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IAI Actuarial Core Principles · Business Economics · Government intervention in a market

A single firm can supply water pipelines to a city at lower average cost than two firms could, because of very large fixed costs. Which is the main reason a government may regulate this firm?

Because large fixed costs make one supplier cheapest, the firm is a natural monopoly. Unregulated, it could exploit market power by restricting output and charging high prices, so government regulates prices or ownership to protect consumers and improve efficiency.

  1. AA natural monopoly could use its market power to charge prices above the efficient levelCorrect
  2. BThe good is non-excludable, so the firm cannot charge
  3. CProducers ignore external costs of pollution
  4. DConsumers are unaware of product quality
  5. Government wishes to raise demand during a recession

Explanation

Economies of scale over the whole market make one firm efficient, but unregulated it can restrict output and raise price. Governments therefore regulate prices, set price caps or own the firm. The other options describe externalities, information problems or macro policy, not the case given.

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