Regulation of Natural Monopolies

This assignment delves into the complexities of regulating natural monopolies. It examines different regulatory approaches such as price capping, rate-of-return regulation, and tax/subsidy mechanisms. The text analyzes the pros and cons of each method, highlighting potential drawbacks like cost window dressing and the lack of incentive for efficiency. Ultimately, it emphasizes the need for a balanced regulatory approach that protects consumer interests while encouraging fair competition.

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Natural Monopoly
In general, monopolies are distinguished by high investment cost and high fixed cost. A natural
monopoly is different in context to the existing concept of monopolies. It is characterised by a
condition where a single firm is in a better position to serve in the market in comparison to two or
more firms. In other words, where a single large business can serve the entire market at a lower price
than other two or more smaller firms. The term, “natural monopoly’’ doesn’t refer to the actual
number of sellers in the market but relation between demand & technology of supply.
In this scenario, the actual cost & prices might increase as there is only one efficient provide of a
good. If it contains more one industry than either the firms will constrict to one through mergers or
failures or the production will continue to consume more resources than required (Posner, 1968)
There are various reasons which can lead to this situation. One of them is where there is decrease in
the overall cost as the production output increases thereby giving the advantage to the existing firm
owing to the large output which a new firm cannot match and eventually this stands as a barrier
( Mankiw, 2014). The other reason would be the control over the less available resources e.g. railway
lines, power supply, telephones line etc. Hence, the key player which have the hold over the scarcely
available resources becomes the only supplier which makes the entry of other firms difficult without
the same resources. Government intervention and policies also contributes to the natural monopolies.
This type of scenario arises in several industries where the starting or the upfront cost is too high. For
instance, electricity transmission, transmission lines of telephones, oil or natural gas etc. One cannot
think of replicating the same due to the exceptionally high cost which leads to only sole player having
all the control over the market.
Determination of price & Quantity
The firm falling under monopolistic takes decisions with an aim to maximize the profits which
ultimately leads to situation where marginal cost is lesser than the price, as the firm keep producing
resulting in under allocation of available resources. This is only occurs as the corresponding output is
lower than the comparable output which is expected in perfect competition while the price charged is
significantly higher. The same can be explained below in the diagram:

Monopoly Diagram
The quantity produced by a monopolist firm is represented by QM & the price charged by PM. It is
apparent that the firm tends to produce until the average cost (AC) is at its lowest point. Thus, to
maximize the profit, a firm need to produce until average cost is at its lowest possible point. In other
way by increasing the production & corresponding lowering the price will never maximize the profits
(Krugman & wells ,2008). So, the firm under natural monopoly produces less as the efficient output
level would be higher. If a new entrant tries to enter the market in this scenario then the monopolist
will increase the production quantity to lower the price compelling the new firm to exit the market
( Mankiw & Taylor, 2011).
Efficiency of Natural monopoly
Knowing the available resources are scarce, it is evident that the resources should be assigned or
utilised in way to maximise the production & efficiency of these resources. The same never happens
in natural monopoly unless there is government intervention. The same can be explained below with
the help of a diagram:

When a natural monopoly is not under regulation, Pm represents the price charged and Qm is the
quantity supplied. At Pso the social optimal price is obtained with corresponding output of Qso. If
government steps in and sets the price for either break even or a fair return, then Pfr and Qfr would be
the price charged & quantity supplied respectively. From the above diagram, it is evident that a non-
regulated monopoly is very highly efficient in comparison to a regulated one. Hence the consumer
supply is highly diminished & give rise to huge deadweight loss. The same can be depicted in the
form of a diagram:

The above statement is again verified by the diagram that there is a need of government intervention
or else without any competitor the firm will maximize the profit by using the available resources
inefficiently (Krugman and wells, 2008)
The below are the cases of government intervention in natural monopoly:
The above instances have already confirmed the need of government regulation. The same is
explained below (Pindyck & Rubinfeld, 2001) :
 To check the prices are under control, a government intervention is required as a non-regulated
monopolist can charge higher from the consumer as there is no competitor and which will also
lead to inefficiency and decrease in consumer trust.
 The quality of product or service under a natural monopolist may degrade as it is only the sole
provider in the market. Hence there must be some kind of standard set by the government to
ensure the quality standards are followed.
 Being the only provider in the market, the suppliers might face the challenges as there is only
buyer of their goods with all market share. Hence an intervention by the government should be
there to ensure monopolist power is not deployed for exploitation of suppliers.
 As in case of monopoly there ought to be some cases of competition to keep the monopolist
under check but in natural monopoly as it difficult for a new entrant because of huge
investment and fixed cost, there has to be a government intervention or regulation to ensure
smooth functioning of the industry.
Below are the methods of government intervention in natural monopoly:
As in the previous section we came to know there has to be a government regulation through
intervention in order to keep the monopolist under check. The various ways by which the government
can exercise the same is explained below. Also, the operating mechanisms along with its positives &
negatives has been briefed.

Price Capping
The price limit imposed by the government on a product is known as price capping. In general, it is
exercised on the essential utilities such as electricity, gas, telecom services where it is important that
the consumer can utilise these services at an affordable and fair price. This type of case arises when a
public utility may be privatised. In this case, the government send its officials for the different sectors
who limits the price in case of inflation. Normally, the monopolist is permitted to increase the value
which is lower than the inflation to ensure the efficiency which are gained is also realised. This gives
added advantage to the private firms in terms of incentive to enhance efficiency in order to have the
profits margin even in an inflationary environment. Also, the re revision of pricing is permitted with
prior approval from the government regulators once the approval is granted (Mankiw and
Taylor,2011).
This practise has a lots of pros. The first being the, the increase in prices are always being monitored
by the officials or the government regulators who keep consumer welfare in their mind while
exercising this process. The second pros are the practice of price capping also provides advantage to
the monopolist firm to improve their efficiency in terms of productions or services to maximize their
profits. This happens because only the prices are monitored not the returns and the regulators while
checking the price rise also expects some kind efficiency gains. Lastly, this helps in reducing the
exploitation of monopolist power.
The practise also has its negatives sides. Firstly, having the equilibrium between the profitability of
the firm and consumer welfare is quite difficult to achieve for the regulator. Hence there comes a
situation where there is drift to the either side from the optimum equilibrium. Secondly, there may be
tussle between the government regulators and the monopolist firm which allows the firm to earn
supernormal profits on a regular basis at the cost of consumer well-being. Lastly, the monopolist firm,
has the incentive to be less efficient to that in every incremental price change, it can increase the
efficiency (Krugman and wells,2008).
Price ceiling
Another way it can be regulated by price ceiling which is by the enforcement of a maximum potential
price being charged. This regulatory strategy ensures by stating a specific product or service cannot be
sold above a certain price.

Quality of service regulation
When there is a natural monopoly for a public utility, then it is evident for the regulator to define the
minimum criteria or the standards or the firm may try to maximize the profit by intentionally
producing low standard products and charging premium price for the same.to regulate this government
intervention is essential. Also, it is necessary that the government regulators must set the minimum
standard that can be practically made (Besanko and Braeutigam, 2010).
Breaking of Monopoly
In order to increase the competition, it is necessary to break the monopoly in extreme cases. Here the
possible solution is geographical spin off into different entities rather than being part of single large
entities. The government can also play major by buying a stake in the firm ensuring that there are
government representatives in the management and the consumer wellbeing is better served.
Nationalization of the firms by providing fair compensation can also be implemented in extreme
scenarios (Arnold, 2008). Although these types of practice may lower the confidence of the investors
and that is why it is usually refrained and external regulation is practiced. Nationalization of the firm
over the long run is inefficient and thus it is not practiced (Nicholson and Snyder, 2011).
Yardstick regulation
When there is no direct competition for the utility suppliers, the regulators can pressurise those firms
by bashing their prices in terms of cost performance of comparable firms. In this type of regulation
instead of price capping, the regulator considers the amount of capital deployed which may offer a
fixed rate of return ensuring the prices in accordance of this objective. Hence, the prices are set by in
line by ensuring fixed returns to the firm. The main drawback with this regulation is that the private
firm would tend to window dress the cost for the sake of increasing the price fixed by the regulators
(Krugman & wells, 2008). Thus, concluding as there is no added incentive for the private party to
ensure the operations are smooth & efficient in every way as the same might lead in lower the prices
set by the regulator (Mankiw, 2014)
Tax or subsidy
As a last major, a government can regulate the natural monopoly by imposing higher taxes on larger
firms and providing subsidies to the smaller firms. In other words, government can provide financial
support to the smaller firms in the form subsidy to the new entrant so that there is healthy and
equitable environment.

Conclusion
We can lastly summarise that in order to have consumer friendly environment there must be
government regulation which should be favourable for the firms too. In the absence of the same, there
might be consequences which may hamper to the overall growth of the country and its people on the
whole. The government regulation should ensure that the consumer interest is being served both in
terms of price and quality of services. The various mechanisms through which the government can act
depends upon the socio-cultural or underlying political conditions which tend to decide the best
possible way forward. Lastly, the nationalisation of the firm or breaking of monopoly should only be
exercised in extreme scenarios when the rest of the measures failed to give the desired results.

References
Mankiw, G (2014) Microeconomics ( 6th ed.). London: Worth Publishers.
Mankiw, G.N. & Taylor, P. (2011). Microeconomics (5th ed.). Sydney: Cengage Learning.
Krugman,P. & Wells, R. (2008). Microeconomics (2nd ed.). London: Worth Publishers.
Samuelson, W. & Marks, S. (2003). Managerial Economics (4th ed.). New York: Wiley Publications.
Pindyck, R. & Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall Publications.
Nicholson, W. & Snyder, C. (2011). Fundamentals of Microeconomics (11th ed.). New York: Cengage
Learning.
Regulation of natural monopoly (2016, may 27). Boundless economics boundless. Retrieved from
https://www.boundless.com/economics/textbooks/boundless-economics-textbook/monopoly-11/
monopoly-in-public-policy-74/regulation-of-natural-monopoly-279-12376/
Besanko, D. & Braeutigam, R. (2010). Microeconomics (4th ed.). New York: John Wiley & Sons
Arnold, A.R. (2008). Microeconomics (9th ed.). Sydney: Cengage Learning.