Final answer:
The subsidy amount is graphically depicted as the rectangle area formed by the price the natural monopoly receives, the average cost at Q*, and the output level, Q*. It represents the total funds needed for the firm to break even while producing the socially optimal output.
Step-by-step explanation:
The main answer to the question of how to graphically depict the subsidy amount for a natural monopoly to produce the socially optimal output, Q*, involves understanding the firm’s cost structures and the market demand. A natural monopoly has declining average costs because of economies of scale, depicted by a downward-sloping Average Cost (AC) curve. The Marginal Cost (MC) curve intersects the AC curve from below. In a competitive market, the socially optimal output is where the MC curve intersects with the Demand Curve (D), which reflects the price consumers are willing to pay.To determine the subsidy amount, first, find the intersection point of MC and D, which will give us Q*. The subsidy is needed because at Q*, the firm’s price (P) based on the Demand curve is below the AC, meaning the firm would incur a loss. The subsidy should be equal to the per-unit loss multiplied by the quantity Q*.Graphically, the required subsidy is the area of the rectangle formed by the price the firm receives (P), the AC at Q*, and the output level, Q*. The height of the rectangle is the difference between AC and P at Q*, and the width is Q*. This rectangle represents the total amount needed from the regulator as a subsidy for the natural monopoly to break even while producing at Q*Conclusion: The subsidy allows the natural monopoly to cover its total costs while producing at the socially optimal level, Q*, without making losses. This aligns the firm’s production level with societal welfare, as it produces where price equals marginal cost.