In the context of natural monopolies, which statement is true about pricing to achieve allocative efficiency?

• A. Price should equal Average Total Cost
• B. Price should equal Marginal Revenue
• C. Price should equal Marginal Cost with a subsidy to cover losses
• D. Price should equal Variable Cost

Answer: (C)

Allocative efficiency is achieved when price reflects the marginal cost of producing an extra unit. In a natural monopoly, the cost structure with large fixed costs and substantial economies of scale means charging a price equal to marginal cost would leave the firm with losses, since marginal cost is below average total cost over the relevant output range. To keep producing at the efficient output while avoiding losses, the government can provide a per-unit subsidy that covers the gap between the price (set at MC) and total cost. This lets the firm charge price = MC and still break even, achieving allocative efficiency. Other options fail because they do not align price with marginal cost, or they ignore the need to cover fixed costs.