Fig. 1 shows the falling average-cost curve of a water supplier. The firm must build treatment works and pipe networks before it can supply households. The ...
Question 1 Report
Fig. 1 shows the falling average-cost curve of a water supplier. The firm must build treatment works and pipe networks before it can supply households. The local market demand is insufficient to support several separate networks at low cost.
(a) Explain, using Fig. 1, why water supply can be a natural monopoly. [3]
(b) Assess whether the government should regulate the price charged by this firm. [3]
Answer Details
(a) Figure 1 shows average cost falling as output rises over the relevant range. [1] The very high fixed costs of treatment works and pipe networks are spread over more households as output increases. [1] Consequently, one large supplier can supply at a lower average cost than several smaller suppliers each building separate networks, creating a natural monopoly. [1]
(b) Government price regulation may prevent the supplier charging excessive prices to consumers who have no alternative provider. [1] Regulation may also require a minimum standard of quality or investment. [1] However, if the regulated price is set too low, profit may be insufficient for maintenance and new investment. A balanced judgement is that regulation is appropriate, but the price should allow efficient costs and necessary investment to be covered. [1]
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