Microeconomics 6th Edition by Robert Hall, Shirley Kuiper, Marc Lieberman

Exercise 6

Some have argued that the music industry is by nature inefficient because once a piece of music is produced,the firm that owns it has a monopoly and charges the monopoly price. Yet,the marginal cost of making the music available to one more member of the public (via the Internet)is zero. Draw a diagram,similar to Figure 1,to represent this situation. Identify on your diagram:
a. The efficient level of production
b. The level of production a government-regulated music industry would earn if it were permitted to charge just enough for a "fair rate of return"
c. The level of production provided by the (currently unregulated)industry
Figure 1 Regulating a Natural Monopoly

Left unregulated,the cable monopoly would serve 50,000 households,where MC = MR. This is inefficient,because units 50,001 to 100,000 have value to some consumers greater than their marginal cost.
By mandating a price of $30,government regulators could achieve the efficient outcome-100,000 households-at point B. But with price less than LRATC ,the monopoly would suffer a loss,so it would have to be subsidized or go out of business.
The alternative,which is typically chosen,is to set price at $58-the lowest achievable average cost in this market,which includes a "fair rate of return." At this price,the monopoly serves 85,000 households-not quite efficient,but closer than without regulation.