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The focus of the essay is the discussion on natural monopoly. The market structure of natural monopoly is analysed to get an insight about the necessity of regulation of this market. A natural monopolist has the potential to supply product or service to the entire market at a lower cost than multiple firm can do (Bos, 2015). The difference between a monopolist and a natural monopolist is that they monopolist operates at the rising segment of the marginal cost curve as MC curve is the supply curve of the firm. On the other hand, a natural monopolist can operate at the falling region of average cost curve. Entry is automatically restricted in natural monopoly market due to its nature.
The possible barriers that can restrict entry of new firm in the market are high start up cost, high sunk cost and many other reasons. A monopolist is a price setter rather than price taker. Natural monopoly may be weak or strong. In the market, where natural monopoly is strong, chances of entry is less and probability of new entry is high when natural monopoly is weak (Baldwin, Cave, & Lodge, 2012). Monopolist tries to exploit market by charging higher price. Therefore, in order to correct market inefficiency, government regulations are required. The necessity of regulation in natural monopoly is thus discussed in this essay.
Natural monopolist operates at the falling region of average cost curve, where the firm gets throughout economies of scale. Hence, the firm is able to produce a higher output at a lower price. However, this result does not happen in an unregulated market (Makholm, 2015). A monopolist charges a price higher than competitive price. In a monopoly market, there is absence of close substitute product or service. Hence, charging higher price excludes some customers from consume the product (Hovenkamp, 2015). Therefore, monopolists reach at the equilibrium level, by producing and supplying output less than socially desirable level. However, the market structure is such that entry is not attractive or new entrants are incapable to survive.
The above figure shows that natural monopolist produces output at the intersection point of marginal revenue and marginal cost curve. The firm operates at the falling portion of the marginal cost curve. In an unregulated monopoly market, the firm charges price much higher than its marginal cost exercising its monopoly power (Joskow & Wolfram, 2012).
As the firm is single producer in the market, it can provide entire output at a lower cost than multiple firms could do. Due to lower operating cost, the firm gets economies of scale in production process. Economies of scale are obtained by firms, when inputs exhibit increasing returns to scale (Hillman & Braeutigam, 2012).It means that, the firm is able to produce a large output with using a smaller unit of inputs. Therefore, variable cost becomes lower although the production. As stated by Nepal, Menezes & Jamasb (2014), natural monopoly may be strong or weak. A strong natural monopolist has decreasing average cost, whereas a weak monopolist has increasing average cost. A weak monopolist finds itself in a position that it cannot be able to restrict the entry of new firm in the presence of supernormal profit (Vikharev, 2013). Therefore, this kind of natural monopoly is unsustainable in long run. Price regulation is desirable for the sustainability of weak monopoly in the market.
A strong monopolist can operate at the point, where the average cost curve still declines to cut the average revenue. Therefore, it naturally restricts the entry of new firm in the market, as it becomes difficult for a new firm to compete with a cost efficient firm with high initial cost structure (Minamihashi, 2012).
In an unregulated monopoly market, the firm charges price much higher than its marginal cost exercising its monopoly power. The price is set as per average revenue. This price output decision reduces social welfare. The price charged in an unregulated monopoly is higher than competitive price and output is less than the competitive output (Carvalho & Marques, 2014). Hence, the government decides to regulate the market in order to bring efficiency in production and resource allocation and to maximise consumer welfare. Deadweight loss is created in the unregulated market due to charging higher price. A portion of consumer surplus is lost, which even cannot be appropriated by the monopolist (Minamihashi, 2012). Triangle AED in the figure is deadweight loss in an unregulated monopoly.
As shown in the figure, market failure occurs in the natural monopoly due to inefficient allocation of goods and services in the economy. A higher level of output can be produced by the firm, which can make consumer better off. Therefore, government has two options to regulate the market. One is average cost pricing and other is marginal cost pricing (Vikharev, 2013). Marginal cost pricing is done by setting price level at the intersection point of average revenue and long run marginal cost. This output is even greater than competitive output. Price is also lower than competitive price. This is the output that maximises consumer welfare. However, this price is optimal for the monopolist. At this level, price is lower than the long run average cost. As P < LRAC firm makes loss in the long run. Therefore, it is unprofitable for the firm to operate in long run. The firm would be compelled to shut down plant (Hillman & Braeutigam, 2012). In this situation government needs to provide subsidy to keep the firm in operation. Marginal cost pricing is costly for the natural monopolist.
Another option for the government is average cost pricing. Price is set at the intersection of long run average cost and average revenue. AR = AC implies TR = TC, which indicates that firm earns only normal profit by operating at this level. The output at this level is greater than unregulated output Qm and price is less than unregulated price Pm. Although, the firm is not getting supernormal profit, it is not making loss even. Therefore, both consumer and producer welfare can be maximised at this level. Hence, among the three situation, average cost pricing is socially optimal as it maximises both production and allocation efficiency (Baldwin, Cave, & Lodge, 2012).
Example of natural monopoly is seen in the economy in the market of public utility such as railways, electricity, water supply, telecommunication and others. Government allows natural monopoly but intervene to protect consumer interest. A single utility company can supply power lines, electricity in the cities, as the operation requires high fixed cost (Makholm, 2015). The nature of demand is such that cities do not allow multiple companies to operate. Joskow & Wolfram (2012) stated that natural monopoly exists where there are large fixed cost and low marginal cost. Marginal cost pricing is undesirable due to having negative externality. Natural monopoly creates market failure in the presence of imperfect market information and inefficient resource allocation.
Hovenkamp (2015) argued that market failure is likely to occur in the network industry. These types of industries are capital intensive and require huge investment at the start up level. Sunk cost is also high in this industry. Most of assets used in this sector is durable and hence creates high barrier to entry. Railways in UK are an example of natural monopoly, where government regulates the market through price discrimination policy. Government regulates the railway fare for longer distance tickets so that the operators cannot increase fare above the price floor (Strether, 2014). On the other hand, the operators have freedom to charge higher price for unregulated types of tickets. Here, the concept of cross subsidy is applied by the government.
Cross subsidisation refers that a firm charges price lower than operating cost to a group of customer and financed by charging high price to other group of customers. It happens in an industry that a supplier concentrates on an area where cost of supply is the lowest (Hillman & Braeutigam, 2012). Low cost production generates profits to allow entry of new firms in the market. Therefore, there is possibility that competitors may enter into the market. Therefore, firm cannot sustain in the market without legislative protection by government.
Peak load pricing is another option for natural monopolist to generate high profits. A firm can charge high price for a service or product, when demand is high and charges lower price when demand is low. This strategy enables the firm to use production capacity effectively. Carvalho & Marques (2014) opined that technological up gradation in production leads to transformation of natural monopoly into competitive market.
Technological development has made telecommunication industry more competitive in recent times. Technological improvements can decrease operating by bringing efficiency in production. Technology improves productivity of the inputs by ensuring increasing returns to scale (Vikharev, 2013). Therefore, firm can produce large output with minimum cost generating super normal profit as the marginal cost of production is falling.
Existence of super normal profit in the market induces external firms to enter into the market. Therefore, external forces can break natural monopoly and produces socially inefficient output. Government intervention can correct the market failure in this situation (Carvalho & Marques, 2014). Government can use price ceiling strategy to set the price at the level of average cost incurred by existing firm.
The firm earn only normal profit at this level. Hence, there will be no incentive for other firms to enter into the market. The existing firm can freely operate in the market by producing socially optimal output same as competitive level without making loss. This king of regulation restricts competition and maximises social welfare as well.
The essay presents an extensive analysis on natural monopoly. It has been seen that monopolist generally maximises profit by producing output where marginal cost curve cuts the marginal revenue curve. However, price is set according to the average revenue and not by marginal revenue. The firm exploits consumer surplus in this way and a portion of consumer surplus results in deadweight loss, which is achieved neither by sellers nor by the consumers. This high price has a social cost as some customers are not able to buy the product due to high price and lack of substitute goods in the market. In order to correct the market failure, government may two decisions such as marginal cost pricing and average cost pricing.
If the price is regulated to set at the level where, long run marginal cost equates with average revenue curve, firm makes loss as average cost is less than price and marginal cost. Therefore, only government subsidy can keep the firm in business, however, this is not the optimal solution. Therefore, another option is average cost pricing. Government regulates the market so that the firm can set price equal to the average cost and average revenue, where the firm can earn only normal profit. Competitive price and output, both are better in the regulated market compared to the unregulated one. Natural monopoly exists in the sector of public utilities such as electricity, railways, waterways, and telecommunication. Natural monopoly can be seen in both public and private sector. It has been studied that technological progress supports the existence of natural monopoly in the presence of government regulation.
Baldwin, R., Cave, M., & Lodge, M. (2012). Understanding regulation: theory, strategy, and practice. Oxford University Press on Demand.
Bos, D. (2015). Pricing and price regulation an economic theory for public enterprises and public utilities (Vol. (Vol. 34). ). Elsevier.
Carvalho, P., & Marques, R. C. (2014). Computing economies of vertical integration, economies of scope and economies of scale using partial frontier nonparametric methods. European Journal of Operational Research, 234(1), 292-307.
Hillman, J. J., & Braeutigam, R. (2012). Price level regulation for diversified public utilities (Vol. (Vol. 5)). Springer Science & Business Media.
Hovenkamp, H. ( 2015). Federal Antitrust Policy, The Law of Competition and Its Practice. West Academic.
Joskow, P. L., & Wolfram, C. D. ( 2012). Dynamic pricing of electricity. The American Economic Review, 102(3), 381-385.
Makholm, J. D. (2015). Regulation of natural gas in the United States, Canada, and Europe: Prospects for a low carbon fuel. Review of Environmental Economics and Policy, reu017.
Minamihashi, N. ( 2012). Natural monopoly and distorted competition: evidence from unbundling fiber-optic networks.
Nepal, R., Menezes, F., & Jamasb, T. (2014). Network regulation and regulatory institutional reform: Revisiting the case of Australia. Energy Policy, 73,, 259-268.
Strether, L. (. (2014). UK Rail Shows Pitfalls of Natural Monopoly Privatization. Retrieved December 25, 2016, from www.nakedcapitalism.com: https://www.nakedcapitalism.com/2014/08/uk-rail-shows-pitfalls-natural-monopoly-privatization.html
Vikharev, S. (2013). Mathematical modeling of development and reconciling cooperation programs between natural monopoly and regional authorities.
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