Long free-response question

Regulating the water company

Units 4 and 6
10 points
About 25 minutes

You can use a calculator on this question, just like on exam day.

A long question with several lettered parts built around one scenario, often a firm in a particular market structure, and it can pull in other units such as a labor market or a payoff matrix. You identify outcomes, explain them, do a calculation, and describe a correctly labeled graph that shows the situation and how a change affects it. On the exam: Question 1 of 3 in Section II (60 minutes including a 10-minute reading period; 33.35% of the exam score); 10 points, half of the section score. About 25 minutes suggested. Four-function calculator allowed.

The question and its sources

ClearFlow is the only provider of piped water in a town, and it is a natural monopoly. ClearFlow's demand and marginal revenue curves are straight lines. Its marginal cost is constant at $30, and its average total cost falls over the whole range of output shown. Quantity is measured in thousands of households served per month, and prices and costs are in dollars per household per month.

Table 1. ClearFlow's demand and costs at selected quantities

Quantity (thousands of households)	Price on demand curve	Marginal revenue	Marginal cost	Average total cost
20	$90	$70	$30	$65.00
40	$70	$30	$30	$47.50
70	$40	−$30	$30	$40.00
80	$30	−$50	$30	$38.75

Source: Hypothetical data

Suggested time: 25 minutes

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Part (a)

2 points

Describe a correctly labeled graph for ClearFlow. Show each of the following: (i) the demand, marginal revenue, marginal cost, and average total cost curves; (ii) the unregulated profit-maximizing quantity and price, labeled Qm and Pm.

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Part (b)

1 point

Calculate ClearFlow's monthly economic profit if it is unregulated. Show your work.

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Part (c)

1 point

Calculate the deadweight loss when ClearFlow is unregulated. Show your work.

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Part (d)

1 point

Using the information given, explain why ClearFlow is a natural monopoly.

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Part (e)

2 points

Suppose a regulator sets the price ClearFlow can charge at the socially optimal (allocatively efficient) level. (i) Identify the quantity ClearFlow will provide. (ii) Will ClearFlow earn a positive economic profit, zero economic profit, or a loss? Explain.

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Part (f)

1 point

Suppose instead the regulator sets a fair-return price. Identify the price and quantity.

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Part (g)

1 point

Is the fair-return outcome allocatively efficient? Explain.

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Part (h)

1 point

Explain why the unregulated ClearFlow chooses a quantity in the elastic portion of its demand curve.

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