Allocative Inefficiency under Natural Monopoly We show a cost structure leading to natural monopoly in Figure 5.9. Margin al cost (MC) constant of output. which is not shown in the figure, must be incurred before any output can be supplied. Be cost and falls cause of the fixed cost, average cost (AC) starts higher than ma output toward it as the output level increases. (AC MC, where would apply level.) Although marginal cost is shown as constant, the same analysis even if marginal cost were rising or falling, provided that it remains small relative to fixed cost. Figure 5.9 shows the divergence between the firm's profit-maximizing b havior and economic efficiency. Let us first consider the economically efficient price and output. Efficiency requires, as we discussed in the previous chapter, that price be set equal to marginal cost (P MC). Because marginal cost is below-average cost the economically efficient level results in the firm suffering a loss equal FC. would not choose this output level on its own. Instead maximize profits by selecting output level Qm, which equates marginal rev it would enue to marginal cost (MR MC). Atoutput level Qm, the market price will be P and profits equal to the area of rectangle PmcbPo FC will result. Relative to output level Q0, consumer surplus is lower by the area of PmcaPo, but the profit of the firm is larger by PncbPo. The net loss in social surplus due to the underproduction equals the area of the shaded triangle abc, the deadweight loss to consumers. (As noted in of Figure 4.5, units of forgone output would have offered marginal benefits in excess of marginal costs-a total loss equal to the area between the mar or schedule, and the marginal cost in 5.9, this loss is the area of triangle abc.) Imagine that public policy forced the natural monopolist to price at the eco- nomically efficient level (Po). The monopolist would suffer a loss of FC. Conse- quently, the monopolist would go out of business in the absence of a subsidy equal to offset the loss. Notice the dilemma presented by natural monopoly: forcing the monopolist to price efficiently drives it out of business; allowing the monopolist to set price to maximize profits results deadweight loss. Briefly consider what would happen if the firm were forced by public policy to price at average, rather that firm priced at P produced QAC in Figure 5.9. Clearly, under these circumstances the firm can survive because its costs are now being just covered. (Note that FC equals though the dead weight loss under average cost pricing is much lower than under monopoly pricing (area def versus area abc), it is not eliminated. Therefore, average cost pricing represents a compromise to the natural monopoly dilemma.