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CFA Level I · CFA Level I Exam · The Firm and Market Structures

A regulator is considering average cost pricing for a natural monopoly with substantial economies of scale. Compared with marginal cost pricing, average cost pricing most likely:

Average cost pricing lets the natural monopoly earn a normal profit, with price equal to average total cost, but output stays below the efficient level, leaving some deadweight loss. It is marginal cost pricing that would cause losses requiring a subsidy.

  1. Arequires a government subsidy to cover the firm's losses
  2. Ballows the firm to earn a normal profit but leaves some deadweight lossCorrect
  3. Celiminates deadweight loss and yields positive economic profit

Explanation

For a natural monopoly, marginal cost lies below average cost, so marginal cost pricing causes losses needing a subsidy. Average cost pricing sets price equal to ATC, giving zero economic profit (normal profit), but output is lower than the efficient level, so some deadweight loss remains.

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