11. One method that is used to regulate prices for natural monopolies is "rate-base pricing." A problem with this method of regulation is that: it encourages over-investment in capital relative to what is efficient.

   If a firm is allowed to raise prices so as to earn a fixed rate of return on investment whenever it increases investment, a powerful incentive to over-invest is created since more investment generates guaranteed returns. In some localities, natural monopolies have been allowed to raise prices as soon as they begin construction of new facilities. This Averch-Johnson effect is a serious concern when natural monopolies are regulated in this way.

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