Regulation of Natural Monopolies

This assignment examines the challenges posed by natural monopolies who never supply efficient quantities at efficient prices. It delves into two primary regulatory pricing options: marginal cost pricing (socially efficient but leading to potential economic losses for the monopolist) and average cost pricing (ensuring profit for the monopolist). The assignment also highlights price cap regulation as a potentially superior alternative when efficiently implemented.

Running head: REGULATION IN NATURAL MONOPOLY
Regulation in Natural Monopoly
Name of the Student
Name of the University
Author note

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Introduction
Based on the number of buyers and sellers, markets are classified in separate
category. The market with a single seller is called a monopoly market. In the monopoly
market, the single seller grabs maximum profit and the entire surplus in the market by
exploiting its market power. The monopoly market when compared to a competitive market
always seems inefficient in terms of resulting in a deadweight loss. A special form of market
similar to a monopoly market is natural monopoly. It is a market that is best operated by a
single seller than two or more.
In a natural monopoly market, the seller enjoys a cost advantage and able to produce
goods at the falling part of average cost curve. Examples of natural monopoly market include
electricity service, public water company and public utilities. Question of regulation comes
when the natural monopolist starts taking operation decision like a pure monopolist. In such a
situation, the monopolist chooses profit-maximizing level of output where a lower quantity is
supplied at a high price. In such a situation, government has taken pricing decision by either
following an socially efficient pricing strategy.
Efficiency comparison between monopoly and perfect competition
Perfect competition is a market scenario where there are numerous participants in
market exchange operation. Market equilibrium occurs at a point where demand and supply
curve matches with each other. The presence of large number of buyers and sellers in the
market makes it impossible for a single buyer or seller to affect price or output. Therefore,
efficient point is reached without any intervention (Hovenkamp, 2015). The market condition
with competition among the sellers is described below.

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Figure 1: Perfectly competitive market
(Source: As created by the Author)
Supply curve in the market coincides with marginal social cost and marginal benefit
curve is the same as market demand curve. Socially efficient point is reached where marginal
social benefit (MSB) is matched with marginal social cost (MSC). In perfect competition, it is
same as free market equilibrium where market demand equals market supply. Hence,
equilibrium in competitive market is efficient as here MSC = MSB (Belleflamme & Peitz,
2015). In the market, consumer enjoys considerable surplus that is the difference between
consumers willing price and actual market price. Consumer surplus is shown as the area
under the demand curve lying above price.
In contrast, the monopoly market is inefficient as here price is greater than social
marginal cost. The monopoly determines its own price and is not a price taker as like a
competitive firm. Because of its market power, the monopolist always chooses profit-
maximizing level of price and supply a lower quantity as compared to competitive market.

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The welfare loss because of a high price charged is shown by the triangle of deadweight loss.
Figure 2 explains this.
Figure 2: Inefficiency of the monopoly market
(Source: As created by the Author)
The consumer surplus is now reduced to a small triangle. Some portion of the reduced
surplus is transferred to the monopolist as producer surplus. The transferred surplus is not
considered as loss to the society (Schmidt, Spann & Zeithammer, 2014). The rest, which is
received neither by the consumer nor by the producer, is an actual cost to the society.
Natural Monopoly
One of the key features of a monopoly market is that entry of a new supplier is
completely restricted in the market. Barriers can be of several forms. Ownership barrier, legal
barriers or natural barriers are some types of barriers ( Weimer & Vining, 2017). When entry

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is restricted with a natural barrier then it is called natural monopoly. The goods or services
offered in the natural monopoly market usually have an abnormally high fixed cost. As a
result, with increase in the plant size or output average cost decrease entailing the benefit of
economies of scale to the seller. When there is more than one supplier then such scale
benefits are reduced and results in market inefficiency (Vikharev, 2013).
Figure 3: Natural Monopoly Market
(Source: As created by the Author)
As shown in figure 3, the monopolist makes market operation with a decline in its
average cost. The optimum price and quantity here are P* and Q*. However, more firms enter
in the market then they fail to reach the efficient point and may supply a lower quantity (Q1)
at a high price (P1)
Unregulated natural monopoly
With a restricted entry, natural monopoly business seems to be a lucrative business for
earning huge economic profit. In the absence of any regulation, line of difference between

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natural monopolist and that of a pure monopolist becomes blurring (Andrade, 2014). Same
like a monopoly market with its pure form, here also standard condition for profit
maximization is used to determine price and output in the market. The economies of scale
enjoyed here, enables the monopolist with a much higher profit (Saglam, 2017).
Figure 4: Unregulated Natural Monopoly
(Source: As created by the Author)
In an unregulated situation, maximization of profit requires Marginal revenue
equalizes with Marginal Cost (Shughart II, & Thomas, 2015). Above figure shows such an
unregulated natural monopoly market. The operation point of the monopolist is point E. The
unregulated price and quantity are Pf and Qf respectively. Profit to the monopolist is shown
by the shaded region in the figure.
Regulation in natural monopoly

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The high price and low quantity in an unregulated monopoly brings the need for
regulation in a natural monopoly market. Market regulation refers to set of rules by which
government administered over different aspects related to market such as quantity, price,
entry or exit condition and the like. There are two prevalent theories explaining basic
working mechanism of regulation (Rifkin, 2014). First is Social interest theory and the
second one is Capture theory. Under the social interest theory, regulatory authority seeks to
find the root cause of inefficient outcomes and then takes step to correct the inefficiency and
maximize welfare. Capture theory explains a regulatory framework where producer manages
to manipulate the regulator in serving self-interest.
Natural monopoly, created with natural condition of demand and cost often result in
market outcome lower than efficient outcome. Role of the regulator here is to secure efficient
price output combination.
Efficient point is obtained at a point where price and marginal cost are equal. It is a
point that balances Marginal social cost and marginal social benefit. Here, MSB curve is the
demand curve and MSC curve is the marginal cost curve or supply curve (Tietenberg &
Lewis, 2016). Efficient regulation sets price at PE and Quantity at QE, shown in figure 5.

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Figure 5: Different pricing strategy in natural monopoly market
(Source: As created by the Author)
Under efficient regulation though best outcome is obtained for the society, however it
causes the monopolist to incur a loss from the market operation. The natural monopolist
operates at the left of the minimum point of average cost. From the relation between average
cost and marginal cost at the falling part of ATC, MC is less than the ATC. Thus for the
whole range of output, MC lies below the average cost (Puller, 2013). Therefore, when price
is equals to the marginal cost then average cost is above the set price and leads to a loss to the
monopolist as shown by the shaded region in the above figure.
Without compensating for the loss, the production cannot be carried out. The
monopolist might be allowed for price discrimination to cover average cost. Alternatively, the
monopolist can consider charging a one-time fixed fee. As maximum portion of the average
total cost is fixed cost, the fixed fee helps to recover loss from efficient pricing (Borenstein,
2016).

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Another alternative to the regulator is to give direct payment as subsidy equals to
economic loss. To provide subsidy government has to increases its revenue. The only source
of government revenue is direct and indirect taxation. Increasing tax rate is not a viable
option because tax itself is associated with a welfare cost or deadweight loss.
Therefore, the second best alternative is to revise the marginal pricing rule settle price
at the level where the monopolist can just cover its average cost. It is called average pricing
rule. Under average cost pricing rule, price is set equals to the average total cost. Equilibrium
is determined at the point where demand curve intersects average total cost (Zhang, Ge, &
Xu, 2013). Price and quantity denoted as Pr and Qr corresponds to average pricing rule.
Here, total revenue earned by the monopolist is just equal to the total cost. Only normal profit
is realized here.
The regulation decision is made considering the cost and benefits of different policy
option. In selecting between two pricing rule, the regulators needs to compare between dead
weight losses from two strategies. Smaller the dead weight loss more efficient is the policy.
Either of the policy depends on the cost of the monopolist. Any pricing regulation based on
firm’s cost is known as cost plus regulation. Cost plus regulation lacks transparency. The
monopolist once come to know that prices are going to be determined based on the computed
cost, the general tendency then is to overestimate cost (Bös, 2014). The monopolist becomes
least aware of reducing production cost rather involves in activities that impose additional
cost. The burden of high cost transfers to the buyers in terms of high price. Hence, the
regulators might fail to set efficient price.
Price cap regulation
Realizing challenges of the cost plus pricing regulation a preferred alternative is Price
cap regulation. It is similar to the policy of price ceiling. Here government sets a maximum

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price for the market. The monopolist cannot charge price above the ceiling price. The price is
set for a few years. After some times, the regulators considering the market condition again
revise price (Czerny & Zhang, 2015). Generally, a declining trend in revised price is
observed. To earn a handsome profit here the monopolists has to focus on reducing cost.
This increases market efficiency. Unlike in cost plus regulation where the monopolist has
tendency to increase unnecessary cost burden here the monopolist reduces cost with own
effort.
When selecting the ceiling price, proper evaluation of market is needed. Any
unrealistic price hampers the market operation. In case the price cap is too low then the
monopolist fails to sustain in the market and close down operation. As the natural monopolist
mostly offers necessary goods like electricity, water sudden close down of operation creates
trouble (Engel & Heine, 2017). While making price revision effect of shocks should also be
considered so that the policy can be carried effectively.
Conclusion
The essay aims at explaining regulation in a natural monopoly market. In a monopoly
market, a single sellers control all the market power. The price and output are inefficient as
compared to competitive market. Natural monopoly is a special form of monopoly where a
natural barrier is imposed on the entry of a new firm. In this form of market, there is an
unusually high fixed cost, which results in a reduction of total average cost. When average
cost reduces with increasing plant size or output then the producer reaps the benefit of
economic scales. This scale benefits allows the producer to supply a relatively large amount
of goods at a price lower than if there are competition between two or more sellers. The
position a sole producer in the market tempts the natural monopolist to behave like a pure

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monopolist. Therefore, unregulated natural monopolist never supplies efficient quantity at an
efficient price. The situation needs to be corrected using regulation.
There are two pricing option for the regulators. One is the marginal cost pricing that is
socially efficient pricing strategy. Because of monopolist’s operation at the falling portion of
average cost marginal cost is below the average cost for the entire output range. As a result,
the marginal pricing rule results in economic loss for the monopolist. The loss can be
recovered either by direct government subsidy or by allowing the monopolist to charge a
fixed fee or discriminate in the market. Another alternative is to set the price by average
pricing rule. Here, the monopolist earns only economic profit. Price cap regulation is the best
alternative to setting price for the natural monopoly market given executed efficiently.

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References
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Belleflamme, P., & Peitz, M. (2015). Industrial organization: markets and strategies.
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Borenstein, S. (2016). The economics of fixed cost recovery by utilities. The Electricity
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Bös, D. (2014). Public enterprise economics: theory and application (Vol. 23). Elsevier.
Czerny, A. I., & Zhang, A. (2015). Single-till versus dual-till regulation of airports.
Engel, C., & Heine, K. (2017). The dark side of price cap regulation: a laboratory
experiment. Public Choice, 1-24.
Hovenkamp, H. (2015). Federal Antitrust Policy, The Law of Competition and Its Practice.
West Academic.
Puller, S. L. (2013). Efficient retail pricing in electricity and natural gas markets. The
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