A local utility company holds a monopoly on water supply in a small town. They have determined that the marginal cost of providing an additional unit of water is $2. However, they set the price for water at $5 per unit. What does this situation indicate about the allocative efficiency of the monopoly, and what might be a potential government intervention to improve it?

In this situation, the utility company is a monopoly because it is the only provider of water in the town. The marginal cost of supplying one more unit of water is $2, but they charge $5, meaning they are making a profit on each unit sold. This pricing indicates that the monopoly is not allocatively efficient because allocative efficiency occurs when the price equals the marginal cost. Since the price is higher than the marginal cost, it suggests that not everyone who values the water at $5 can afford it, leading to less water being consumed than is socially optimal. A potential government intervention could be to regulate the price of water to bring it closer to the marginal cost, ensuring that more residents can access it and improving overall welfare.