By the end of this topic you should be able to:

•Identify examples of natural monopolies

•Explain how economies of scale can lead to natural monopolies

•Discuss reasons why natural monopolies may or may not operate for the good of society

•Demonstrate how natural monopolies can be influenced by the use of subsidies, regulations or public ownership

Types of monopolies Pure Monopoly

One firm dominates the market and can maintain this because of high barriers to entry

Natural MonopolyOne firm is able to supply the entire market at

a lower cost than two or more firms

Natural Monopoly Has the same characteristics as a pure monopoly

and a main distinguishing featureIts average cost curves are downwards sloping over

the whole output due to economies of scale.

Examples – town infrastructure Distribution of electricity Railways Pipelines Fixed-line telephone networks

Economies of Scale and Natural MonopoliesEconomies of scale occur because of two factors

High fixed costs Costs involved in setting up the business

Low marginal costs Cost of adding new consumers to the network is low

As output increases, the AC curve falls as greater economies of scale are achieved.

Cost Curves for a Natural Monoply

Cost Curves for a Pure Monopoly

Qq

p MC AC

The average cost curve begins to rise after it cuts the MC curve.

Natural Monopolies Society benefits from allowing the natural

monopoly to occur. As it can increase output and allow prices to be lower due to economies of scale.

It would not be efficient to encourage competition as it would mean creating duplicate networks that could not gain economies of scale.

NetworksMost monopolies occur in networks, commonly the infrastructure of

towns. E.G.Distribution of water, waste gas, telecommunications, electricity, roading and postal services.

Networks are expensive to set up but gain economies of scale as output increases

Q TC AC

1 100 100

2 100 50

Q TC AC

1 100 100

2 100 50

50 100 2Producer Consumer

The need for intervention The natural monopolist will aim to maximise

its profits and will do this by restricting output to charge a higher price. (Profit max level MC=MR)

The firm will then not gain the potential economies of scale and there will be a loss of allocative efficiency.

Intervention Two types

Public ownership (Government owning the natural monopoly )

Regulations ( price controls)

Public Ownership and Natural Monopoly – notes The government taking over the ownership of

an industry = Nationalisation

Under public ownership the government could operate the monopoly At an allocatively efficient level of outputCharge a price equal to marginal costCover any losses out of tax revenues

NZ history of govt ownership1930s, a lot of NZ firms were nationalised.

The govt identified strategic businesses they felt had to be kept going.

Example: NZ rail, postal services, telecommunications, broadcasting, electrical power and many other services have been run by the state.

In the 1980s and 1990s during the reforms, monopolies were deregulated and turned into State Owned Enterprises and some were sold to the private sector called privatisation

Regulatory Pricing for a Natural MonopolistA private owned natural monopoly can be

regulated to produce at a more socially desirable level of output in order to increase allocative efficiency.

Regulatory pricing can be set at the following levelsMarginal cost pricing ( where price =MC)Average cost pricing (where price = AC in order

to provide a normal profit )

Marginal Cost Pricing This is where allocative efficiency will be

achieved.

Output (millions)

Rev

enue

and

cos

ts

MR

AR

MCAC

Ppm

Pmc

Qpm Qmc

Price and Quantity before regulation Ppm & Qpm.

Govt imposes a maximum price of Pmc resulting in an output of Qmc where P=mc

This will result in subnormal profits

Subnormal Profits To make sure the business continues

operating in the long run, this subnormal profit can be paid for in two ways

1. Amount of loss can be matched by a subsidy payment from the govt

2. The monopolist could charge a two part tariff. Amount of loss can be paid for from a daily

charge or line rental paid by consumers MC can be the user charge, per unit consumed.

Average Cost PricingIt is difficult to determine where AC is. It

involves finding the value of normal profits.

Output (millions)

Rev

enue

and

cos

ts

MR

AR

MCAC

Setting P=AC

Consumers will be able to pay a lower price.

This type of regulation does not require any remedial action by the govt in the form of a subsidy.

Qac

Pac

DWL

Issues for Natural MonopoliesSome times monopolies can be

split up into different elements.

Natural monopoly elements have been isolated from more competitive elements. The competitive elements of the industry can be allowed to operate in a competitive market.

Example NZ electricity. Electricity generation split from line-transmission and retail activities.

Issues for Natural MonopoliesBundling.

Using a monopoly in one product to create a monopoly in another product.

Telecom has a monopoly in handling local calls through the copper wire network of phone lines.

This network also is the main platform for carrying broadband internet – also monopolised.