Natural Monopoly Pricing:

First, we show the monopolistic pricing process to ascertain the potential loss of social surplus in the form of monopoly  profits (super-normal profits) for the public utilities behaving as monopolists in absence of any regulation by the government and in absence of competition in the market. Thus we get the monopoly equilibrium price E and monopoly equilibrium quantity O" through the equality between marginal cost and marginal revenue in the following figure. To avoid the loss in social surplus, i.e. to avoid social cost of monopoly, one option could be the average cost pricing. Thus  the firms could be compelled (regulated by the government) to charge price P' and produce output O'. These are derived by equating average cost and average revenue, so that, market demand at P' is met with O' production and average cost is fully covered by the firms. However, it is clear that this does not at all satisfy the profit maximizing conditions for the firms, which is (Marginal Revenue = Marginal Cost). Hence, it is not a feasible solution.  

However, another option could be to induce competition. The government could encourage competition so that the firms are compelled to practice competitive pricing or marginal cost pricing. The government could regulate the firms so that they charge a price like D and produce output O, which is achieved at point C. At C, [(given) Price = Marginal Revenue = Marginal Cost = Average Revenue or Demand]. At C, market demand for price D is met with O amount of output and the 'first-order condition' of profit maximization i.e. [(given) Price = Marginal Revenue = Marginal Cost] is also satisfied. However, this solution is unstable with falling average and marginal costs. Though Price = Marginal Revenue = P', a given value, marginal cost is falling. Hence, at C, the 'second-order condition' of profit maximization [d(MR)/dQ < d(MC)/dQ] is violated, which makes the equilibrium unstable. Moreover, at C,  there is operating loss as P < AC. Two solutions could be proposed for such a  problem. First, practicing marginal cost pricing as above, and subsidizing the operating loss. This is possible if the firms are directly or indirectly regulated by the government. On the other hand, if market is allowed to perform its role,  the private firms would practice average cost pricing, where price would be set at A and the corresponding output level at O. However, under such a situation, the largest firm with maximum capacity would be able to charge the minimum price and thereby can compete out all other firms. Consequently, the largest firm emerges as the monopolist. Thus, ultimately the firms emerge as very large natural monopolies with average cost pricing.

Subsequently, the monopolist may even practice monopoly pricing at E, with output O". The figure 1 (below) shows this. To check such tendenciesgovernment has to step in. The government has to intervene in the whole process of pricing and output determination for public utilities. However, where is the guarantee that the government itself would not behave like a monopolist and would not practice monopoly pricing? This could be ensured to a large extent by inducing inter-governmental competition. Such a competition is particularly possible under the situation of decentralized governance with localized provision of public goods.