what is the potential benefit to society of the natural monopolist?
Chapter 11. Monopoly and Antitrust Policy
11.3 Regulating Natural Monopolies
Learning Objectives
By the end of this department, you volition be able to:
- Evaluate the appropriate competition policy for a natural monopoly
- Interpret a graph of regulatory choices
- Contrast toll-plus and price cap regulation
Virtually true monopolies today in the U.S. are regulated, natural monopolies. A natural monopoly poses a hard challenge for competition policy, considering the construction of costs and need seems to make contest unlikely or costly. A natural monopoly arises when average costs are failing over the range of production that satisfies market place need. This typically happens when stock-still costs are large relative to variable costs. Every bit a issue, one business firm is able to supply the total quantity demanded in the market place at lower cost than two or more than firms—so splitting upwardly the natural monopoly would raise the average price of production and force customers to pay more than.
Public utilities, the companies that have traditionally provided water and electrical service across much of the United States, are leading examples of natural monopoly. It would make little sense to argue that a local water visitor should exist broken up into several competing companies, each with its own separate set of pipes and water supplies. Installing iv or five identical sets of pipes under a metropolis, one for each water company, so that each household could choose its own water provider, would be terribly costly. The same argument applies to the idea of having many competing companies for delivering electricity to homes, each with its own set of wires. Before the appearance of wireless phones, the statement also practical to the thought of many different telephone companies, each with its own set of telephone wires running through the neighborhood.
The Choices in Regulating a Natural Monopoly
So what and then is the appropriate competition policy for a natural monopoly? Effigy 1 illustrates the case of natural monopoly, with a market place demand curve that cuts through the downward-sloping portion of the average cost curve. Points A, B, C, and F illustrate four of the main choices for regulation. Table 5 outlines the regulatory choices for dealing with a natural monopoly.
| Quantity | Price | Full Acquirement* | Marginal Revenue | Full Price | Marginal Toll | Average Cost |
|---|---|---|---|---|---|---|
| one | 14.seven | 14.vii | – | 11.0 | – | xi.00 |
| 2 | 12.iv | 24.7 | 10.0 | xix.5 | 8.5 | nine.75 |
| three | 10.6 | 31.7 | 7.0 | 25.5 | 6.0 | 8.50 |
| 4 | ix.3 | 37.two | 5.5 | 31.0 | 5.5 | 7.75 |
| 5 | 8.0 | forty.0 | 2.8 | 35.0 | 4.0 | 7.00 |
| half dozen | 6.v | 39.0 | –1.0 | 39.0 | 4.0 | 6.50 |
| 7 | v.0 | 35.0 | –4.0 | 42.0 | iii.0 | six.00 |
| viii | 3.five | 28.0 | –7.0 | 45.5 | 3.5 | five.seventy |
| 9 | 2.0 | 18.0 | –10.0 | 49.5 | 4.0 | 5.5 |
| Table 5. Regulatory Choices in Dealing with Natural Monopoly. (*Total Acquirement is given past multiplying price and quantity. Yet, some of the price values in this table have been rounded for ease of presentation.) | ||||||
The first possibility is to exit the natural monopoly alone. In this case, the monopoly will follow its normal approach to maximizing profits. It determines the quantity where MR = MC, which happens at point P at a quantity of iv. The house so looks to point A on the need curve to find that it can accuse a price of 9.3 for that profit-maximizing quantity. Since the price is above the average cost curve, the natural monopoly would earn economic profits.
A second outcome arises if antitrust government decide to split up the company, so that the new firms can compete. Equally a uncomplicated example, imagine that the visitor is cut in one-half. Thus, instead of 1 large firm producing a quantity of 4, two half-size firms each produce a quantity of 2. Because of the declining boilerplate price curve (AC), the average toll of production for each of the half-size companies each producing two, as shown at point B, would exist nine.75, while the average cost of production for a larger house producing iv would only be vii.75. Thus, the economy would become less productively efficient, since the good is being produced at a college average toll. In a situation with a down-sloping average cost curve, ii smaller firms volition e'er take higher average costs of production than ane larger firm for any quantity of total output. In addition, the antitrust authorities must worry that splitting the natural monopoly into pieces may be just the start of their problems. If one of the ii firms grows larger than the other, it will have lower boilerplate costs and may be able to drive its competitor out of the market. Alternatively, two firms in a market may discover subtle means of coordinating their behavior and keeping prices high. Either way, the outcome volition non exist the greater competition that was desired.
A 3rd alternative is that regulators may determine to set prices and quantities produced for this industry. The regulators will effort to choose a signal along the market demand curve that benefits both consumers and the broader social interest. Point C illustrates one tempting choice: the regulator requires that the business firm produce the quantity of output where marginal toll crosses the need curve at an output of 8, and charge the cost of 3.5, which is equal to marginal toll at that bespeak. This rule is appealing because it requires price to be fix equal to marginal cost, which is what would occur in a perfectly competitive marketplace, and it would clinch consumers a higher quantity and lower price than at the monopoly choice A. In fact, efficient allocation of resource would occur at point C, since the value to the consumers of the terminal unit bought and sold in this market is equal to the marginal toll of producing information technology.
Attempting to bring about point C through force of regulation, withal, runs into a astringent difficulty. At point C, with an output of 8, a price of 3.5 is beneath the average price of production, which is 5.seven, and so if the firm charges a toll of 3.5, information technology volition be suffering losses. Unless the regulators or the authorities offer the house an ongoing public subsidy (and in that location are numerous political bug with that choice), the firm will lose money and leave of business.
Perchance the most plausible option for the regulator is betoken F; that is, to set the toll where AC crosses the demand curve at an output of 6 and a toll of 6.5. This plan makes some sense at an intuitive level: permit the natural monopoly charge plenty to cover its average costs and earn a normal rate of profit, so that information technology tin continue operating, just prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Of grade, determining this level of output and price with the political pressures, time constraints, and limited data of the real world is much harder than identifying the point on a graph. For more than on the problems that can arise from a centrally determined price, see the discussion of toll floors and price ceilings in Demand and Supply.
Price-Plus versus Price Cap Regulation
Indeed, regulators of public utilities for many decades followed the full general approach of attempting to choose a point like F in Figure i. They calculated the average cost of production for the water or electricity companies, added in an amount for the normal charge per unit of profit the firm should look to earn, and prepare the price for consumers accordingly. This method was known as price-plus regulation.
Cost-plus regulation raises difficulties of its own. If producers are reimbursed for their costs, plus a flake more, and so at a minimum, producers accept less reason to be concerned with high costs—because they tin can just pass them along in higher prices. Worse, firms under toll-plus regulation even have an incentive to generate high costs by building huge factories or employing lots of staff, because what they can accuse is linked to the costs they incur.
Thus, in the 1980s and 1990s, some regulators of public utilities began to use price cap regulation, where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, information technology can make a high level of profits. Withal, if the firm cannot keep up with the toll caps or suffers bad luck in the market, information technology may endure losses. A few years down the road, the regulators will and then gear up a new serial of toll caps based on the firm'southward operation.
Price cap regulation requires delicacy. It will not piece of work if the price regulators set the price cap unrealistically low. Information technology may non piece of work if the marketplace changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if free energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to come across price caps that seemed reasonable a year or 2 agone. But if the regulators compare the prices with producers of the same skilful in other areas, they tin, in effect, pressure a natural monopoly in one area to compete with the prices being charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an boilerplate rate of profit locked in every year by price-plus regulation—tin provide the natural monopoly with incentives for efficiency and innovation.
With natural monopoly, market place competition is unlikely to take root, then if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation volition need to play a function. In attempting to design a system of toll cap regulation with flexibility and incentive, regime regulators practise non have an easy job.
Key Concepts and Summary
In the case of a natural monopoly, marketplace competition will not work well and then, rather than allowing an unregulated monopoly to raise toll and reduce output, the government may wish to regulate price and/or output. Common examples of regulation are public utilities, the regulated firms that oftentimes provide electricity and h2o service.
Cost-plus regulation refers to government regulation of a house which sets the price that a firm can charge over a catamenia of time by looking at the house's accounting costs and so adding a normal rate of profit. Cost cap regulation refers to government regulation of a firm where the government sets a cost level several years in accelerate. In this case, the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.
Self-Bank check Questions
- Urban transit systems, peculiarly those with rail systems, typically experience pregnant economies of scale in operation. Consider the transit organization whose data is given in the Table half-dozen. Annotation that the quantity is in millions of riders.
Demand: Quantity 1 2 3 4 five half dozen 7 8 9 10 Toll 10 nine 8 7 6 five 4 three 2 1 Marginal Revenue 10 8 six 4 2 0 –ii –4 –vi –8 Costs: Marginal Cost 9 6 five 3 2 3 4 v 7 10 Average Cost 9 seven.5 half dozen.7 5.8 5 4.seven 4.6 4.six 4.9 v.four Table 6. Depict the demand, marginal revenue, marginal cost, and average cost curves. Do they have the normal shapes?
- From the graph you drew to answer Self-Check Question 1, would you lot say this transit organisation is a natural monopoly? Justify.
Review Questions
- If public utilities are a natural monopoly, what would exist the danger in deregulating them?
- If public utilities are a natural monopoly, what would be the danger in splitting them up into a number of separate competing firms?
- What is toll-plus regulation?
- What is cost cap regulation?
Critical Thinking Questions
- In the middle of the twentieth century, major U.Southward. cities had multiple competing city motorbus companies. Today, there is ordinarily just i and it runs every bit a subsidized, regulated monopoly. What do you suppose caused the change?
- Why are urban areas willing to subsidize urban transit systems? Does the argument for subsidies make sense to you?
Trouble
Use Table six to respond the following questions.
- If the transit arrangement was immune to operate as an unregulated monopoly, what output would it supply and what price would information technology accuse?
- If the transit system was regulated to operate with no subsidy (i.e., at zero economic profit), what judge output would it supply and what approximate price would it charge?
- If the transit system was regulated to provide the most allocatively efficient quantity of output, what output would it supply and what toll would it accuse? What subsidy would exist necessary to insure this efficient provision of transit services?
Glossary
- cost-plus regulation
- when regulators allow a regulated firm to cover its costs and to make a normal level of turn a profit
- price cap regulation
- when the regulator sets a price that a firm cannot exceed over the next few years
Solutions
Answers to Self-Check Questions
- Yep, all curves have normal shapes.
Effigy ii. - Yep information technology is a natural monopoly because boilerplate costs decline over the range that satisfies the market need. For example, at the point where the demand curve and the boilerplate cost curve meet, there are economies of scale.
Source: https://opentextbc.ca/principlesofeconomics/chapter/11-3-regulating-natural-monopolies/