Pricing Strategies in Natural Monopolies

This assignment examines the unique characteristics of natural monopolies and analyzes various pricing strategies employed within this market structure. It delves into average cost pricing, two-part pricing, and their role in balancing consumer welfare with the interests of the monopolist. The discussion also highlights the importance of regulatory intervention in preventing potential exploitation and ensuring efficient resource allocation.

Running head: NATURAL MONOPOLY: REGULATIONS
Natural Monopoly: Regulations
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Author Note

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Introduction
In economics, a market is defined as the place of interaction of the demand and the
supply forces that is a market is an area where the buyers and the sellers interact and reach to
price and quantity decisions. Depending upon the nature of commodity or service produces,
number of buyers and sellers, barriers to entry and exit and distribution of the market power,
markets can be perfectly competitive or non-perfectly competitive. Monopoly is the extreme
opposite to that of perfectly competitive market (Scitovsky, 2013). One seller and many buyers,
thereby implying that the single seller enjoys the total market power, characterize a monopoly
market. In general, the monopoly framework does not lead to efficient allocation of resources, as
the sellers tend to maximize their own profit, thereby leading to the presence of dead-weight loss
in the market. However, there arises several instances where the presence of a monopolist do
bring efficiency in the market by operating at economies of scale. This efficient form of
monopoly is known as natural monopoly and it generally occurs when a firm produces at the
falling part of its average cost curve and is still able to fulfill the demands in the market (Chen &
Schwartz, 2013).
Natural monopoly, thus, can be said to be an efficient form of monopoly and in that case,
intervention and division may lead to a inferior market condition with higher costs of production
and as a result a higher level of prices. Generally, public services and utilities lie those of
electricity, water, in some cases arms and ammunition, are examples of natural monopoly, as one
big seller (In most of the cases government being the producer) produces the good at a lower cost
due to the presence of increasing returns to scale. In most of the cases, natural monopoly arises
in those productions of goods and services where there is a very high fixed cost as compared to

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the variable cost. After incurring the huge fixed cost, as production increases, the seller starts
enjoying economies of scale.
Monopoly market, by nature, tends to give all the market power and decision making
capabilities in the hands of the sellers and therefore, in absence of any kind of regulations, the
seller may try to misuse his power to fulfill his interest of personal welfare maximization, even if
it comes at the cost of the welfare of the society. The essay discusses the difference between
natural monopoly, market monopoly and perfectly competitive situations, emphasizing on the
pricing strategies that an be taken in a regulatory natural monopolistic framework to increase the
welfare of both the buyers and the sellers (Scitovsky, 2013).
Comparison between perfect competition and monopoly
The exact opposite of the monopolistic market condition is that of the perfectly
competitive market, where there are many sellers and many buyers and the market power is
uniformly distributed. The sellers and buyers being many in numbers, each of them is a price
taker. The perfectly competitive market allows free entry and exit of new and old economic
agents, buyers or sellers. Due to the presence of uniform knowledge and market power, the
sellers or the buyers cannot take extra advantages. Therefore, the equilibrium in this market
occurs at the point where the welfare of the society is maximized, at the point of interaction of
the demand and the supply curve, resulting in normal profit for the firms in the long run (Thiel,
2014).
However, in case of the monopoly market, the firm itself is the industry. Therefore, the
supply curve of industry is itself the marginal cost curve of the monopolistic producer. This

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implies that being a decision maker, he tries to set the price of its product at the point where
marginal revenue is equal to the marginal cost of the monopolist. The difference between the two
markets can be shown with the help of two diagrams, which are as follows:
(Source: As created by the author)
It is evident from the above comparison between the monopoly and the perfectly
competitive market that there is no dead-weight loss in the latter one. The consumers and the
producers interact in the market to reach to the efficient equilibrium E, where the equilibrium
price becomes Pc and the equilibrium quantity becomes Qc. However, in presence of the
monopolistic condition, the monopolist operates at the point where MC cuts his MR curve.
Therefore, the price the monopolist charge becomes Pm, which is much more than the Pc, and

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the monopolist produces only Qm which is again less than Qc. The difference between the cost
and the price charged by the monopolist can be given by the length between Mc and Pm,
showing that the monopolist earns profit at the cost of producing a dead weight loss for the
society, which is given by the triangular portion. Therefore, in absence of regulation, monopoly
can lead to an inefficient situation, especially unfavorable for the buyers, if the dead weight loss
becomes too high and the price and cost gap increases uncontrollably (Thiel, 2014).
Natural Monopoly
Natural monopoly, as discussed in the above sections, is different from that of the pure
market form of the monopolistic condition. Natural monopolies mostly occur in those markets
where competitive structure is not an efficient solution. Examples of such markets are mostly
those of public utilities and necessities, where if competition is allowed, may lead to higher
price, which can be harming for those on the buyers’ side. Natural monopolistic producer,
already operating at the left of the Average Cost Curve’s minimum point, enjoys the economics
of scale, thereby being able to produce at much lower cost, than would prevail if the market was
divided among the competitors (Stiglitz & Rosengard, 2015).

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Figure 2: Natural Monopoly
(Source: As created by the author)
It is seen from the above diagram that in presence of a natural monopoly the cost of
production reduces drastically due to the presence of the economies of scale. In normal situation
where the price would have been P1 and the quantity would have been Q1, in the natural
monopolistic condition, the price can fall to Pnm and the quantity of production can increase to
Qnm (Stiglitz & Rosengard, 2015).

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Pricing Strategy in Natural Monopoly
In a natural monopoly framework, there can be presence of ambiguity in the market
regarding the pricing situations, as there can be three types of pricing strategies present in the
market, depending upon the control of government and the magnitude of control. These
strategies are discussed in details in the following sections:
Figure 3: Different points of Pricing in Natural Monopoly
(Source: As created by the author)
There can be three cases depending upon the regulations and market situations, which are
as follows:

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Natural Monopoly in an unregulated environment
If in the natural monopoly market, there is no regulation or restrictive controls imposed
by the government, then the producer, enjoying the whole of the market power, will behave like
that of a pure monopolistic producer. This implies, the monopolist will set a price such that its
profit can be maximized, not caring about the welfare of the customers as he has no fear of
facing competitions from other sellers (Baldwin, Cave & Lodge, 2012).
In Figure 3, this situation can be seen at the monopoly price level, Pm, where, the seller
produces at the point where the MR curve intersects the MC curve of the seller. He produces
only Qm amount of output and earns huge profits as can be seen from the above figure.
Perfectly optimal price for the society
For the maximization of the welfare of the society, the firm should produce and sell at the
perfectly competitive price. This is the point, the firm needs to charge the price, which is equal to
its MC. This is known as efficient pricing strategy.
As can be seen in the above figure, Pe is the optimal price and Qe is the optimal quantity
produced at the socially efficient level of price. However, it is evident that this level of price is
less than that of the price, which prevailed in the monopolistic market situation. In this situation,
the competitive firm operates at the minimum point of its average cost curve, but given the
presence of natural monopoly, the firm enjoying natural monopoly operates at the falling part of
the average cost curve, thereby failing to recover its average cost. Therefore, in this situation, the
monopolist faces a loss (Mahoney & Weyl, 2014).

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If the government tries to regulate the prices of the monopolist and chooses the optimal
price situation, then as the monopolist is experiencing loss at this price, the government needs to
compensate the natural monopolist by that particular amount. Otherwise, the natural monopolist
may want to exit from the market, which may not be desirable for the society. Depending upon
the cases, the burden of subsidy borne by the government may also exceed the level of dead
weight loss, thereby making this price strategy non-optimal for operation of the monopolist.
Regulatory Pricing
It is seen from the above discussion that optimal pricing can lead to greater losses on part
of the government. This in turn shows the need of making some alternative strategy for pricing.
A third option of choosing a pricing strategy is the one where the price charged by the natural
monopolist is equal to that of the average cost of production of the firm at that particular point.
It is seen from the above figure, Pr is the regulatory price in this case, where the price is
equal to the average cost incurred by the monopolist. Here, as price is equal to the average cost
of production, therefore, the monopolist produces Qr amount of the good, earning only normal
profit as the revenue earned is equal to the cost of production of the monopolist (Mahoney &
Weyl, 2014).
There have been substantial debates among the economists, regarding the choice of the
optimal pricing strategy, which will maximize the possible welfare of both the monopolists and
the buyers in a natural monopolistic market. The regulation has to be either the marginal cost

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pricing or the average cost pricing. The natural monopolist will never produce at a level which is
higher than Qr. Given that natural monopoly prevails in the market, in the long run, the marginal
cost of the natural monopolistic producer will lie under the average cost curve of the monopolist.
This implies that the monopolist will incur losses if the regulator chooses the marginal cost
pricing strategy. This means, the possible regulatory pricing strategy that will take care of the
interests of consumers without creating losses for the monopolist and extra burden of
compensating the monopolist on the government, is the average cost pricing strategy. Here, the
natural monopolist can only earn normal profit, which means the presence of no extra profit or
loss in the market (Bös, 2015).
Two-part pricing strategy
In many cases, to keep the interest of both the buyers and the monopolists fulfilled, a two
part pricing strategy is implemented in a monopolistic market. Two part pricing strategy implies
that the monopolist charges different two different prices from different consumers with different
willingness to pay for the same product.

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Figure 4: Two-part pricing
(Source: as created by the author)
In this situation, for those consumers whose willingness to pay is higher, the monopolist
can charge a higher price, thereby capturing the market surplus and for those who cant afford to
pay the price, the government can facilitate MC pricing. Therefore, apart from the three types of
pricing strategy, this can be another option for the regulators to impose regulations o a naturally
monopolistic market, such that the interests of the participants are fulfilled. However, apart from
these strategies, the regulators can also undertake steps like price cap regulatory methods or
regulation of cost plus regulatory methods (Herweg & Mierendorff, 2013).

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Conclusion
In this essay, keeping in mind the natural monopolistic market and its inherent
characteristics, the different pricing strategies that can be undertake, are discussed. In general,
natural monopoly is different from that of pure market monopoly as it is required in some cases
and incorporating competition may lead to a worse off situation. However, there may be some
cases, where due to the absence of proper regulatory methods, the natural monopolistic producer
may charge abnormally hiked prices and supply low levels of quantity, thereby behaving like a
pure monopolist. In these cases, the intervention of the regulators becomes necessary. It is seen
form the above discussion that average cost pricing or two-part pricing can be efficient forms
price regulations that can be implemented by the government in these cases.

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References:
Baldwin, R., Cave, M., & Lodge, M. (2012). Understanding regulation: theory, strategy, and
practice. Oxford University Press on Demand.
Bös, D. (2015). Pricing and price regulation: an economic theory for public enterprises and
public utilities (Vol. 34). Elsevier.
Chen, Y., & Schwartz, M. (2013). Product innovation incentives: Monopoly vs.
competition. Journal of Economics & Management Strategy, 22(3), 513-528.
Herweg, F., & Mierendorff, K. (2013). Uncertain demand, consumer loss aversion, and flat-rate
tariffs. Journal of the European Economic Association, 11(2), 399-432.
Mahoney, N., & Weyl, E. G. (2014). Imperfect competition in selection markets. Review of
Economics and Statistics, (0).
Scitovsky, T. (2013). Welfare & Competition (Vol. 103). Routledge.
Stiglitz, J. E., & Rosengard, J. K. (2015). Economics of the Public Sector: Fourth International
Student Edition. WW Norton & Company.
Thiel, P. (2014). Competition is for losers. Wall Street Journal, 12.