to achieve allocative efficiency ( P=MC) regulated monopoly is more likely to suffer losses. Conversely, when the price is set for productive efficiency/ fair-return price (P=ATC) monopolists can cover its costs, but in this case underallocation of resources problem is solved only partially, since the quantity output increases from Qm to Qf, while the social optimal price is Qr. Besides this dilemma regulations can improve results of monopoly from social point of view. Price regulation process reduces price, increases output, and reduces economic profit of monopolies.