Principles of Microeconomics / Unit 10 MIC 0909 worked example, 60 to 90 seconds
Regulating a Natural Monopoly: The Numbers
The idea
From a demand schedule, a fixed cost and a constant marginal cost, compute revenue, marginal revenue and average cost at each quantity. The unregulated point is where marginal revenue meets marginal cost, price from demand; report the profit. The marginal-cost point is where price equals marginal cost; report the loss, which equals the fixed cost when marginal cost is constant. The average-cost point is where price equals average cost: zero profit.
In practice
Worked example: a water utility faces demand of two thousand households at ten dollars, three at nine, four at eight, five at seven, six at six, seven at five, eight at four, nine at three and ten at two. Fixed cost is twenty-one thousand and marginal cost two dollars per household. Marginal revenue per household for the third through sixth thousand is seven, five, three and one, so the unregulated utility serves five thousand at seven dollars; average cost there is six dollars twenty, profit four thousand. Marginal-cost pricing means two dollars and ten thousand households, a loss of twenty-one thousand. Average-cost pricing lands at seven thousand households and five dollars, where average cost is exactly five: zero economic profit.
Where people slip
Read the regulated price from demand at the chosen quantity. And the average-cost point is the course's fair-return price; the firm earns a normal profit there, which is what zero economic profit means.
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