1. Natural Monopoly P AC MC D QM Q

2. Problems with MC pricing • When marginal-cost pricing creates a deficit, one regulatory option is to maintain these prices and subsidize the firm to cover the deficit. • Dupuit (1844), Lewis (1941) and Clemens (1950) - society’s welfare might be better served with a price-discriminating monopolist. • Harold Hotelling (1938) argued that in decreasing-cost industries, prices should be set equal to marginal cost. • Lump sum vs. excise taxes (land, income, inhertance)

3. Problems with Taxes • Meade (1944), Stigler (1946) and Boulding (1948), pointed out in Hotelling’s discussion, that they could distort the work-leisure trade-off, income taxes, which would be needed as a main source of deficit covering revenues, would not be neutral like lump-sum taxes.

4. Problems with Subsidies • Frisch (1939) pointed out that whereas Hotelling’s exercise had been carried out using the Pareto criterion, the fact that some would be made worse off obviously violated the criterion. • Samuelson (1947) stated that the compensation must be paid in order to avoid interpersonal comparisons of utility. • Coase (1946) emphasized equity, noting that unless those who use a good cover its cost, there will be a redistribution in favor of the consumers of products produced by decreasing-cost industries.

5. Rolph and Break (1949), M. Friedman (1952) Figure 2.10. Pricing above MC in the q industry.

6. bc is the production possibility frontier showing the goods available to an economy of identical consumers after a lump-sum tax has been imposed. • k is a welfare maximum, where the marginal rate of substitution for consumers is equal to the marginal rate of product transformation for producers. • After introducing an excise tax on q, production possibility frontier is the same bc. But the consumers face a ratio of prices given by the slope of price line fj . • Therefore, a necessary condition for Pareto optimality is not met: The marginal rate of substitution does not equal the marginal rate of product transformation.

7. Problem with Decreasing AC • Wilson (1945) argued that unless the cost of an investment is covered through prices (such as tolls on a bridge), we cannot be certain that the initial investment in the bridge is worthwhile.

8. Restatement of Problems • Price discrimination can be a remedy for the problem. • A perfectly discriminating monopolist would make the socially efficient decision and not build the bridge, given the conditions in Figure 2.8. • Bureaucracies have little incentive to halt production if subsidies are available. • Distortions will result unless factors of production have the same price to consumers in all uses.