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Suppose that the government allows a natural monopoly market structure to exist in the petroleum industry but the industry must face government regulation.
a) Under competitive pressure, a firm will set output at the level where Price = marginal cost. Discuss the desirable attributes for regulators to set P=MC when a natural monopoly exists and the problems created by a P=MC policy.
b) Suppose that average cost pricing is employed. Find and compare the price, output, profit, and the deadweight loss of average cost price to marginal cost pricing.
c) Now consider two-part pricing – a type of nonlinear (or non-uniform) pricing. Each consumer must pay a fixed fee regardless of consumption level plus a price per unit. Assume that the market consists of n-number of consumers with identical demand curves for the product. If the price is set equal to marginal cost, what is the largest fixed fee that a consumer would pay for the right to buy at that price? What fixed fee would permit the monopolist to break even? What is the deadweight loss in this case.
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