Answer to Question 1
Marginal cost pricing: The regulated price is set equal to marginal cost. In this case, the efficient quantity is produced so there is no deadweight loss. Consumer surplus is maximized. The firm incurs an economic loss unless it can raise revenues in an additional way, such as using price discrimination or a two-part tariff.
Average cost pricing: The regulated price is set equal to average cost. While this form of regulation does not produce an efficient outcome, it allows firms to make a normal profit. There is a deadweight loss.
Rate of return regulation: The regulated price enables a regulated firm to earn a specified target percent return on its capital. If a regulator could observe the firm's total cost and also know that the firm minimized total cost, the regulation would be the same as average cost pricing. In some cases, however, the firm is able to capture the regulator, which enables the firm to exaggerate it costs and so set its price and produce the amount of output that it would were it an unregulated monopoly.
Price cap regulation: The regulator sets a price ceiling. The firm can charge any price it wants below the price cap and keep some or all of any economic profit it makes. This regulation induces the firm to operate efficiently and control costs. If the firm makes a profit that is too high, the regulator might impose earnings share regulation, which requires the firm to make refunds to customers when profits rise above a target level.
Answer to Question 2
B
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