CHAPTER 11 Price and Output  Under these circumstances, one supplier of the good

or service is able to produce the output more cheaply

Determination: Monopoly and than can a group of smaller competitors.
Dominant Firms  These so-called natural monopolies are usually closely
 In this chapter we analyze how firms that operate in regulated by government agencies to restrict the
monopoly or near-monopoly markets make output profits of the monopolist.
and optimal pricing decisions.
 In such markets the dominant firm does not have to Increasing Returns from Network Effects
accept the market price as a given.  Finally, increasing returns in network-based
 These firms base their price-cost markups on other businesses can be a source of monopoly market
factors such as the demand projections at various power.
price points, indicative of the target customers’ price  When Microsoft managed to achieve a critical level of
elasticity. adoption for its Windows graphical user interface
 In this chapter we identify the reasons for single-firm (GUI), the amount of marketing and promotional
dominance and analyze the components of the expenditure required to secure the next adoption
contribution margin and the gross margin for such actually began to fall.
firms.  Marketing and promotions are generally subject to
 We introduce spreadsheet, graphical, and algebraic diminishing returns, as depicted in Figure 11.1.
methods to calculate profit maximizing price and  From 0 to 30 percent market share, the marketing
output decisions. required to achieve each additional share point has a
 In addition, we look at these decisions for regulated diminishing effect on the probability of adoption by
industries: electric power, natural gas distribution and the next potential user (note the reduced slope of the
transmission, and broadcast communications. sales penetration curve).
 Deregulation continues to be a topic of debate, and it  Consequently, additional share points become more
is important that any policy changes be consistent and more expensive over this range.
with microeconomic principles.  When the number of other users of a network-based
device reached a 30 percent share, the next 50 or so
MONOPOLY DEFINED share points became cheaper to promote.
 Monopoly is defined as a market structure with  That is, beyond the 30 percent inflection point, each
significant barriers to entry in which a single firm additional share point of users connected to Windows
produces a highly differentiated product. increased the probability that another user would
 Without any close substitutes for the product, the adopt.
demand curve for a monopolist is often an entire  Therefore, the marketing expense required to secure
relevant market demand. another unit sale decreased. (Note the increased slope
 Just as purely competitive market structures are rare, of the sales penetration curve in the middle portion of
so too are pure monopoly markets rare. Figure 11.1.)
 Then beyond 85 percent, diminishing returns again set
SOURCES OF MARKET POWER FOR A MONOPOLIST
in.
 Monopolists or near-monopoly dominant firms enjoy
 These network-based effects of compatibility with
several sources of market power.
other users increase the value to the potential
 First, a firm may possess a patent or copyright that
adopter.
prevents other firms from producing the same
 The same thing occurs as more independent software
product.
vendors (ISVs) write applications for an operating
 Second, a firm may control critical resources.
system like Windows that has effectively become an
 A third source of monopoly power may be a
industry standard by achieving more than 30 percent
government-authorized franchise.
acceptance in the marketplace.
 The same type of monopoly power occurs when a
 The inflection points in the sales penetration curve
government agency such as the FCC adopts an
make it likely that Microsoft will achieve an 85 percent
industry standard that favors one company over
monopoly control of the operating system market.
another.
 Whatever customer relationships preexisted, once
 Monopoly power also happens in natural monopolies
Microsoft achieved a 30 percent share, its increasing
because of significant economies of scale over a wide
returns in marketing caused a network effect that
range of output.
displaced other competitors.
 The first entrant firm will enjoy declining long-run
average costs.
 Microsoft’s share then grew to 92 percent. Netscape’s  Unlike autos or steel, once R&D costs have been
Internet search engine experienced similar recouped, the marginal cost of additional copies of the
displacement by Microsoft’s Internet Explorer when software, additional doses of the medicine, or
Microsoft achieved a 30 percent-plus market share by additional users on the wireless system are close to
bundling Internet Explorer with Windows. zero; that means every single unit sold thereafter is
 In effect, it gave away the search engine or free to close to pure profit.
reach the range of increasing returns on the sales  Competitor firms who have incurred the up-front fixed
penetration curve for OS software. costs but not succeeded in reaching the inflection
 Even with increasing returns set off by network point of increasing returns will rationally spend
effects, monopoly seldom results for three reasons. enormous sums seeking to recoup these rents through
 First, a higher price point for innovative new products the political process and in the courts.
can offset the cost savings from increasing returns of a  For example, Netscape and Sun Microsystems
competitor. succeeded during Microsoft’s long antitrust trial of
 This has been Apple’s approach to combatting 1997–2002 in restricting their competitor.
Microsft dominance on the operating systems of Dell  U.S. courts ordered restrictions on Microsoft’s
and Hewlett-Packard PCs. installation agreements for Windows and prohibited
 Apple’s gross margin exceeded 32 percent for 2005– Microsoft’s refusal to deal with Windows licensees
2008, whereas Dell and HP averaged 18 percent and who install Netscape’s competing Web browser
25 percent, respectively. software.
 Second, network effects tend to occur in technology-  And Genentech’s first commercial success was a
based industries that have experienced falling input multiple sclerosis drug that avoided direct challenge to
prices. a broad Schering-Plough Corporation patent by
 Figure 11.2 shows that between 1997 and 2009, the employing a special FDA rule. Similarly, Xerox was
cost per megahertz for silicon computer chips fell from forced by antitrust authorities in the United States to
$2.00 to $0.25, hard drive storage device cost per license its wet paper copier technology at low royalty
megabyte fell from $0.40 to $0.03, and the cost per fees.
month for a T1 high-speed data transmission line fell  How do firms attempt to get around the inflection
from $475 to $300. point of Figure 11.1 and achieve increasing returns?
 During the same period, Corning fiber-optic cable Free trials for a limited period of use is one approach.
became essentially free to anyone who would install  Another is giving the technology away if it can be
it. bundled with other revenue-generating product
 In short, as these input suppliers grew to serve the offerings.
expanding product markets in computer equipment  Microsoft gave away Internet Explorer (IE) for free
and telecom devices, they encountered new without being charged with predatory pricing (IE’s
productivity from learning curves and innovative variable cost was $0.004; that is, it rounded to zero).
design breakthroughs that drove down their costs.  Another approach is to undertake consolidation
 Because flash memory chips and telecom equipment mergers and acquisitions; this strategy drove IBM’s
markets tend to be highly competitive, the cost acquisition of a host of smaller software companies,
savings of input suppliers such as AMD and Corning such as Lotus, and Oracle engaged in a hostile
get passed along to the final product producers, takeover of PeopleSoft.
including Apple, PC-assembler Dell, cell phone  Some companies such as Sun Microsystems also
manufacturer Nokia, and router manufacturer Cisco. provide JAVA and Linux programming subsidies to
 Consequently, generally lower costs for all inputs independent software vendors whose applications will
offset in large part the dominant firm advantage from provide network effects as complements to Sun’s
increasing returns in promotion and selling expenses JAVA-based OS.
for companies such as Microsoft.  Finally, having a product adopted as an industry
 Third, technology products whose primary value lies in standard leads to increasing returns.
their intellectual property (e.g., computer software,  Sony achieved this network effect with its Blu-Ray
pharmaceuticals, and telecom networks) have HDTV standard.
revenue sources that are dependent on renewals of  Sales penetration curve. An S-shaped curve relating
governmental licensures and product standards. current market share to the probability of adoption by
the next target customer, reflecting the presence of
increasing returns.
PRICE AND OUTPUT DETERMINATION FOR A  But we know that reducing output must also reduce
MONOPOLIST total costs, resulting in an increase in profit.
 A firm will continue to raise prices (and reduce output)
Spreadsheet Approach
as long as the price elasticity of demand is in the
Graphical Approach inelastic range.
 Figure 11.3 shows the price-output decision for a  Therefore, for a monopolist, the price-output
profit-maximizing monopolist. combination that maximizes profits must occur where
 Just as in pure competition, profit is maximized at the |ED| ≥ 1.
price and output combination, where MC = MR.  Equation 11.2 also demonstrates that the more elastic
 This point corresponds to a price of P1, output of Q1, the demand (suggesting the existence of better
and total profits equal to BC profit per unit times Q1 substitutes), the lower the price (relative to marginal
units. cost) that any given firm can charge.
 For a negatively sloping demand curve, the MR  This relationship can be illustrated with the following
function is not the same as the demand function. example.
 In fact, for any linear, negatively sloping demand THE OPTIMAL MARKUP, CONTRIBUTION MARGIN,
function, the marginal revenue function will have the
AND CONTRIBUTION MARGIN PERCENTAGE
same intercept on the P axis as the demand function
 Sometimes it is useful and convenient to express
and a slope that is twice as steep as that of the
these relationships among optimal price, price
demand curve.
elasticity, and variable cost as a markup percentage or
 If, for example, the demand curve were of the form
contribution margin percentage.
 Using Equation 11.2 to solve for optimal price yields
(with MC = variable cost)

 where the multiplier term ahead of MC is 1.0 plus the

percentage markup.
 For example, the case of ED = –3 is a product with a
Algebraic Approach −3/(−3 + 1) = 1.5 multiplier on MC—i.e., a 50 percent
markup.
The Importance of the Price Elasticity of Demand
 The optimal profit-maximizing price recovers the
 Recall from Chapter 3 that marginal revenue (MR), the
marginal cost and then marks up MC another 50
incremental change in total revenue arising from one
percent.
more unit sale, can be expressed in terms of price (P)
 If MC = $6, this item would sell for 1.5 × $6 = $9 and
and the price elasticity of demand (ED), or
the profit-maximizing markup is $3, or 50 percent
more than the marginal cost.
 The difference between price and marginal cost (i.e.,
the absolute dollar size of the markup) is often
referred to as the contribution margin.
 With the incremental variable cost already covered,
these additional dollars are available to contribute to
covering fixed cost and earning a profit.
 They are expressed as a percentage of the total price.
 Note from Equation 11.2 that a monopolist will never In the previous example, the $3 markup above and
operate in the area of the demand curve where beyond the $6 marginal cost represents a 33 percent
demand is price inelastic (i.e., |ED| < 1). contribution to fixed cost and profit, that is, a 33
 If the absolute value of price elasticity is less than 1(| percent contribution margin on the $9 item. Using
ED| < 1), then the reciprocal of price elasticity (1/ED) Equation 11.3 and ED = –3,
will be less than –1, and marginal revenue P (1 + 1/ED)
will be negative.
 In Figure 11.3, the inelastic range of output is output
beyond level Q2.  To summarize, an elasticity of –3.0 implies that the
 A negative marginal revenue means that total revenue profit-maximizing markup is 50 percent, and that 50
can be increased by reducing output (through an percent markup implies a 33 percent contribution
increase in price). margin.
 Price elasticity information therefore carries  Value proposition. A statement of the specific
implications for the marketing plan. source(s) of perceived value, the value driver(s), for
 Combining the contribution margin percentage (33%) customers in a target market.
with incremental variable cost information indicates
what dollar markups and product prices to announce. Components of the Gross Profit Margin
 One takeaway is that the more elastic the demand  Gross profit margin (or just “gross margin”) is a term
function for a monopolist’s output, the lower the price often used in manufacturing businesses to refer to the
that will be charged, ceteris paribus. profit margin after direct fixed costs as well as variable
 In the extreme, consider the case of a firm in pure manufacturing costs are subtracted.
competition with a perfectly elastic (horizontal)  For example, in a carpet plant, the gross margin on
demand curve. each product line would be the plant’s wholesale
 In this case the price elasticity of demand approaches revenue minus the sum of input costs plus machinery
–∞; hence, 1 divided by the price elasticity setup costs for the product’s production runs involving
approaches 0 and marginal revenue in Equation 11.1 that type of carpet.
becomes equal to price.  A manufacturer’s income statement identifies variable
 Thus, the profit-maximizing rule in Equation 11.2 manufacturing costs plus direct fixed manufacturing
becomes “Set price equal to marginal cost,” and the cost as the “direct cost of goods sold” (DCGS).
profit-maximizing markup in Equation 11.3 is zero (i.e.,  Thus, the gross margin is revenue minus direct cost of
the marginal cost multiplier equals just 1.0). goods sold.
 Of course, this conclusion is the same price-cost  Gross profit margins differ across industries and across
solution developed in Chapter 10 in the discussion of firms within the same industry for a variety of reasons.
price determination under pure competition.  First, some industries are more capital intensive than
 So, the question remains: how does a noncompetitive others.
firm establish a strategy to sustain higher contribution  Aircraft manufacturing with its large assembly plants is
margins such as Chanel No. 5’s 91 percent when Ole much more capital intensive than software
Musk achieves only 8 percent? The key ideas are laid manufacturing.
out in the Strategy Map shown in Figure 11.4.  Boeing wide-body airframes have 72 percent gross
 We will illustrate with Natureview Farms (NVF) Yogurt, profit margins, not because they are particularly
a Vermont-based green producer of dairy products. profitable, but because airframes have high fixed costs
 All effective business plans begin with a value for the capital investment tied up in large assembly
proposition for the target customers. plants.
 As the U.S. population became more environmentally  The first component of the gross profit margin
conscious, Natureview Farms identified a younger, percentage, then, is capital costs per sales dollar.
better-educated yogurt buyer who perceived value  Second, differences in gross margins reflect
from higher-quality ingredients with longer shelf life differences in advertising, promotion, and selling
than was typical of natural and organic ingredients. costs.
 Despite the absence of chemical preservatives, NVF’s  Leading brands in the ready-to-eat cereal industry
yogurt remains fresh for 50 days rather than 20. have 70 percent gross margins, but half of that price-
 This additional functionality in combination with cost differential (35 percent of every sales dollar) is
higher-quality ingredients reliably exceeding customer spent on advertising and promotion.
expectations for fresh texture and taste warranted an  The automobile industry also spends hundreds of
enhanced price premium. millions of dollars on advertising, but that amounts to
 But to create financial value from these customer only 9 percent per sales dollar.
value drivers, NVF found it necessary to boost unit  The second component of the gross profit margin
sales growth and increase asset utilization by moving percentage is the advertising and selling expenses per
from the natural foods stores into Whole Foods and sales dollar.
other specialty supermarkets.  Third, differences in gross margins arise because of
 Handling the distribution channel issues with robust differential overhead in some businesses.
operations management processes and effective  The pharmaceutical industry has high gross margins, in
marketing communications proved critical to large part because of the enormous expenditures on
sustaining a high profit margin. research and development to find new drugs.
 The symbol MC may be understood to refer to the  To conduct business in that product line, other
accountant’s narrow definition of variable costs, pharmaceutical firms then incur patent fees and
operating costs that vary with the least aggregated licensing costs, which raise their overhead costs and
unit sale in the business plan. prices.
 Overhead costs also may differ if headquarters salaries  With a limit-pricing strategy, the firm forgoes some of
and other general administrative expenses are high in its short-run monopoly profits in order to maintain its
certain firms but not others. monopoly position in the long run.
 Finally, after accounting for any differences in capital  The limit price, such as PL in Figure 11.5, was set
costs, selling expenses, and overhead, the remaining below the minimum point on a potential competitor’s
differences in gross margins do reflect differential average total cost curve (ACpc).
profitability.  The appropriate limit price is a function of many
 The gross margin definition can be applied to retail different factors.
firms but not to service firms whose direct cost of  The effect of the two different pricing strategies on
goods sold is undefined by accountants. the dominant firm’s profit stream is illustrated in
 In services, the contribution margin definition of unit Figure 11.6.
profit is prevalent, and activity-based costing (ABC)  By charging the (higher) short-run profit-maximizing
determines which b costs are variable to a product price, the firm’s profits are likely to decline over time
line or an account. at a faster rate, as in Panel (a), than by charging a limit
 Gross profit margin. Revenue minus the sum of price as shown in Panel (b).
variable cost plus direct fixed cost, also known as  The firm should engage in limit pricing if the present
direct costs of goods sold in manufacturing. value of the profit stream from the limit-pricing
strategy exceeds the present value of the profit
Monopolists and Capacity Investments stream associated with the short-run profit-
 Because monopolists do not face the discipline of maximization rule of MR = MC.
strong competition, they tend to install excess  Such a decision is more likely the higher the discount
capacity or, alternatively, fail to install enough rate is.
capacity.  Choosing a high discount rate will place relatively
 A monopolist that wants to restrain entry of new higher weight on near-term profits in the calculation
competitors into the industry may install excess of present discounted value and relatively lower
capacity in order to threaten to flood the market with weight on profits that occur further into the future.
supply and lower prices, which makes entry less  A high discount rate is justified when the firm’s long-
attractive. term pricing policy, and hence profits, are subject to a
 Even in regulated monopolies such as electric utility high degree of risk or uncertainty.
companies, considerable evidence shows that  The higher the risk, the higher is the appropriate
regulation often provides incentives for a firm to discount rate.
overinvest or underinvest in generating capacity.  The limit-pricing model illustrates the importance of
 Because utilities are regulated so that they have an potential competition as a control device on existing
opportunity to earn a “fair” rate of return on their firms.
assets, if the allowed return is greater (less) than the
firm’s true cost of capital, the company will be REGULATED MONOPOLIES
motivated to overinvest (underinvest) in new plant  Several important industries in the United States
and equipment. operate as regulated monopolies.
 In broad terms, the regulated monopoly sector of the
Limit Pricing U.S. economy includes public utilities such as electric
 Maximizing short-run profits by setting marginal power companies, natural gas companies, and
revenue equal to marginal cost in order to yield an communications companies.
optimal output of Q1 and an optimal price of P1 may  In the past, many of the transportation industries
not necessarily maximize the long-run profits (or (airlines, trucking, railroads) also were regulated
shareholder wealth) of the firm. closely, but these industries have been substantially
 By keeping prices high and earning monopoly profits, deregulated over the past 10 to 25 years
the dominant firm encourages potential competitors
 Public utilities. A group of firms, mostly in the
to commit R&D or advertising resources in an effort to
electric power, natural gas, and communications
obtain a share of these profits.
industries, that are closely regulated by one or more
 Instead of charging the short-run profit-maximizing
government agencies. The agencies control entry into
price, the monopolist firm may decide to engage in the business, set prices, establish product quality
limit pricing, where it charges a lower price, such as PL
standards, and influence the total profits that may be
in Figure 11.5, in order to discourage entry into the earned by the firms.
industry by potential rivals.
Electric Power Companies
 Electric power is made available to the consumer  In either event, the rates charged to final users also
through a production process characterized by three are subject to regulatory control
distinct stages.
 First, the power is generated in generating plants. Communications Companies
 Next, in the transmission stage, the power is  In the communications industry, the most important
transmitted at high voltage from the generating site to activities are radio, cable, television, and telephone
the locality where it is used. service that are regulated by the Federal
 Finally, in the distribution stage, the power is Communications Commission (FCC).
distributed to the individual users.  Local service in the intrastate markets, which may be
 The complete process may take place as part of the provided either by one of the former Bell System
operations of a single firm, or the producing firm may companies or by one of the so-called local telephone
sell power at wholesale rates to a second enterprise independents, is regulated by state commissions.
that carries out the distribution function.  Radio station ownership continues to become more
 In the latter case, the distribution firm often is a concentrated; perhaps 70 percent of the stations in
department within the local municipal government or the top 100 markets are now controlled by two
a consumer cooperative. companies.
 Investor-owned electric power companies are subject
THE ECONOMIC RATIONALE FOR REGULATION
to regulation at several levels.
 As described in the preceding section, regulated
 Integrated firms that carry out all three stages of
industries furnish services that are critical to the
production are usually regulated by state public utility
functioning of the economy.
commissions.
 What are the justifications for imposing economic
 These commissions set the rates to be charged to the
regulation on certain industries?
final consumers.
 The firms normally receive exclusive rights to serve Natural Monopoly Argument
individual localities through franchises granted by  Firms operating in the regulated sector are often
local governing bodies. natural monopolies in which a single supplier tends to
 As a consequence of their franchises, electric power emerge because of a production process characterized
companies have well-defined markets within which by massive economies of scale.
they are the sole provider of output.  In other words, as all inputs are increased by a given
 Finally, the Federal Energy Regulatory Commission percentage, the average total cost of a unit of output
(FERC) has the authority to set rates on power that decreases.
crosses state lines and on wholesale power sales.  Consequently, the long-run unit cost of output
 Some states are continuing to partially or totally declines throughout the relevant range of output.
deregulate the power production and transmission  This situation is illustrated in Figure 11.7 for a firm in
elements of this industry. long-run stable equilibrium.
 The California crisis with deregulated electricity raises  Suppose that the market demand curve for output is
questions about the desirability of fully deregulated represented by the curve DD in Figure 11.7.
competition at the retail (distribution) level.  The socially optimal level of output would then be Q*;
at that level of output, price would be well below the
Natural Gas Companies
average total cost per unit AC* but equal to short-run
 The highly regulated natural gas industry also is a
and long-run marginal cost.
three-stage process.
 A single producer is able to realize economies of scale
 The first stage is the production of the gas in the field.
that are unavailable to firms in the presence of
 Transportation to the consuming locality through
competition.
pipelines is the second stage.
 From a social perspective, competition would result in
 Distribution to the final user makes up the third stage.
inefficiency in the form of higher costs such as unit
 The FERC historically set the field price of natural gas, cost (ACC) for the competitive firm than the unit cost
but regulation at the wellhead has been effectively (ACM) for the monopoly firm that is six times as large.
phased out.
 The argument follows that production relations like
 Today, the FERC oversees the interstate those in Figure 11.7 will lead to the emergence of a
transportation of gas by approving pipeline routes and single supplier.
by controlling the wholesale rates charged by pipeline
 Competing firms will realize that their costs decrease
companies to distribution firms.
as output expands.
 The distribution function may be carried out by a
private firm or by a municipal government agency.
 As a consequence, they will have an incentive to cut higher price than would exist in a more competitive
prices as long as MR exceeds LRMC to increase sales market structure.
volume and spread the fixed cost.  This conclusion assumes no significant economies of
 During this period, prices will be below average cost, scale that might make a monopolist more efficient
resulting in losses for the producing firms. than a large group of smaller firms.
 Unable to sustain such losses, the weaker firms  The primary sources of monopoly power include
gradually leave the industry, until only a single patents and copyrights, control of critical resources,
producer remains. government “franchise” grants, economies of scale,
 Thus, competitive forces contribute to the emergence and increasing returns in networks of users of
of the natural monopoly. compatible complementary products.
 If a monopolistic position were to exist in the absence  Increasing returns from network effects are limited by
of regulation, the monopolist would maximize profit input cost reductions among competitors, by
by equating marginal revenue and marginal cost at an innovative new product introductions, and by lobbying
output QM, leading to a higher price PM and lower efforts.
output.  Monopolists will produce at that level of output where
 Thus, intervention through regulation is required to MR = MC if their goal is to maximize short-run profits.
achieve the benefits of the most efficient organization  The price charged by a profit-maximizing monopolist
of production. will be in that portion of the demand function where
 In its simplest form, this is the explanation of demand is elastic (or unit elastic).
regulation based on the existence of natural  The greater the elasticity of demand facing a
monopolies. monopolist, the lower will be its price relative to
 Figure 11.7 illustrates one problem stemming from a marginal cost, ceteris paribus.
genuine natural monopoly.  Contribution margins are defined as revenue minus
 Suppose that a regulatory agency succeeds in incremental variable cost, or revenue minus marginal
establishing the socially optimal price for output, P*. cost when only one unit is sold.
 As the cost curves indicate, this price would lead to  Contribution margins and markups are inversely
losses for the producing firm, because price would be related to the price elasticity of demand.
below the average total cost AC*.  Financial value derives from lower unit cost and better
 This is obviously an unsustainable result. asset utilization in the cost structure as well as higher
 In this situation the regulating agency normally sets price premiums and more unit sales in the revenue
prices at average cost to make sure revenues are model.
sufficient to cover all costs.  A customer value proposition derives from the
 The most efficient way to realize revenue, however, is attribute, relationship, and image value drivers for a
to charge a per-unit price equal to LRMC(P*) and target customer market.
collect the shaded deficit area in Figure 11.7 as a lump  Internal process value derives from operations
sum access fee, perhaps divided equally among one’s management processes, customer service, innovation,
customers. and regulatory initiatives.
 Alternatively, with time-of-day metering, the lump  Gross margins are defined as revenue minus direct
sum access fees can depend on when the customer costs of goods sold, and serve to recover capital costs,
uses power—higher lump sum access fees charged at selling costs, and overhead as well as earn profits.
peak periods such as 4:00 P.M. to 8:00 P.M.  Limit pricing—pricing a product below the short run
 Natural monopoly. An industry in which maximum profit-maximizing level—is a strategy used by some
economic efficiency is obtained when the firm monopolists to discourage rivals from entering an
produces, distributes, and transmits all of the industry.
commodity or service produced in that industry. The  Public utilities are firms, mostly in the electric power,
production of natural monopolists is typically natural gas pipeline, and communications industries,
characterized by increasing returns to scale that are closely regulated with respect to entry into
throughout the relevant range of output. the business, prices, service quality, and total profits.
 The rationales for public utility regulation are many.
SUMMARY  The natural monopoly argument is applied in cases
 Monopoly is a market structure with significant where a product is characterized by increasing returns
barriers to entry in which one firm produces a to scale.
differentiated product.  The one large firm can theoretically furnish the good
 In a pure monopoly market structure, firms will or service at a lower cost than a group of smaller
generally produce a lower level of output and charge a competitive firms.
 Regulators then set utility rates to prevent monopoly
price gouging, ideally allowing the regulated firm to
earn a return on investment just equal to its cost of
capital.
 Price discrimination by utilities is often economically
desirable on the basis of cost justifications and
demand justifications.
 Peak-load pricing is designed to charge customers a
greater amount for the services they use during
periods of greater demand.
 Long-distance phone services typically have been
priced on a peak-load basis.