Government policy to improve the efficiency of a monopoly
Why this page is compulsory, not optional
- The standard lists "a government policy to improve the efficiency of a monopoly market" as an Achieved-level requirement, alongside pricing, output and efficiency.
- Excellence then asks you to compare and contrast the effectiveness of different policies.
- Question Three of the paper has been a natural monopoly and its pricing options every year since 2023.
The three pricing options
All three are shown on the same natural monopoly diagram. Learn them as a set, because the exam compares them.
1. Profit maximising pricing (unregulated): MR = MC
- The firm chooses this itself if left alone.
- Output is the smallest of the three; price is the highest.
- Supernormal profit is at its largest.
- Consumer surplus is the smallest of the three; deadweight loss is the largest.
- Least efficient of the three.
2. Average cost pricing: P = AC
- The regulator requires the firm to set price equal to average cost.
- The firm makes normal profit — it covers all its costs including the opportunity cost of its capital, but no more.
- Output is larger and price lower than profit maximising.
- P is still above MC, so a smaller deadweight loss remains. Not fully efficient, but much better.
- The firm is financially viable without a subsidy. This is why it is the option regulators usually choose.
3. Marginal cost pricing: P = MC
- The regulator requires the firm to set price equal to marginal cost.
- This is the allocatively efficient outcome — P = MC, so D = S and the deadweight loss is zero.
- Output is the largest and price the lowest, so consumer surplus is the largest.
- But: because a natural monopoly's AC lies above MC at every output, setting P = MC means P < AC, so the firm makes a subnormal profit — a loss.
- The firm cannot survive on this without a government subsidy, which has its own cost and its own deadweight loss.
The comparison table
| Profit maximising | AC pricing | MC pricing | |
|---|---|---|---|
| Rule | MR = MC | P = AC | P = MC |
| Price | Highest | Middle | Lowest |
| Output | Smallest | Middle | Largest |
| Consumer surplus | Smallest | Middle | Largest |
| Firm's profit | Supernormal | Normal | Subnormal (loss) |
| Deadweight loss | Largest | Smaller | Zero |
| Allocatively efficient? | No | No | Yes |
| Viable without subsidy? | Yes | Yes | No |
- The 2024 report names exactly the Achieved-level points from this table: consumers are best off under MC pricing because consumer surplus is largest; worst off under profit maximising because CS is smallest; the market is most efficient under MC pricing and least efficient under profit maximising.
Other government policies
- Regulation of price and quality. New Zealand's Commerce Commission sets price-quality paths under Part 4 of the Commerce Act 1986 — effectively AC-style pricing with a required service standard.
- Breaking up the monopoly or removing barriers to entry. Effective for an ordinary monopoly, because more firms flatten each firm's demand curve and push price towards MC. Counterproductive for a natural monopoly, because it duplicates the fixed cost and pushes every firm up its falling AC curve.
- Subsidy. Makes MC pricing survivable, but must be funded by taxation, which carries its own deadweight loss elsewhere in the economy.
- Government ownership. Removes the profit motive entirely, but replaces it with no strong incentive to control costs.
Worked ExampleComparing the three pricing options
An illustrative natural monopoly's cost and revenue curves give the following outcomes:
| Pricing option | Price ($) | Quantity | AC at that output ($) |
|---|---|---|---|
| Profit maximising (MR = MC) | 90 | 20,000 | 55 |
| Average cost pricing (P = AC) | 62 | 34,000 | 62 |
| Marginal cost pricing (P = MC) | 25 | 48,000 | 48 |
Marginal cost is $25 at every output.
Compare and contrast the impact of the three options on consumers, on the firm, and on allocative efficiency.
Step 1 — Calculate the firm's profit under each option
Profit maximising: profit per unit = 55 = $35 total profit = $35 × 20,000 = $700,000 supernormal profit
AC pricing: profit per unit = 62 = $0 total = $0 supernormal profit — the firm makes normal profit, which is included in AC.
MC pricing: profit per unit = 48 = −$23 total = −$23 × 48,000 = −$1,104,000 — a subnormal profit, that is a loss of $1.104 million
Step 2 — Compare the impact on consumers
Consumers are best off under marginal cost pricing and worst off under profit maximising, and there are two reasons in each case.
Under MC pricing, consumer surplus is the largest because:
- the price is the lowest of the three, at $25, so the difference between what consumers are willing to pay and what they actually pay is greatest on every unit; and
- the quantity is the highest, at 48,000, giving them the most units from which to gain surplus.
Under profit maximising, consumer surplus is the smallest because:
- the price is the highest, at $90; and
- the quantity is the lowest, at 20,000.
AC pricing sits between the two on both measures — a price of $62 and a quantity of 34,000.
Step 3 — Compare the impact on the firm
The three options are in the opposite order for the firm:
- Profit maximising gives it $700,000 of supernormal profit — its best outcome, and the one it will choose if unregulated.
- AC pricing gives it normal profit. It covers all its costs including the opportunity cost of its capital, so it remains viable in the long run, but earns nothing above that.
- MC pricing gives it a loss of $1.104 million. Because a natural monopoly's AC lies above MC at every output, requiring P = MC guarantees P < AC. The firm cannot sustain this and would eventually exit unless the government pays a subsidy of at least $1.104 million a year.
Step 4 — Compare allocative efficiency
- MC pricing is allocatively efficient. P = MC = $25, so the market is at D = S and the deadweight loss is zero. This is the most efficient option.
- AC pricing is not efficient, because P (25), so a deadweight loss remains — but it is much smaller than under profit maximising, because output is far closer to the efficient 48,000.
- Profit maximising is the least efficient. P ($90) is far above MC ($25) and output is only 20,000 against an efficient 48,000, so the deadweight loss is the largest of the three.
Step 5 — The trade-off, and a justified recommendation
The two "best" options pull in opposite directions. MC pricing delivers the best outcome for consumers and the only allocatively efficient one, but it makes the firm unviable and requires a permanent subsidy funded by taxation, which imposes its own cost and its own deadweight loss elsewhere in the economy.
AC pricing is the practical compromise: consumers pay $62 rather than $90 and receive 34,000 units rather than 20,000, the deadweight loss shrinks substantially, and the firm is financially viable without any subsidy at all.
Recommendation: average cost pricing, on the grounds that it captures most of the available efficiency gain and most of the consumer benefit while requiring no ongoing fiscal cost. Marginal cost pricing would be preferable on pure efficiency grounds only if the government were willing and able to fund the subsidy indefinitely, and if the deadweight loss created by raising that tax revenue were smaller than the deadweight loss it removes here.
This is essentially the approach the Commerce Commission takes in New Zealand under Part 4 of the Commerce Act 1986, setting price-quality paths that allow a regulated business to earn a normal return on its capital and no more.