Pricing Strategies for Natural Monopolies
Added on 2020-02-24
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Running Head: Natural Monopoly Pricing
Price Setting for Natural Monopoly
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Price Setting for Natural Monopoly
Student Name
Institutional Affiliation
Course/Number
Instructor Name
Due Date
Natural Monopoly Pricing 2
Price Setting for Natural Monopoly
Introduction
A natural monopoly refers to an industry in which it is most efficient to have only one
firm as opposed to several smaller firms providing the same product or service. Due to the high
fixed costs, it becomes impractical to have several firms offering the same goods or services in
that industry (Pettinger, 2012). Examples of natural monopolies include water and sewerage,
natural gas industry, electricity, cable TV, railway lines, among others. In such industries, it
defeats economic sense to have several firms laying underground pipes and other infrastructure
to provide the same goods or services since the average costs will be much higher than they
could be if only one of the firms offered the services in the particular industry (Gallego, 2017).
The regulation is governed by various theories. The first is the Public Interest Theory (PIT)
where the government is responsible for promoting social welfare. The next is capture theory
where the industries interest is served and lastly the public choice theory where the agencies
theory is served.
This paper discusses the scale economies of a natural monopoly and examines the need
for regulation of natural monopolies by the government and further the various ways the
regulators use to intervene in price setting for natural monopolies. The government may choose
the average pricing strategy of the price ceiling strategy Consumers are to benefit most from the
information contained in this paper and also students who generally need to understand the
importance natural monopolies in specific industries and how the government plays a role in
regulating these monopolies.
Analysis
Economies of Scale for a Natural Monopoly
Natural monopolies are sole suppliers with high level of economies of scale. The term
“economies of scale” explain the reason for the existence of a natural monopoly and is used in
description of the competitive advantage enjoyed by large firms over small ones which means
that the larger a firm is, the lower its costs of production are. An example is when unit
production costs decrease with quantity (Amadeo, 2017). Therefore, as explained above, in some
of the industries which were identified earlier, it is more efficient to have a single firm in
operation rather than several firms. The essence is that due to the high fixed costs, it will not be
Student’s Name; Student’s ID
Price Setting for Natural Monopoly
Introduction
A natural monopoly refers to an industry in which it is most efficient to have only one
firm as opposed to several smaller firms providing the same product or service. Due to the high
fixed costs, it becomes impractical to have several firms offering the same goods or services in
that industry (Pettinger, 2012). Examples of natural monopolies include water and sewerage,
natural gas industry, electricity, cable TV, railway lines, among others. In such industries, it
defeats economic sense to have several firms laying underground pipes and other infrastructure
to provide the same goods or services since the average costs will be much higher than they
could be if only one of the firms offered the services in the particular industry (Gallego, 2017).
The regulation is governed by various theories. The first is the Public Interest Theory (PIT)
where the government is responsible for promoting social welfare. The next is capture theory
where the industries interest is served and lastly the public choice theory where the agencies
theory is served.
This paper discusses the scale economies of a natural monopoly and examines the need
for regulation of natural monopolies by the government and further the various ways the
regulators use to intervene in price setting for natural monopolies. The government may choose
the average pricing strategy of the price ceiling strategy Consumers are to benefit most from the
information contained in this paper and also students who generally need to understand the
importance natural monopolies in specific industries and how the government plays a role in
regulating these monopolies.
Analysis
Economies of Scale for a Natural Monopoly
Natural monopolies are sole suppliers with high level of economies of scale. The term
“economies of scale” explain the reason for the existence of a natural monopoly and is used in
description of the competitive advantage enjoyed by large firms over small ones which means
that the larger a firm is, the lower its costs of production are. An example is when unit
production costs decrease with quantity (Amadeo, 2017). Therefore, as explained above, in some
of the industries which were identified earlier, it is more efficient to have a single firm in
operation rather than several firms. The essence is that due to the high fixed costs, it will not be
Student’s Name; Student’s ID
Natural Monopoly Pricing 3
tenable to have more than one small firms. Figure 1 below is used to explain the economies of
scale in a natural monopoly:
Fig (1): Economies of scale in a natural monopoly situation
Source: Ghosh (2016)
As illustrated in fig (1) above, there are processes when the average production cost
reduces over the entire range of demand, thus cementing the fact that one firm can meet the
whole demand at lower costs than having several forms. It is at such production processes that a
natural monopoly may be born. From the graph above, a natural monopoly may be producing
3000 units at an average cost of £17. However, we can see a reduction in cost from £17 to £9 if
the firm’s production rose from 3000 to 10,000 units. The 10,000 units is the maximum output
that be produced since the demand curve is equal to the long run average cost. Producing any
units lower than 10,000 is inefficient to the natural monopoly as it is on a higher cost. In such an
industry, therefore, it is economically sensible to have only one firm to produce all the 10000
units to lower the production costs and at the same time to meet the demand. Competition by
other firms would only make the natural monopoly to produce at a higher cost. In additional to
the presence of economies of scale, presence of barriers to entry and high start-up capital are also
some other contributing factors (Cliffsnotes.com, 2016). For instance the capital for electricity
distribution is very high such that entrance to this industry is limited.
Student’s Name; Student’s ID
tenable to have more than one small firms. Figure 1 below is used to explain the economies of
scale in a natural monopoly:
Fig (1): Economies of scale in a natural monopoly situation
Source: Ghosh (2016)
As illustrated in fig (1) above, there are processes when the average production cost
reduces over the entire range of demand, thus cementing the fact that one firm can meet the
whole demand at lower costs than having several forms. It is at such production processes that a
natural monopoly may be born. From the graph above, a natural monopoly may be producing
3000 units at an average cost of £17. However, we can see a reduction in cost from £17 to £9 if
the firm’s production rose from 3000 to 10,000 units. The 10,000 units is the maximum output
that be produced since the demand curve is equal to the long run average cost. Producing any
units lower than 10,000 is inefficient to the natural monopoly as it is on a higher cost. In such an
industry, therefore, it is economically sensible to have only one firm to produce all the 10000
units to lower the production costs and at the same time to meet the demand. Competition by
other firms would only make the natural monopoly to produce at a higher cost. In additional to
the presence of economies of scale, presence of barriers to entry and high start-up capital are also
some other contributing factors (Cliffsnotes.com, 2016). For instance the capital for electricity
distribution is very high such that entrance to this industry is limited.
Student’s Name; Student’s ID
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