Understanding Natural Monopolies

This assignment delves into the concept of natural monopolies, examining the factors that lead to their formation and the unique economic challenges they present. It explores various aspects, including cost structures, market dominance, and regulatory considerations related to pricing in natural monopoly environments. The analysis emphasizes understanding the implications of natural monopolies for both consumers and producers.

Running Head: Natural Monopolies Price Regulation
Governments Intervention on Natural Monopoly Pricing
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Natural Monopolies Price Regulation 2
Governments Intervention on Natural Monopoly Pricing
Introduction
There are different types of market structures; perfect competition, monopolistic
competition, oligopolies and monopoly markets. It is argued by most economists that
competition is present in the perfect competitive markets because the number of sellers are
many, small in size and price takers. However, when we consider the case for monopolies, this is
a market whose supplier is a sole supplier who is large in size. There is no competition in the
monopoly markets and the sole supplier is the price maker. The government is always against the
presence of oligopoly and monopoly markets since they are inefficient in price and outputs. The
role is promoting competition in an economy by the government is achieved through monopoly
pricing regulation.
Being driven by the objective of maximizing profits, monopoly markets produced less
output than would be for a competitive case and then sell this at a high price. The goods
produced by the monopolies allow for the higher price charges since there are no close
substitutes; the consumers have no other option than to accept the price offered no matter how
high it becomes (Textbook Equity Edition, 2014). The natural monopoly is a special kind of
monopoly existing due to the presence of high startup costs and fixed costs. Hillman (2007)
noted that all pure public goods fall under a natural monopoly and it shall be seen on the analysis
that its more efficient to supply pure public goods through a natural monopoly than by
duplication (Economicsonline.co.uk (2017). There are two important theories that explains price
regulation for a natural monopolist. These are the Average cost pricing and the marginal cost
pricing (Greer, 2012). The first one is the pricing made on the basis of average cost while the
other one is the pricing made on the basis of marginal cost whether regulated or unregulated. It is
expected that the natural monopolies should be maintained in the economy for some goods to be
provided at a lower price.
Analysis
A pure public good like water is best supplied by the natural monopoly because the
production costs associated to the supply falls as the number of users increase. These natural
monopolies have increased economies of scale (Linfo.org, 2006). Duplication would lower the
economies of scale and the competitors would fight for prices which would make the prices
charged to be higher (Textbook Equity Edition, 2014). Natural monopolies are present in the

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case of electricity distribution. The production of electricity is not such expensive and can be
done by many investors. However, the infrastructure used to get the electricity to the final users
is very expensive. There are many examples of natural monopolies like the water distribution
and the postal services. According to Hütcher (2011), the pressure on pricing on natural
monopolies is very high which makes it difficult for competitors to survive in this market.
According to Regulationbodyofknowledge.org (2017), natural monopolies have market
powers and when a business recognizes that it falls under a natural monopoly, it limits its output
level and raises its prices; the prices are set above the marginal cost. This unlike in the
competitive markets results in a reduced social welfare (Tutor2u, 2017). Since most of the times
the commodities offered by a natural monopolists are basic goods, such as water, electricity and
communication, people cannot avoid their consumption even if prices were raised. Social welfare
is lost in that the extra income used could be used in the demand for some other goods or
services. The role of the government therefore is to make sure that such prices are not charged
and that the monopolists charge fair prices. However, scale economies prevents this marginal
cost pricing from being the optimal choice (Mankiw, 2011).
The price for a natural monopoly is set by the government at the best-price for a single
product; it is set equal to the marginal cost (MC) of production. Hütcher noted that the setting of
the price by the government is with an aim of ensuring that the social welfare is maximized.
However, the first-best price which is equal to MC will not apply in all the cases; sometimes the
fixed costs may be higher compared to the variable costs. This would mean that Average cost
(AC) would exceed the marginal production cost. For this reason, the government is forced to set
the second-best price at a level higher than the first-best price, at the point where it is equal to the
AC. Many natural monopolies produce many goods and services and these are priced differently.
This creates a challenge for the AC to be the optimal basis for pricing; the challenge is on
determining the optimal combination that would result in the lowest dead weight loss. There
therefore has to be another optimal basis for pricing. This bring about the idea of Ramsey
pricing. Ramsey noted that the reason by the government regulate natural monopoly prices is to
prevent the consumers from suffering from the high monopoly prices. His idea therefore was to
maximize social surplus by reducing the prices for the monopoly’s’ unique goods.

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Fig: Dead weight loss for unregulated Monopoly
Source: Faculty.winthrop.edu (2017)
The graph shows that unregulated monopolistic strategy of producing at MR = MC is
resulting in a high level of deadweight loss equal to the shaded region. This is interpreted to a
reduced consumer surplus and an increased producer surplus. However, deadweight loss cannot
be avoided in the case for natural monopolies since the consumers are charged a price higher
than the competitive price would be. The government’s interest is to ensure that the smallest
dead weight loss is incurred. QUN is the quantity produced from free operation, QOPT is the
maximum (optimal) output that could be produced at the competitive level.

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Fig: Pricing options for a natural monopoly
Price &
Costs
11
10
8 AC
7
4 MC
MR Demand
3 6 10 14 Quantity
The competitive level of production is 14 units and at a price of $4; this is at the
intersection of demand and the MC; this is if the natural monopoly is regulated to produce at this
point. At this point, the AC can be observed to be very high and the monopoly could only make
losses. The maximization of profit level for a natural monopolist is at 6 units at a price of $10;
this is at the intersection of the MR and the MC; then where this solution level cuts the demand
curve; this happens if the natural monopolist is left alone without any regulation (Haworth,
2017). At this point, it is also observed that the AC is below the price charged. So this natural
monopoly is making abnormal profit. The breakeven point for a natural monopoly is thus at
producing 10 units and selling at a price of $8; this happens if regulated to produce at a price
equal to the AC. This is the point where the social surplus is maximized and the price charged is
lower than what would otherwise be offered by the unregulated monopoly; the output level is
also higher (Welker, 2013). Thus at this level, the resources are allocated efficiently. The reason
for regulation is observed from the graph; let’s assume that the regulators allowed the division of
the market into two such that each firm produces 3 units, at 3 units, the AC of production rises

Natural Monopolies Price Regulation 6
and thus the price for the goods rise to $11. The natural monopoly is producing at a lower AC
than it would be the case for many suppliers.
The price charged should be regulated to be on maximum equal to the average cost. Any
price below the Ac even if the regulators push for it is not achievable unless the regulators could
offer subsidies for the losses to be incurred. The subsidies help in ensuring that even after selling
at the lower price below the AC, the supplier is able to break even. There is no way a regulator
with an aim of improving social surplus can push for the price to be above the AC; therefore all
prices above the AC are not possible unless the supplier was let to operate with no regulation.
Under regulation by the government, the quantity produced is higher than for the unregulated
monopoly and lower than for the competitive market.
One of the solution proposed by many economies on resolving the problem of pricing the
natural monopolies is to ensure that all the private natural monopolies transfer their ownership to
the government. This could improve efficiency as the losses the government makes will be
catered for in its budget. This would help in skipping all the pricing challenges for natural
monopolies. The other solution is fragmenting the markets and then allowing for marginal
costing. This is the realization of the fact that consumer’s ability to pay are different. Price
discrimination would ensure that lower prices are charged in the markets for low income
consumer brackets with no profit interest; the compensation for this is achieved by charging
higher prices in the markets for high income bracket consumers. Through this, the government
goal of improving social surplus is achieved.
The government need to ensure that there is sufficient supply of the good produced by the
natural monopoly. This is why the government do not allow these firms to charge a price equal to
marginal cost since losses would put these firms to a risk of closing down. For a single-product
monopolist, average pricing is the best regulation strategy as it ensures a breakeven point for the
natural monopolist in addition to improving the consumer surplus.
Conclusion
The government has to consider all the production costs in setting their prices for a
natural monopoly. The first-best price is not always the best price for a natural monopoly as it
could lead to the natural monopoly making losses if the variable cost is small and a very high
fixed cost. The average cost is the cost that determines the breakeven point of a natural
monopoly; at the price where the price is equal to the average cost. There should be no natural

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monopoly that could be making losses. Social welfare is maximized at the price which is equal to
the marginal cost. Since the natural monopoly is not able to break even at this price, the
government should subsidize the difference between average cost and marginal cost for the price
equal to the marginal cost to make the monopoly breakeven and at the same time maximize
social welfare.
It is difficult for the government to determine the true AC for a natural monopoly and
thus misinformed decisions may be made by the government since these supplier report more
than the true value of AC so as to be allowed to sell at a higher price and gain some profit. This
can be resolved by introducing a proper strategy of estimating such costs by the government.
Otherwise the goal of maximizing social welfare cannot be reached. The natural monopolists are
only expected to make normal profits at the price that is equal to AC. It can therefore be
concluded that there is no possibility for a natural monopolist to be left to operate freely and thus
the regulators are important in restricting their prices.

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References
Economicsonline.co.uk. (2017). Natural monopolies exist when one firm dominates an industry.
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August 2017, from http://econpage.com/201/handouts/natmonop.html.
Hillman, A. L. (2007). Public finance and public policy: Responsibilities and limitations of
government. New York, NY [u.a.: Cambridge Univ. Press.
Hütcher, P. (2011). Theory of Natural Monopoly: Ramsay Pricing and Loeb-Magat Proposal.
Investopedia.com. (2017). Franchised Monopoly. Investopedia. Retrieved 27 August 2017, from
http://www.investopedia.com/terms/f/franchised-monopoly.asp.
Linfo.org. (2006). Natural Monopoly Definition. Linfo.org. Retrieved 27 August 2017, from
http://www.linfo.org/natural_monopoly.html.
Mankiw, N. G. (2011). Principles of economics. Mason, Ohio: Thomson South-Western.
Regulationbodyofknowledge.org. (2017). Deviations from Marginal Cost Pricing: Ramsey
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http://regulationbodyofknowledge.org/tariff-design/economics-of-tariff-design/ramsey-
pricing/.
Textbook Equity Edition. (2014). Principles of Economics Volume 1 of 2. [S.l.]: Lulu com.
Tutor2u. (2017). Explaining Natural Monopoly. Tutor2u. Retrieved 28 August 2017, from
https://www.tutor2u.net/economics/reference/natural-monopoly.
Welker, J. (2013). Monopoly prices – to regulate or not to regulate, that is the question!
Economics in Plain English. Retrieved 28 August 2017, from

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http://welkerswikinomics.com/blog/2013/03/04/monopoly-prices-to-regulate-or-not-to-
regulate-that-is-the-question/.