Economics Assignment: Natural Monopoly - Definition, Causes, Analysis

This economics essay provides a detailed analysis of natural monopolies. It begins by defining natural monopolies and exploring their underlying causes, such as economies of scale and control over resources. The essay then delves into how monopolistic firms determine price and quantity, emphasizing the potential for under-allocation of resources and inefficiency. The analysis extends to the efficiency considerations in natural monopolies, highlighting the need for government intervention to correct market failures and protect consumer welfare. The essay discusses various methods of government intervention, including price capping, quality of service regulation, and breaking up monopolies, along with their respective advantages and disadvantages. The conclusion underscores the importance of government regulation in addressing the inefficiencies and potential abuses associated with natural monopolies to ensure fair pricing, maintain service quality, and promote overall economic efficiency. The essay uses diagrams to illustrate key concepts and references relevant economic literature.

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Natural Monopoly – Definition and Causes
Natural monopoly refers to a situation when a single firm is in a better position to serve the
market in comparison with two or more firms. Typically in a natural monopoly due to the
significant cost advantage that is enjoyed by the existing player, the other players have no
chance with regards to entering the market (Samuelson & Marks, 2003). There are various
reasons which can give rise to a natural monopoly. One of these is economies of scale which
essentially refers to a situation where there is a decrease in the overall cost as the production
output increases. As a result, the existing firm owing to the large output tends to have a cost
advantage which a new entrant would not be able to match and this acts as a natural entry
barrier against any competition (Mankiw, 2014). Another key reason contributing to a natural
monopoly is in the form of control over scarcely available resources. This may be in the form
of network or existing infrastructure which related to railway lines, transmission lines of
telephone etc. Thus, the player which has control over the above resources tends to act as the
sole supplier and the new firms cannot enter the market without the same resource. Further,
another reason for existence of natural monopolies is in the form of government intervention
and policies. This is typically the case in various industries where the upfront costs are
exceptionally high such as electricity transmission, gas pipeline etc. In such cases, it makes
sense not to cause duplication of this immense infrastructure and thereby confining the
market to only one player makes sense (Nicholson & Snyder, 2011).
Natural Monopoly – Determination of Price and Quantity
The monopolistic firm would tend to take economic decisions with the objective of
maximising profit. As a result the firm tends to produce till the price is greater than the
marginal cost. This would lead to the available resources being under-allocated. This is
because the corresponding output is lower than the comparable output expected in perfect
competition while the price charged is significantly higher. The equilibrium for the
monopolistic firm is indicated below (Besanko & Braeutigam, 2010).
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The corresponding quantity produced by a monopolist firm is indicated by Qm while the price
charged by the firm is indicated by Pm. It is noteworthy that the firm tends to produce at a
level where the AC or Average cost is not at its lowest point. Hence, in order to maximise
efficiency ideally, the firm should produce at a point where the AC is at the lowest point.
However, increasing the production and corresponding lowering the price would not enable
the firm to maximise profits (Krugman & Wells, 2008). Thus, a firm in the natural monopoly
tends to under-produce as the efficient output level would be higher. Additionally, if
theoretically some competitor does try to entry to market, the monopolist firm can enter the
production quantity thus lowering the cost further and reducing the price, thereby ensuring
that the competitor would have to quit the market (Mankiw & Taylor, 2011).
Natural Monopoly – Efficiency
Considering that resources are scarce, it is essentially that these should be allocated and
utilised in a manner so that the productive and allocative efficiency is maximised. This does
not happen in case of natural monopoly especially if there is no intervention from the
government. The analysis of the efficiency in monopoly can be reflected in the diagram
indicated below (Nicholson & Snyder, 2011).
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In the above diagram, it is apparent the when a natural monopoly is unregulated, then the
respective price charged and quantity supplied are Pm and Qm respectively. The social optimal
pricing is obtained at PSO with a corresponding output of QSO. Alternately if the government
intervenes and sets a price for either break even or a fair return, then the respective price
charged and quantity supplied would be Pfr and Qfr respectively. It is apparent from the above
diagram that unregulated monopoly is highly efficient (Mankiw, 2014). As a result there is a
huge deadweight loss and the consumer surplus is highly diminished which is demonstrated
below (Mankiw & Taylor, 2011).
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The above graphs clearly reflect the need for the regulation of the natural monopoly so that
efficiency can be enhanced or else without any competition; the firm would aim at making
profits while using resources in an inefficient manner (Krugman & Wells, 2008).
Natural Monopoly – Case for government intervention
From the above discussion in relation to efficiency and also the market power available with
the monopolist, it is apparent that there is a need for government regulation. The various
reasons in this regards are summarised below (Pindyck & Rubinfeld, 2001).
 The government intervention is required in order to check prices as an unregulated
monopolist would charge excessive prices that would lead to inefficiency and loss
decrease in consumer welfare.
 It is quite possible that the quality of the product or service provided by the
monopolist firm may fall over time as there is no competition. Hence, government
intervention ensures that minimum quality standards are upheld.
 Considering the monopolist is the only provider of a particular product or service, it is
likely that the suppliers may face a difficult time as there is only buyer of their goods
with 100% market share. Thus, regulation by the government would ensure that
monopsony power is not deployed for exploitation of suppliers.
 While in case of monopoly, there may be the case of increasing competition to keep
the monopolist under check, but in case of a natural monopoly, it is not possible for
any competitor to enter and hence the regulation has to be performed by government
only as no alternative to the same may be available.
Natural Monopoly – Methods of government intervention
While the need for government regulation through intervention is established in the previous
section, this section aims at highlighting the various means that the government deploys in
order to ensure the same. Further, the operating mechanism of each of these government
measures along with their respective pros and cons has been discussed.
Price Capping
The pricing capping is commonly practiced for key utilities such as electricity, water, gas
where it is essential that the consumers tend to receive these vital services at affordable costs.
This is especially the case when a public utility may be privatised. In that case, the
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government appoints regulators for the various sectors which tend to limit price in case of
inflation. Usually, the monopolistic firm would be allowed to increase the firm by a value
which is lower than inflation which would ensure that efficiency gains are also realised. This
provides the incentive to the private firms to enhance efficiency in order to safeguard profit
margin in an inflationary environment. Further, the upward revision of pricing is allowed
with prior approval from regulator after the approval is granted (Mankiw & Taylor, 2011).
This mechanism has a host of advantages. Firstly, the price increases are monitored by the
regulator that can take into consideration various factors including public welfare. Secondly,
this system of price capping provides incentive to the monopolistic firm to improve
efficiency for maximising the respective profits. This is because the returns are not regulated,
only the price is and also the regulator which deciding on the price increases also expects
some amount of efficiency gains. Thirdly, this practice helps in curbing the abuse of
monopsony power (Pindyck & Rubinfeld, 2001).
However, there are certain disadvantages which are associated with this approach. Firstly,
maintaining a balance between profitability of the firm and public welfare is difficult to
achieve for the regulator and usually there is a drift to either side from the optimum
equilibrium, Secondly, there may be collusion between the regulator and the monopolistic
firm which allows the firm to earn supernormal profits on a sustainable basis at the cost of
public welfare. Thirdly, the firm has incentive to be little inefficient to that in every
incremental price increase, it can increase the efficiency (Krugman & Wells, 2008).
Quality of service regulation
When a natural monopoly exists for a public utility, then it is imperative for the regulator to
define the minimum service standards or the firm may try to maximise the profit or price by
intentionally maintaining poor quality and charging a premium for good quality services. In
order to avoid this, government regulation is essential. However, it is essential that regulators
must also specify a minimum service standard that can be realistically met (Besanko &
Braeutigam, 2010).
Breaking of monopoly
In extreme cases, there may be breaking of the monopoly in order to increase the
competition. For the natural monopoly, it is possible that geographical spin off is possible
into different entities rather than being part of a single huge entity. Additionally, the
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government may buy a stake in the firm which would ensure that the management has
government representatives and the public welfare is better served. In extreme cases, there
may be nationalisation of the firm and suitable compensation may be provided (Arnold,
2008). However, this may dent the investor confidence and usually is refrained from and
external regulation is practiced. But as a measure, this is available if there is a need. Over the
long time nationalisation of the firm may lead to inefficiency and hence is not preferred
(Nicholson & Snyder, 2011).
Yardstick regulation
This is another means of achieving price regulation besides price capping. In this regulation,
instead of capping the price, the regulator taking into consideration the amount of capital
deployed may offer a fixed rate of return and thereby ensure prices in accordance of this
objective. Thus, the underlying prices are decided in line with ensuring fixed returns to the
monopolist firm. However, one major issue with this method is that the private player would
tend to overstate the cost in order to increase the price set by the regulator (Krugman &
Wells, 2008). Further, in this method, there is no incentive for the private player to ensure
that the operations are run efficiently as the same would lead to lower prices bring set by the
regulator. Besides, it may also be difficult to ascertain a reasonable rate of interest which
satisfies both the regulation and the firm (Mankiw, 2014).
Conclusion
Based on the above discussion, it would be fair to conclude that in a natural monopoly, there
is potential danger of inefficiency and public interest not being served since the form could
be driven by the profit motive and hence would tend to maintain an artificial scarcity while
maintaining the prices high. In order to ensure that monopoly position is not abused,
efficiency gains are realised, quality of services is maintained and price is affordable,
government intervention is required. There are various mechanism through which the
government can intervene and it depends on the underlying political and socio-cultural
factors which tend to determine the best way forward. Also, the extreme measures such as
nationalisation or monopoly breaking should be practised only in extreme scenarios when the
other solutions fail to give desired results.
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References
Arnold, A.R. (2008). Microeconomics (9th ed.). Sydney: Cengage Learning.
Besanko, D. & Braeutigam, R. (2010). Microeconomics (4th ed.). New York: John Wiley &
Sons.
Mankiw, G. (2014) Microeconomics (6th ed.). London: Worth Publishers.
Mankiw, G.N. & Taylor, P. (2011). Microeconomics (5th ed.). Sydney: Cengage Learning.
Nicholson, W. & Snyder, C. (2011). Fundamentals of Microeconomics (11th ed.). New York:
Cengage Learning.
Krugman,P. & Wells, R. (2008). Microeconomics (2nd ed.). London: Worth Publishers.
Pindyck, R. & Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall
Publications.
Samuelson, W. & Marks, S. (2003). Managerial Economics (4th ed.). New York: Wiley
Publications.
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