Natural monopoly firms are often regulated so that they can only charge prices set by the authorities. Under one approach, prices are based on the monopolist’s costs so that for any given quantity of sales, the monopolist can only set prices equal to its average costs.

a Why might regulators believe that forcing the monopoly to charge a price equal to average cost is a good outcome? Does this price regulation maximise social welfare? What problems do you see with this form of price regulation?

b Suppose the monopolist can undertake innovation that will lower its average cost. If the monopolist faces average-cost price regulation, does it face strong or weak incentives to innovate? Explain your answer.

c An alternative to average-cost price regulation is to set a ‘price cap’ for the natural monopoly firm. With a price cap, the regulator does not adjust the regulated price as soon as monopolist’s costs change but keeps the same regulated prices for a number of years. It is argued that pricecap regulation encourages innovation. Do you agree with this and why?