Analysis of Price Setting and Regulation in Natural Monopolies

This report examines the concept of natural monopolies, industries where a single firm is most efficient due to high fixed costs and economies of scale. It explores the economic principles behind natural monopolies, including economies of scale and barriers to entry, and explains why government regulation is often necessary to prevent these monopolies from exploiting their market power. The report analyzes various pricing strategies, such as average cost pricing and price caps, and discusses how these methods can be used to balance the interests of both consumers and the natural monopoly. It highlights the potential for allocative inefficiency and the lack of incentive for high-quality products in unregulated monopolies, justifying government intervention to ensure fair pricing and consumer welfare. The report concludes that while natural monopolies are sometimes necessary, regulation is crucial to prevent abuse of market power and promote economic efficiency.

Running Head: Natural Monopoly Pricing
Price Setting for Natural Monopoly
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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
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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.
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Following the above analysis, Gallego (2017) states that natural monopolies are
necessitated by economic and technical consideration which include high capital costs, barriers
to entry and economies of scale. Gallego proceeds to state that the existence of natural
monopolies has nothing to do with legal imperatives. Therefore, it is arguable that the term
“natural” implies the absence of such acts as collusion, takeovers or mergers. The main
distinguishing characteristics of s natural monopoly are high industry costs with one firm being
able to produce and supply the product or service at low costs than smaller competitors (Mankiw
& Taylor, 2011).
The advantage of having a natural monopoly is that the only firm will be able to use the
limited resources of the industry to produce goods or services at volumes that will service the
entire market and at low unit prices. Further, natural monopolies avert the possibility of a highly
competitive market and high cost which would be unsustainable. However, as necessary as
natural monopolies are, at times, firms that realize this form often tend to exploit their status for
their own benefits by increasing prices and lowering output (Investopedia, 2017; Thoma, 2014).
Fig (2): Pricing in a monopoly market
Source: Pettinger (2012)
E1: P=MC; E2: P=AC; E3: MR=MC
If unregulated, the natural monopoly may develop a profit maximization policy which
would be unbearable to the market. Figure 2 shows the AR, MR, AC and MC curves of a natural
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monopoly firm. The most efficient allocation of resources is achieved when the price equals
marginal cost (P=MC) which means the price for a unit is equal to the unit’s additional cost.
Points E1, E2 and E3 represent the options available for a natural monopoly in price setting. E1
represents a competitive solution, E2 represents the average cost pricing solution while E3
represents the monopoly profit maximization solution. Ghosh (2016) argues that the competitive
solution is the most efficient because output oqc is the largest and price opc is the smallest
whereas the monopoly profit-maximization is the least preferable option because output oqm is
the smallest where price opm is the highest. Therefore, without regulation, the monopoly would
prefer to operate at point E3 .since this is the most profitable level for the monopoly firm.
The Need for Regulation
Various theories have been fronted to justify the need for regulation. In the first instance,
the public interest theory holds that regulation is meant to safeguard public interest and therefore
officials must act in ways meant to serve the public interest. There is also the capture theory
which proceeds that the regulatory agency is susceptible to being controlled by the industry
under regulation and regulation may be used to serve the interests of the industry. Finally, the
public choice theory holds that regulation serves the government interests and the regulatory
agency will choose an approach that will be beneficial to the agency (Den Hertog, 2010).
Pettinger (2012) argues that being uncontestable and by the fact that natural monopolies
do not have any real competition, without government intervention, they are likely to abuse their
power and inflate product prices. From figure 2 above, if a natural monopoly is left unchecked, it
would prefer to operate at point E3 where MR=MC which is the monopoly profit maximization
solution. At this point, the firm will decide to supply very little products or services at very high
unit prices. Riley (2015) notes that a natural monopoly raises complications for the competition
policy because whereas it is most productively efficient to have only one dominant firm in an
industry, there is the temptation that these firms may exploit their market power to raise product
prices to make supernormal profits at the expense of the consumers’ welfare.
Welker (2013) argues that a firm in a natural monopoly is given to produce at a point
where the product price will be greater that the marginal cost. At MR=MC, the marginal cost will
be lower than the price and marginal revenue will be lower than the price charged and thus profit
will be made. Consumers will be charged higher prices because the goods or services are limited;
this then is indicative of allocative inefficiency where the quantity in demand will not be met
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while price will be high. Besides excessive prices, it is argued that the firm in a natural
monopoly lacks incentive to offer high quality products as services (Minamihashi, 2012). These
therefore justifies the need for government intervention in the form of regulations.
Price Regulation for Natural Monopoly
Having noted the foregoing, it is important that due to the substantial threat represented
by natural monopolies to the free markets and consumers, the government has to device
approaches through which it can regulate the price (Boundless, 2016). The approached regulators
can choose to employ include average cost pricing and price caps as discussed in detail below:
Average Cost Pricing
When regulating a natural monopoly, regulators must ensure that the natural monopoly
operates at the point where all its costs are recovered. The regulators can choose to employ the
method of average cost pricing whereby the regulators ensure that the natural monopoly operates
at the point where all its costs are recovered shown in the figure above.
Fig: Natural monopoly average cost pricing
Source: Guru (2016)
From the figure above, this means that the firm needs to operate at point G where P=AC
which is the full-cost pricing solution. The average costing price is R and the corresponding
quantity is Z. This therefore means that the price of the product will be equal to the average cost
of production (Ghosh, 2016). Average cost pricing therefore compels firms operating as a natural
monopoly to reduce product prices to the level where average total cost meets the market
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demand curve. The consequent effect therefore is that there will be increased production and
decreased prices, increased consideration of the social welfare and the generation of normal
profits (Stigler, 2008).
Price Caps or Ceilings
Another form of regulatory mechanism that gained traction in the 1980s and 1990s is the
price cap regulation. Here, the regulator sets a price to be charged for a product or service over a
certain period of years. The caps need to be revised from time to time as economic situations
keep on varying. In this case, the firm is at liberty to device ways of reducing costs so as to make
more profits. However, in the event that the firm cannot keep up with the caps, it may suffer
losses. Based on the firm’s performance, the regulators will set new caps after the fixed period
expires. Caution must however be taken because if the caps are set too low, the firm may be
doomed to making loses especially if market changes are not in the firm’s favor. The possibility
that the firm can earn profits or suffer losses depending on its innovativeness can serve as an
incentive for efficiency and innovation (Opentext.ca, 2016). The price cap will cause the natural
monopoly to maximize sales now that its not possible to sell at higher prices.
Conclusion
In sum, settled that monopolies are a necessary evil going by the economic and technical
consideration which include high capital costs, barriers to entry and economies of scale. The
advantage of a natural monopoly is that the single firm is be able to exhaustively use the limited
resources in the industry to produce goods or services at quantities that will meet the demand and
offer low unit prices and by extension avoid creating a competitive market and inefficiency
which would be unsustainable. However, as necessary as natural monopolies are, in the absence
of regulation, they may exploit their status. The absence of competition in natural monopoly
presents the natural monopoly with the opportunity to lower production costs and increase unit
prices. This connotes allocative inefficiency in the market where the quantity in demand will not
be met while price will be high. Further, a natural monopoly may lacks incentive to offer high
quality products as services. These, among other reasons not considered in this paper, justifies
the need for government intervention in the form of regulations.
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