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

A regulator wants to force a natural monopoly to set price equal to marginal cost. The most likely consequence for the firm is that it:

Marginal-cost pricing leads to an economic loss for a natural monopoly. Because of large economies of scale, average total cost is above marginal cost, so a price equal to marginal cost fails to cover total cost. The regulator would need to subsidize the firm or allow average-cost pricing.

  1. Aearns an economic profit and produces less than the efficient output
  2. Bearns zero economic profit because average cost equals marginal cost
  3. Cincurs an economic loss because average total cost exceeds marginal costCorrect

Explanation

A natural monopoly has economies of scale, so its average total cost declines and lies above marginal cost. Pricing at marginal cost therefore yields a price below average total cost and an economic loss, which may require a subsidy. Average-cost pricing, not marginal-cost pricing, gives zero economic profit.

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