1. Natural Monopoly P Q QMQM AC MC D

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