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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

In a market economy, which of the following is the most widely accepted economic justification for government regulation of a firm that is a natural monopoly, such as a regional electricity transmission company?

Regulation is justified because a natural monopoly has falling average costs across the whole market, making a single supplier efficient, but that supplier could exploit its market power and charge excessive prices unless the government controls them.

  1. AAverage cost falls over the whole range of market demand, so a single firm is efficient but could use its market power to charge excessive pricesCorrect
  2. BMarginal cost rises sharply at low output, so several competing firms would be cheaper
  3. CConsumers are unable to buy substitutes, so demand is perfectly elastic
  4. DThe firm earns normal profit only, so it needs a subsidy to survive
  5. Firms in such industries produce too little of a demerit good

Explanation

A natural monopoly has economies of scale over the entire market, so one firm is the least-cost supplier. Without regulation it may restrict output and raise price. Option B is wrong because costs fall with scale, so competition would duplicate fixed costs.

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