Notes on Natural Monopoly

Natural Monopoly

 

A natural monopoly exists when economies of scale provide a large cost advantage to having all of an industry's output produced by a single firm

 

•    the source of this situation is one where there are large fixed costs
• ex. local utilities --water, gas, electricity, local phone, cable

 

Breaking up a natural monopoly in such a situation (where one large producer has a lower average total cost than smaller producer) would raise the average total costs --> raising the price for the consumer

 

Profit maximizing monopolists act in a way that causes inefficiencies--it charges consumers a price that is higher than marginal cost and therefore presents some potentially beneficial transactions

• large profits at consumer expense brings up a question of equity as well

 

What can be done?

 

There are two common policy solutions for a Natural Monopoly

 

1)  Public Ownership -- the good is supplied by the government or by a firm owned by the government

 

In many countries it is the preferred answer to the problem of a natural monopoly

 

• examples
• before 1984 in Britain telephone service was produced by British Telecom
• before 1987 British Airline travel was provided by British Airways
• US--Amtrak, US Postal Service, Some cities such as Los Angeles have publicly owned electric power companies

 

The advantage of public ownership is that a publicly owned natural monopoly can set prices based on the criterion o efficiency rather than profit maximization

• In a perfectly competitive industry, profit-maximizing behavior is efficient because producers set prices equal to marginal cost

 

Experience suggests that public ownership can work badly in practice--publicly owned firms are often less eager than private companies to keep costs down or offer high-quality products;too often they end up serving political interests providing contracts or jobs to people with right connections

 

2) Regulation

 

The more common solution in the U.S. is to leave the industry in private hands and subject it to regulation

 

Most local utilities like electricity, telephone service, natural gas... are cover by price regulation which limits the prices they can charge.

• putting a price ceiling on a competitive industry can lead to shortages, black markets, and other side effects
• a price ceiling on a monopolist doesn't necessarily do so--in the absence of a price ceiling, a monopolist would charge a price that is higher than the marginal cost of production
• even if forced to to charge a lower price the monopolist can break even on total output as long as the price is above the marginal cost; the monopolist still has an incentive to produce the quantity demanded at that price 

 

 In the first example we have a company that faces a demand curve D, with an associate marginal revenue curve MR.  We will assume that the marginal cost is constant--so that MC is a horizontal line.  The average total cost curve (ATC) is the downward-sloping because the higher the output the lower the average fixed cost [*you can tell that this is a natural monopoly because the average total cost curve is downward sloping over the range of output relevant for market demand] 

 

The unregulated natural monopoly chooses the monopoly output Q: M and charges the price P: M.  Since the monopolist receives a price greater than ti average total cost it earn a profit.  The profit is equal to the producer surplus in the market--the green shaded area.  Consumer surplus is blue shaded area.

 

Next we show regulators imposing a price ceiling at P: R.

 

  

At this price the quantity demanded is Q: R.

 

The firm ignores the Marginal Revenue curve and is willing to expand output to meet the quantity demanded because the price it receives for the next unit is greater than the marginal cost and the monopolist breaks even on total output. 

 

With price regulation in this scenario the monopolist produces more at a lower price.

 

The monopolist won't be willing to produce at all if the imposed price means producing at a loss--the price ceiling has to be set high enough to allow the firm to cover its average total cost. 

 

In this example any lower price and the firm would lose money because the price is as low as possible--we are at a price ceiling where the average total cost curve crosses the demand curve.  P*:R is the best regulated price possible. 

 

The welfare effects of this regulation can be seen by comparing the shared areas in both figures--consumer surplus is incurred by the regulation with gains coming from two sources

• profits are eliminated and added instead to consumer surplus
• the larger output and lower price leads to an overall welfare gain--increasing total surplus

 

Consumers are better off, profit are eliminated, and overall welfare increases.

 

The biggest problem with regulation natural monopolies is that regulators don't have the information required to set the price at the exact level desired--where the demand curve crosses the average total cost curve. 

• sometimes its set too low creating shortages
• sometimes set too high

 

Regulated monopolies like publicly owner firms tend to exaggerate their costs to regulators and provide inferior quality to consumers

Posted via email from Jim Nichols