2. Consider a market with 100 identical individuals, each with the demand schedu

Question

2. Consider a market with 100 identical individuals, each with the demand schedule for electricity of P = 10 - Q. The electricity utility server operates with a fixed cost 1,200 and a constant marginal cost of 2. A regulator would like to introduce a two-part tariff pricing, where S is a fixed subscription charge and m is a usage charge per unit of electricity consumed. a. How should regulator set S and m to maximize the sum of consumer and producer surplus while allowing the firm to earn exactly zero economic profit? b. If this natural monopoly were free to set their two- part tariff pricing, what would be S and m to maximize their profit?

Explanation / Answer

a) To maximize total surplus, there should be no deadweight loss and this implies a price which is equal to MC. Then we have P = MC = 2. Now at this level, Q = 10 - 2 = 8 units. Each consumer pays $2 and buys 8 units with a consumer surplus of 0.5*(10 - 2)*8 = $32. Total consumer surplus = 32 x 100 = 3200

The aim is to ensure that monopoly earns zero economic profit, the fixed cost has to be covered. For 100 consumer, the per consumer burden of fixed cost is 1200/100 = 12 and so the fixed charge should be $12 per consumer.

b)  If this natural monopoly were free to set their two- part tariff pricing, it would have priced the same level, P = 2 so that it can maximize the profits and then it would charge a subscription fee, S = 3200/100 = $32. This is the entire consumer surplus.

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