Hawaiian Electric Company (HECO) is a monopoly. Let us suppose that increasing returns to scale (IRTS) exist, such that the provision of electricity a natural monopoly. The relevant curves for electricity look like the graph below. Note that AC is falling because of IRTS, and that MC is below AC because AC is falling. Trace this graph onto your answer sheet.

(a) Label the price and output that HECO would choose if it maximized profits. Label them Pm and Qm.

(b) Suppose HECO were to price at marginal cost. Label the price and output that would result. Label them Pc and Qc.

(c) HECO would have negative profits if it priced at marginal cost. Show the area of loss on the graph.

(d) If HECO were to price at marginal cost, it would have to subsidize HECO by the amount of loss shown in 3. The government decides that it will not subsidize HECO. Suppose that the government were force HECO to price at average cost. Trace the graph into your answer sheet again. Label the price Econ 130, Sec. 1 Fall 2015 Homework 5 Michael J. Roberts University of Hawaii at Manoa and output that would result from pricing at average cost Pa and Qa. For comparison, put the monopolist?s price and output, Pm and Qm, on this graph too.

(e) Show the gain in consumer surplus that arises from lowering the price from Pm to Pa.

(f) Show that the gain in consumer surplus exceeds the loss in profits to HECO.

(g) In addition to pricing too high, HECO does not keep costs as low as possible. Workers are paid higher than market wages as a way to subsidize them, and workers have little incentive to be as productive as possible. The AC curve is therefore higher than necessary. In the graph below, AC0 is the curve when costs are kept as low as possible; AC1 is the curve that represents HECOs costs (including the high wages and less-than-fully productive workers). Trace this graph onto your answer sheet. Show:

i. The price and output that HECO will choose if the government forces it to price at its average cost (but the government cannot force it to keep costs as low as possible).

ii. The loss of consumer surplus that arises because HECO does not keep costs as low as possible.

(h) Can you think of a way for the government to assure that costs are as low as possible? (There is no correct answer here.) Your answer should recognize that it is difficult for the government to determine market wages and is especially difficult to determine whether workers are fully productive.

P AC MC MR D Q