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Economic Systems and Market Failure: Question 10

Syllabus 2.8, 2.9, 2.10

Multiple choice 1 mark

Frayle Water Co. is the only supplier of piped water across the region of Ostgate, because building a rival network of pipes would be prohibitively expensive for any competitor (a natural monopoly). Left completely unregulated, Frayle Water Co. could restrict the quantity of water it supplies and charge a higher price than would prevail if the market were competitive.

Which government intervention addresses this cause of market failure by giving the state formal ownership and direct control over Frayle Water Co.'s pricing and output decisions, rather than merely constraining a privately owned firm's behaviour from outside?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall why a monopoly can cause market failure

A firm with monopoly power, such as Frayle Water Co. facing no realistic competitor, can restrict the quantity it supplies and charge a higher price than would prevail under competition, without losing many customers (since there is nowhere else for them to go). This misallocation of resources (too little output, at too high a price) is why monopoly is treated as a cause of market failure.

Step 2: Recall the range of government responses to monopoly power

Governments have several distinct tools for dealing with monopoly power:

  • Regulation (e.g. a maximum price or a required minimum service standard) constrains a privately owned firm’s behaviour from outside, without changing who owns it.
  • Public ownership (nationalisation) goes further: the state itself buys and owns the firm, giving it direct control over pricing and output decisions rather than merely restricting a private owner.
  • Taxes and subsidies are tools normally used to correct externalities or under/over-consumption of particular goods, not to give government direct control over a monopolist’s decisions.

Step 3: Test each option against what the question asks for

The question specifically asks for the intervention that gives the state formal ownership and direct control, not one that merely constrains a private firm from outside.

  • Option A is exactly this: the state buys Frayle Water Co. and runs it itself, so pricing and output decisions become the government’s own decisions rather than a private firm’s decisions constrained by a rule.
  • Option B (an indirect tax) does not give the state ownership at all, and by raising the monopolist’s costs it would tend to make the firm restrict output and raise price even further, the opposite of correcting the market failure.
  • Option C (a subsidy) also does not give the state ownership; a subsidy is typically used to encourage more output of an under-provided merit good, not to control a monopolist that is already over-charging and under-supplying.
  • Option D (a maximum price) does limit what Frayle Water Co. can charge, but the firm remains privately owned and the government is only constraining its behaviour from outside. This is regulation, not public ownership, so it does not match what the question asks for.

Step 4: Select the option that matches

Only option A gives the government formal ownership and direct control over the firm’s decisions.

Final answer

Public ownership (nationalisation), option A, is the intervention that gives the state formal ownership and direct control over Frayle Water Co.’s pricing and output, distinguishing it from regulation (option D), which only constrains a privately owned monopolist from outside.