Under regulation to achieve allocative efficiency in a natural monopoly, the regulator should set price equal to marginal cost with a subsidy to cover losses

• A. Price equals Average Total Cost
• B. Price equals Marginal Revenue
• C. Price equals Marginal Cost with no subsidy
• D. Price equals Marginal Cost and subsidy to cover the loss

Answer: (D)

Allocative efficiency comes from setting price equal to the marginal cost of producing the good, so that society’s marginal benefit equals the marginal cost of resources used. For a natural monopoly, long-run average costs fall over a wide range of output, so the marginal cost lies below the average total cost. If the regulator tried to price at MC, the firm would not cover its total costs and would incur losses, risking underprovision or disruption of service. By setting price at MC and providing a subsidy to cover those losses, the regulator keeps the price aligned with the true social cost while ensuring the firm remains viable and able to supply the efficient quantity.

Pricing at average total cost would remove some incentive to minimize costs but would not achieve P = MC, leading to deadweight loss. Pricing at marginal revenue would not reflect the true social cost of capacity and could limit output. And without a subsidy, MC pricing would be unsustainable for the firm.