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Perhaps the most plausible option for the regulator is point F; that is, to set the price where AC crosses the demand curve at an output of 6 and a price of 6.5. This plan makes some sense at an intuitive level: let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit, so that it can continue operating, but prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Of course, determining this level of output and price with the political pressures, time constraints, and limited information of the real world is much harder than identifying the point on a graph. For more on the problems that can arise from a centrally determined price, see the discussion of price floors and price ceilings in Demand and Supply .

Cost-plus versus price cap regulation

Indeed, regulators of public utilities for many decades followed the general approach of attempting to choose a point like F in [link] . They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation    .

Cost-plus regulation raises difficulties of its own. If producers are reimbursed for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing lots of staff, because what they can charge is linked to the costs they incur.

Thus, in the 1980s and 1990s, some regulators of public utilities began to use price cap regulation    , where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.

Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. But if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices being charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.

With natural monopoly, market competition is unlikely to take root, so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task.

Key concepts and summary

In the case of a natural monopoly, market competition will not work well and so, rather than allowing an unregulated monopoly to raise price and reduce output, the government may wish to regulate price and/or output. Common examples of regulation are public utilities, the regulated firms that often provide electricity and water service.

Cost-plus regulation refers to government regulation of a firm which sets the price that a firm can charge over a period of time by looking at the firm’s accounting costs and then adding a normal rate of profit. Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.

Problems

Use [link] to answer the following questions.

If the transit system was allowed to operate as an unregulated monopoly, what output would it supply and what price would it charge?

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If the transit system was regulated to operate with no subsidy (i.e., at zero economic profit), what approximate output would it supply and what approximate price would it charge?

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If the transit system was regulated to provide the most allocatively efficient quantity of output, what output would it supply and what price would it charge? What subsidy would be necessary to insure this efficient provision of transit services?

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Questions & Answers

what is labor
Grace Reply
labor is any physical or mental effort that helps in the production of goods and services
Kwabena
what is profit maximizing level of out put for above hypothetical firm TC = Q3 - 21Q2 + 600 + 1800 P = 600 MC = 3Q2 - 42Q + 600
Sosna Reply
consider two goods X and Y. When the price of Y changes from 10 to 20. The quantity demanded of X changes from 40 to 35. Calculate cross elasticity of demand for X.
Sosna
sorry it the mistake answer it is question
Sosna
consider two goods X and Y. When the price of Y changes from 10 to 20. The quantity demanded of X changes from 40 to 35. Calculate cross elasticity of demand for X.
Sosna
The formula for calculation income elasticity of demand is the percent change in quantity demanded divided by the percent change in income.
Sosna
what is labor productivity
Lizzy Reply
if the demand function is q=25-4p+p² 1.find elasticity of demand at the point p=5?
Puja Reply
what are some of the difference between monopoly and perfect competition market
Obeng Reply
n a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economic
Naima
what are some characteristics of monopoly market
Obeng Reply
explicit cost is seen as a total experiences in the business or the salary (wages) that a firm pay to employee.
Idagu Reply
what is price elasticity
Fosua
...
krishna
it is the degree of responsiveness to a percentage change in the price of the commodity
Obeng
economics is known to be the field
John Reply
what is monopoly
Peter Reply
what is taxation
Peter
why do monopoly make excess profit in both long run and short run
Adeola Reply
because monopoly have no competitor on the market and they are price makers,therefore,they can easily increase the princes and produce small quantity of goods but still consumers will still buy....
Kennedy
how to identify a perfect market graph
Adeola Reply
what is the investment
jimmy
investment is a money u used to the business
Mohamed
investment is the purchase of good that are not consumed today but are used in the future to create wealth.
Amina
investment is the good that are not consumed
Fosua
What is supply
Fosua
 Supply represents how much the market can offer.
Yusif
it is the quantity of commodity producers produces at the market
Obeng
what is the effect of scarce resources on producers
Phindu Reply
explain how government taxes and government producer subsidies affect supply
Chanda
what is economic
Charles Reply
what are the type of economic
Charles
macroeconomics,microeconomics,positive economics and negative economics
Gladys
what are the factors of production
Gladys
process of production
Mutia
Basically factors of production are four (4) namely: 1. Entrepreneur 2. Capital 3. Labour and; 4. Land but there has been a new argument to include an addition one to the the numbers to 5 which is "Technology"
Elisha
what is land as a factor of production
Gladys
what is Economic
Abu
economics is how individuals bussiness and governments make the best decisions to get what they want and how these choices interact in the market
Nandisha
Economics as a social science, which studies human behaviour as a relationship between ends and scarce means, which have alternative uses.
Yhaar
Economics is a science which study human behaviour as a relationship between ends and scarce means
John
Economics is a social sciences which studies human behavior as a relationship between ends and scarce mean, which have alternative uses.....
Pintu
how will a country's population be equal to it's labour force
Hope Reply
what is the meaning of ppf
Obeng Reply
Production Possibility Frontier
Igbekele

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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