Tag Archives: Natural Monopoly

NCEA Level 3 and CIE A2 Economics – Natural Monopoly

Natural Monopoly-Features

A natural monopoly is when one firm has the ability to supply the entire market at lower prices than two or more firms. A natural monopoly faces downward-sloping average cost (AC) for the entire range for which demand is applicable. The reason for its downward-sloping AC curve is usually that the initial investment in the infrastructure of the firm is large, but once it is in place, the marginal cost (MC) of production is low, for example hydro power. This high establishment cost is a strong barrier to entry and a natural monopoly could undercut any would-be competitor so they could not survive. Natural monopolies often involve some kind of network, for example water, gas,phone, rail.

Equilibrium Output-Natural Monopoly

The rule for maximising profit or minimising a loss (the equlibrium) for a natural monopoly is the same as any other firm. The most profitable output or smallest loss is where marginal revenue (MR) equals marginal cost (MC). Any other position will result in a smaller profit or greater loss. Therefore, the equilibrium output is at a price of Pe and quantity Qe (determined from the intersection of the marginal cost and marginal revenue curves). At the equilibrium output Qe the natural monopoly is making a supernormal profit (of $100m) and produces less than what society or consumers desire. Operating at the equilibrium output position creates a deadweight loss of BFG because consumer surplus and producer surplus are not maximised. The natural monopoly is charging a price in excess of marginal cost (P > MC), this is called mark-up pricing. At the equilibrium output in perfect competition, price and marginal cost are the same. Sellers cannot charge higher prices because they would immediately lose sales to competitors. This is called marginal cost pricing and occurs in perfect competition where at the equilibrium output position price equals marginal cost (P = MC). A natural monopoly charges more and produces less than would be the case if the firm operated as a perfect competitor. Overpricing and not operating at the allocatively efficient (socially optimum) level means that a natural monopoly can be seen as socially undesirable. However, if consumers are not subject to competitive advertising and marketing, they receive the good or service at cost and the firm carries out R & D (research and development) a natural monopoly can be viewed as socially desirable. A natural monopoly may also be seen as socially desirable because it is wasteful to duplicate the existing infrastructure, so encouraging competition is seen as undesirable. If output is below equilibrium Qe (where MR equals MC), the firm would be missing out on marginal profits because the revenue from producing the last article is greater than its cost of production, implying that the firm could increase output and increase profit. However, increasing output beyond Qe reverses the position. The firm will be making marginal losses because the revenue from one additional article is now less than the cost of its production. If increased output adds more to cost than to revenue, a firm has obviously passed the point of maximum profit (or minimum loss). Price discrimination may be practised by any monopolist. This is where they segment the market in some way, for example domestic and industrial users may be charged at different rates. A two-part tariff is a system where users are charged a fixed amount for a given time period and per unit charge for use, for example with the phone there is a line rental and a charge for toll calls. Off-peak pricing is a system of charging that results in a higher price at peak time usage than at off-peak times, for example toll calls made after 6 p.m. are at a cheaper rate.

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Natural Monopoly Theory

I picked up this natural monopoly theory from University of Waikato Senior Economics Lecturer Michael Cameron on his excellent blog entitled Sex, Drugs and Economics. This is very useful for A2 students when studying market structures.

A natural monopoly arises where one producer of a product is so much more efficient (by efficient I mean they produce at lower cost) than many suppliers that new entrants into the market would find it difficult, if not impossible, to compete with them. It is this cost advantage that creates a barrier to entry for other firms, and leads to a monopoly. Natural monopolies typically arise where there are large economies of scale (when, as a firm produces more of a product, their average costs of production fall). Economies of scale are common when there is a very large up-front (fixed) cost of production, and the marginal costs (the cost of supplying an additional unit of the product) are small (the cost structure is shown in the figure below, with a simplifying assumption that the marginal cost of production is low and constant). The markets for utilities, where the up-front cost includes the cost of having all of the infrastructure in place, are good examples. Rail is another example, since you need the tracks, the rolling stock, and the associated stations and other buildings in place before you can start to provide rail services.

Natural Monopoly

Now natural monopolies, like other firms, are assumed to be profit maximisers. That is, they will operate at the point where marginal revenue is equal to marginal cost. That is, they will operate at the price PM and the quantity QM in the diagram above. At that point, the producer surplus is the area PMBHPS, while the firm’s profit is the area PMBKL (the difference between profit and producer surplus arises because of the large up-front fixed costs, which are subtracted from profits, but not from producer surplus). However, consumer surplus in this market is GBPM, and total welfare is GBHPS. This leaves a deadweight loss equal to the area BEH.

Now, if the government owned the natural monopoly, it doesn’t necessarily have to profit maximise if it doesn’t want to. Government could choose to maximise total welfare instead. It would do this by setting the price at the point where marginal social benefit is equal to marginal social cost. That is, the market will operate at the price PS and the quantity QS. At that point, producer surplus is zero (since every unit is sold for marginal cost), but the profit is negative (JDEPS) because price is below average cost. On the other hand, consumer surplus is GEPS, and total welfare is maximised at GEPS.