Why Governments Regulate Natural Monopoly Price Setting? Essay

This essay provides a comprehensive overview of government regulation of natural monopolies, exploring the reasons behind such intervention and the methods employed to control price setting. It defines natural monopolies and highlights their potential for price manipulation, emphasizing the need for government oversight to protect consumers and ensure fair market practices. The essay delves into various regulatory approaches, including price capping (RPI-X), service quality regulation, merger policies, and the breaking up of monopolies, as well as rate of return regulation. It examines the advantages and disadvantages of each method, using the electricity market as a key example. The essay explains why governments regulate natural monopolies, focusing on preventing excessive prices, ensuring service quality, and promoting competition. It concludes by underscoring the crucial role of government in balancing consumer and firm interests within a democratic framework, particularly in the context of essential services like electricity.

[EXPLAIN HOW AND WHY GOVERNMENTS MAY WANT TO REGULATE THE PRICE SETTING OF A
NATURAL MONOPOLY]
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INTRODUCTION
Natural monopolies are favorable to businesses wherever the principal providers gain price
rewards and have to be synchronized to diminish threats. Theoretically speaking, a natural
monopoly is defined by a current in an industry wherein it is the highest supplier but even
then has the capability to give a price which is the lowest with the help of economies of scale.
Thereby those who are a part of this kind of a monopoly are always exposed towards creation
of a higher risk of actual monopoly. However the society tends to gain by regulating these
scenarios to even playing the field. Although the general concept is that monopolies are a
threat to free market, however some kinds of monopolies such as natural one are either
practically of use or almost inescapable. Thereby with the above definitions it seems clear as
to why the government is inclined towards regulation of the price setting of a natural
monopoly. The said essay discusses the reason and the method of the said regulation.
(Source: http://www.economicshelp.org/blog/glossary/natural-monopoly/)
HOW GOVERNMENT MAY REGULATE THE PRICE SETTING OF A NATURAL
MONOPOLY
Monopoly is one type of a market structure which needs regulation and intervention of the
government compulsorily as many a times the same may be misused by the businesses for
their own benefits thereby conducting the business which is not for the good health of the
society as a whole. Hence the government regulates natural monopoly too even though the

same is not as threatening as the other forms of monopoly. Many ways are adopted via which
a government may regulate the price setting in a natural monopoly such as price capping by
regulators RPI-X, regulation of service quality, merger policies, breaking up a monopoly,
yardstick or ‘Rate of Return’ regulation and examination of exploitation of domination
command.
Various regulatory bodies were formed by the government for fresh privatized industries such
as electricity. OFGEM is the body created for the regulation of electricity. These bodies help
to ensure that the price increase is within permissible limits and the same is asked by them to
do by the application of a formula names RPI-X wherein X denotes the price by which these
industries are required to reduce the prices in real terms. However the said method has
various benefits as well as flaws. The advantages amongst them are that th refulator has full
authority to fix the increment in the prices with respect to the condition of the industry
presently and the expected efficiency savings. Thus if a company reduces the costs more than
X, they would in turn be able to gain more. Another very stark advantage is that of surrogate
competition wherein the absence of competition, RPI-X is a method to increment the
antagonism and avoid the misuse of the monopoly power. The disadvantages are however
also to be taken into account. Firstly, it is quite an expensive affair to decide what would be
the level of X. Further there is always a risk of a situation wherein the regulators may become
inclined towards the favor of the company and thereby allow them to increase profits out of
reach. Last but the not the least, the companies are generally found to be unable to maintain
the efficiency savings simply because they may become too efficient and in turn be penalized
because they possess higher levels of X (economicshelp.org. 2016).
Further to this price setting may be regulated by close examination of the kind of service
being given by the monopoly such as in the electricity market, the regulators have to ensure
that those who are aged are given special treatment such as not allow electricity to cut down
the supply in summers. Thirdly, the regulators have full rights to check upon the various
mergers which may lead to creation of monopolies, thereby ensuring to interfere and break
them or allow them depending upon the kind of merger and the companies involved in the
merger. Fourth and one of the most common ones is the breaking up of the existing
monopoly when the regulator is of the view that the monopoly concern has become powerful
enough to misutilize its powers for the detriment of the people. However the said way of
regulation is a rarity as it is taken only in very extreme cases when the monopolist is
behaving in an untoward manner thereby harming people (Joskow, 2007).

Fifthly, apart from the RPI-X methodology, there lies another way which also contributes to
regulation of price setting in a natural monopoly. The Rate of Return regulation methods
takes into account the size of the firm and appraises what would make an acceptable level of
gain from the capital base. Thus it is rightly said that if a company is seen to make a lot of
financial gain in comparison to the actual size of the firm, then in such a scenario the
regulator may end up cutting the prices or levy a one time tax. However the flaw in the
particular method is that it can lead to ‘cost padding’ wherein a firm is seen to give
permission to increase the cost to such a level that the financial level of gain are not
understood by people as excessive. It gives less motivation to be competent and augment
financial gains. In addition to the same, rate of return regulation may not be able to examine
the level of gains which would be considered to be rational. Hence if the same is set at a
higher level then the firms may take undue advantage of the monopoly power.
Last but not the least, there are various investigators who if find the situation as such wherein
they feel that the monopoly firm is misusing the power, then the same can be investigated.
The unwanted actions may comprise of collusion wherein the firms are of the opinion to
augment prices, collusive tendering of bids, predatory pricing wherein they would set the
price at such a level wherein the competition gets wiped out in totality and selective
distribution (Winston, 1993).
For example in the electricity business, a differentiation is found in the rates i.e. the
residential and commercial rates are different. The said industry is categorized as a high fixed
cost industry. Here the cost of producing a watt of electricity is extremely high, however as
soon as the first investment is done, then the average costs gets reduced with every unit being
produced. Competition in the particular industry is not welcomed by the society simply
because the existence of a huge number of firms would lead to repetition of capital
investment (Depoorter, 1999).
The market reforms which started off in the 1990s, there the government played a very
crucial part in price setting for publicly-owned electricity authorities. Such as in Victoria and
Tasmania wherein the electricity boards had the authority to fix the rates , however the same
had to be approved or be adjusted y the government. In New South Wales, the person who
was the then minister had the power to fix prices in consultation with the public enquiry.
However when the electricity market reforms came into existence, the ultimate pries of
electricity was not regulated . The generated price of electricity is unfettered and is fixed via

the electricity pool basis the competitive bid for transmit. This has helped in the fall of the
prices of electricity (treasury.gov.au.2015) .
WHY GOVERNMENT WANT TO REGULATE PRICE SETTING OF A NATURAL
MONOPOLY
It is very crucial to understand that in real scenario it is highly unlikely to find a ray of hope
between industries that are ‘natural monopolies’ and those that fall under the captegory of
‘competition’. There lies various reasons as to why the government wishes to regulate the
price setting of a natural monopoly. As is a known fact that if the monopolies are not
regulated well, then it may lead to shooting up of the prices of the goods which may e
detrimental to the health of the society specially for products which are of daily necessity
such as electricity. However the said process may lead to allocative loss of efficiency and a
reduction in the welfare of the consumers. Secondly, it is a necessity specially in case of
services supplied by electricity firms, water suppliers etc that the service beign provided by
them are of a high quality. If there exists a monopoly then the firm may take undue benefit of
the said fact and end up providing a bad service. Thereby one of the main reasons behind
government intervention is to ensure that the consumers are not required to comprise on the
quality even after making payments as required (Hertog, 2010).
Generally it is perceived that those firms who are monopoly in the selling areas may also
have the benefit of taking undue benefit of monopsony buying power i.e. to squeeze the
financial profits of the sellers. Fourthly, encouraging competition also would help
government to regulate as by doing so the firms will automatically shift from being a part of
natural monopoly to being a part of competition market. The said attempt would in turn
ensure that the government is not required to impose much of regulations. Also such an act
would help in controlling the price increase and undue exploitation as well (Demsetz, 1968).
Further the intervention of government is seen in price setting of utilities such as electricity.
The main reason is that it is inelastic in nature. If the government is not allowed to intervene
in the pricing of the same, then it would lead to an unbalanced economy as the absence of the
regulation would make the monopolistic entities increase their prices by a very high
percentage. For example the state governments may be of the opinion that de-regulation of
the electricity industry may help in reducing the prices substantially in the long run. The
reason behind the same is that even if the presently, the firms may end up reaping in more
gain but in the long run it is sure that newer firms would emerge leading to downsizing the

profit of the present company. The electricity industry would branch out into various
companies who would further ensure execution of prices which are competitive enough
thereby beating the competition (Singh, 2015).
Electricity is one industry which falls into the natural monopoly and if the prices are not
regulated then it would lead to a condition wherein the entire economy balance faces a hit. It
is such a big necessity that people end up paying as demanded, hence is termed as inelastic.
Thereby this way it is sure that the firms would make all attempts to misuse their power and
augment the prices considerably. Last but not the least, the government specially in a
democratic set up is ‘for the people, by the people and of the people’ and thereby the phrase
makes it clear that the government’s job is to fulfill the requirements of its people wherein it
has to ensure that it is fair with both the consumers as well as the firms (Kim, & Horn, 1999).
CONCLUSION
Thus on a concluding note, it is very clear that the regulation of the natural monopoly is also
a must. The government is formed to serve the people of its country and one of the duty and
responsibility is to ensure that regulation is imposed so that exploitation is prevented.
Electricity being one of the most crucial utility, if not regulated may end up ruining the
economy as well as people may end up spending more on it as it is a necessity which would
in turn hit other industries. The methods are many and depending on the kind of exploitation
that may occur, the government imposes regulation hence trying to cut the price and set it a
level which is acceptable by all thereby ensuring that natural monopoly does not create an
imbalance in the economy. Various ways although suggested, the one best suited as per the
situation should be applied so as to ensure that the price setting is done to the best health of
the country as a whole.
REFERENCES:

Demsetz,H. (1968). Why Regulate Utilities? Journal of Law and Economics. 11(1). 55-65.
Retrieved from http://www.sfu.ca/~wainwrig/Econ400/documents/demsetz68-JLE-
utilities.pdf
Depoorter,B.W.F. (1999). Regulation of Natural Monopoly. Retrieved from
http://reference.findlaw.com/lawandeconomics/5400-regulation-of-natural-
monopoly.pdf
economicshelp.org. (2016). Regulation of monopoly. Retrieved from
http://www.economicshelp.org/microessays/markets/regulation-monopoly/
Hertog, J.D. (2010). Review of Economic Theories of Regulation. Retrieved from
https://www.uu.nl/sites/default/files/rebo_use_dp_2010_10-18.pdf
Joskow, P.L. (2007). Regulation of Natural Monopolies. Retrieved from
https://economics.mit.edu/files/1180
Kim,S.R. & Horn, A. (1999). Regulation Policies concerning natural monopolies in
developing and transition economies. Retrieved from
http://citeseerx.ist.psu.edu/viewdoc/download?
doi=10.1.1.537.6168&rep=rep1&type=pdf
Singh,A. (2015). Economics in Power Markets. Retrieved from
https://www.iitk.ac.in/ime/anoops/IEX%202015%20Training/IITK%20-%20PPTs
%20-%202015/Day%20-%201%20IITK/1%20-%20Anoop%20Singh%20-
%20Economics%20of%20Power%20Markets%20-%202015.pdf
Treasury.gov.au. (2015). Price Regulation of Utilities. Retrieved from
https://archive.treasury.gov.au/documents/194/PDF/round5.pdf
Winston,C. (1993). Economic Deregulation : Days of Reckoning for Microeconomists.
Journal of Economic Literature. 31(3). 1263-89