Question

If setting the price of a natural monopoly at the socially optimal level would cause the seller to incur losses, the government may end up:

a. providing the good or service itself and covering any losses with tax revenue.
b. not regulating the natural monopoly, allowing it to charge the profit-maximizing price.
c. funding research to bring down the cost of production.
d. subsidizing new entrants to create competition that will bring the price down.

Answer 1

If the socially optimal price of a natural monopoly would result in losses for the seller, the government may subsidize new entrants to create competition and lower the price.

Step-by-step explanation:

In the case of a natural monopoly, market competition is unlikely to take root, so government regulation becomes necessary to prevent high prices and restricted output. If setting the price of a natural monopoly at the socially optimal level would cause the seller to incur losses, the government may end up subsidizing new entrants to create competition that will bring the price down.

This approach is known as price cap regulation, which involves setting a maximum price that the natural monopoly can charge. However, it is important to set the price cap at a level that is not too low to prevent the firm from incurring losses. If the market changes dramatically and the firm cannot meet the price cap due to rising costs, regulators can compare prices with producers of the same good in other areas to pressure the natural monopoly to compete. By allowing the possibility of greater profits or losses, the natural monopoly is motivated to improve efficiency and innovation.