ECON 201
WEEK 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
 Scale 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?
 Do 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 H A P P E N S I F W E
D O N ’ T R E G U L AT
E?
Unregulated
Monopolist
MR = MC
Ideal Output
P=MC
WHAT ARE THE
CONSEQUENCES
 Rate-of-return regulation:
• Set rates such that they cover firm’s cost + normal rate of return
 Set 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?
Economically 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
10
MARGINAL-COST PRICING FOR A NATURAL
MO
NOPOLY
Price
Average total cost
Average
total cost
Loss
Regulated
price
Marginal cost
Demand
0
Quantity
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.
10
Rate of Return
Price = ATC
France
P= MC
THE EUROPEAN APPROACH
 Assuming LRAC is still falling
• Set P = MC
• Subsidize the difference between ATC and P
MC
10
THE FRENCH APPROACH: P=MC + SUBSIDY
Price
Average total cost
Average
total cost
Subsidy
Regulated
price
Marginal cost
Demand
0
Quantity
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
13
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.