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 Monopoly
 One 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 feature
 Its 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 Monopolies
 Economies 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
MC
p
q
AC
Q
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.
Networks
Most 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
Producer
Consumer
Q
TC
AC
1
100
100
2
100
50
Q
TC
AC
1
100
100
2
100
50
50
100
2
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 output
 Charge a price equal to marginal cost
 Cover any losses out of tax revenues
NZ history of govt ownership
 1930s, 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 Monopolist
 A 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 levels
 Marginal 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.
Revenue and costs
Price and Quantity
before regulation Ppm
& Qpm.
Ppm
AC
MC
Pmc
AR
Qpm
Qmc
MR
Govt imposes a
maximum price of
Pmc resulting in an
output of Qmc where
P=mc
This will result in
subnormal profits
Output (millions)
Subnormal Profits

To make sure the business continues operating in the
long run, this subnormal profit can be paid for in two
ways
1.
2.
Amount of loss can be matched by a subsidy payment
from the govt
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 Pricing
 It is difficult to determine where AC is. It involves
finding the value of normal profits.
Revenue and costs
Setting P=AC
Consumers will be
able to pay a lower
price.
DWL
Pac
AC
MC
AR
Qac
MR
Output (millions)
This type of
regulation does not
require any
remedial action by
the govt in the form
of a subsidy.
Issues for Natural Monopolies
 Some 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 Monopolies
 Bundling.
 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.