ECON 201WEEK 7

Finishing Up Monopolies:

Natural Monopolies

NATURAL MONOPOLIES

natural monopoly

• one firm can produce a desired output at a lower social cost than two or more firms—

• there are economies of scale • Having multiple firms providing a good or service is less

efficient than if a single firm provided a good or service. • Examples of claimed natural monopolies include railways,

telecommunications, water services, electricity, and mail delivery.

An industry is said to be a natural monopoly if only one firm is able to survive in the long run,

• result of high fixed costs of entering an industry which causes long run average costs to decline as output expands

FIGURE 13.7 A Natural Monopoly

A natural monopoly is a firm in which the most efficient scale is very large. Here, average total cost declines until a single firm is producing nearly the entire amount demanded in the market. With one firm producing 500,000 units, average total cost is $1 per unit. With five firms each producing 100,000 units, average total cost is $5 per unit.

MARKET CONDITIONS FOR A NATURAL

MONOPOLY

S

cale is such that it is cost-efficient for only 1

firm to supply the market, i.e., economies of

scale

THE REGULATOR’S DILEMMA

A

couple of alternatives:• No regulation

• Firm will price like a monopolist

• Set price at ATC• Rate-of-return regulation: sets utility’s prices based on

cost-of-service

WHAT ARE THE CONSEQUENCES?

D

o nothing• Firm chooses Q at the point where MR = MC

• Less than perfect competition• Sets Price > MC

• Higher than perfect competition

• Higher price and lower Q => deadweight loss

WHAT HAPPENS IF WE DON’T REGULATE?

Unregulated MonopolistMR = MC

Ideal OutputP=MC

WHAT ARE THE CONSEQUENCES

R

ate-of-return regulation:• Set rates such that they cover firm’s cost + normal rate of return

S

et price = ATC• Since ATC is falling => MC < ATC• And P = ATC > MC

• Still producing too little – would like P= MC at Q*

WHAT’S THE DOWNSIDE TO MONOPOLIES?

E

conomically inefficient• Deadweight loss

• Higher price and lower quantity demanded/supplied• Efficiency loss: consumers MV (WTP) > MC of

resources used to produce the good• Transfer losses

• From CS to PS• Economists have no opinion• Pareto efficient: winners can (potentially) compensate

losers

• No/less incentive for innovation

MARGINAL-COST PRICING FOR A NATURAL MONOPOLY

1

0

10

Price

Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money.

Quantity0

Average total cost

Loss

Averagetotal cost

Demand

Marginal costRegulatedprice

Rate of ReturnPrice = ATC

FranceP= MC

THE EUROPEAN APPROACH

A

ssuming LRAC is still falling• Set P = MC• Subsidize the difference between ATC and P

MC

THE FRENCH APPROACH: P=MC + SUBSIDY

1

0

13

Price

Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, regulator will have to subsidize the “loss” – difference between ATC and price

Quantity0

Average total cost

Subsidy

Averagetotal cost

Demand

Marginal costRegulatedprice

REGULATORY RESPONSES

doing nothing

setting legal limits on the firm's behaviour, either directly or through a regulatory agency

setting up competition for the market (franchising)

setting up common carrier type competition

setting up surrogate competition ("yardstick" competition or benchmarking)

requiring companies to be (or remain) quoted on the stock market

public ownership

Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecommunications industry is a leading example globally.

TELECOMMUNICATIONS – AN EXAMPLE

Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable costs.

• fixed costs of establishing a national distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small.

• average total cost will continue to decline as the scale of production increase, because fixed (or overhead) costs are being spread over higher and higher levels of output

The telecommunications industry has in the past been considered to be a natural monopoly. Like railways and water provision,

• existence of several companies supplying the same area would result in an inefficient multiplication of cables, transformers, pipelines etc.

• perception of what constitutes a natural monopoly is now changing – • new technology reduces traditional barriers to entry within markets.

telecommunications industry

• in the UK, British Telecom has faced increasing levels of competition from new telecommunications service providers during the 1990s - not least the rapid expansion of mobile and cable services. T

• this has led to a change in the role of the industry regulator (OFTEL). Its main role now is not necessarily the introduction of even more competition into the telecommunications industry - but a policing role to ensure fair competition between service providers.