The Regulation of Price Setting in Natural Monopoly Markets

This essay delves into the intricacies of natural monopolies, defining them as market structures where a single provider can supply a product or service most efficiently due to high fixed costs and economies of scale. The paper highlights the inherent dilemma these monopolies present, balancing production efficiency with the potential for consumer exploitation. It explores the advantages, such as investment in research and development and potential cost reductions, alongside disadvantages, including the risk of allocative inefficiency and reduced consumer surplus. The core of the essay examines price regulation methods, including price caps, price discrimination, and peak-load pricing, as essential tools for mitigating the negative impacts of monopolies and ensuring consumer welfare. The essay concludes by emphasizing the need for direct government controls to regulate natural monopolies and encourages the exploration of alternative regulatory mechanisms.

Running Head: Natural Monopoly Market Structure
The Regulation of Price Setting in Natural a Monopoly
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Natural Monopoly Market Structure 2
The Regulation of Price Setting in Natural a Monopoly
Introduction
A monopoly refers to a market structure where there is only one provider of a service or a
product without any close substitutes or competitors. Riley (2015) notes that in such a setting,
the market must not be necessarily nationwide but the term “monopoly” can be used in reference
to a territorial market. Having noted the foregoing, attention is given to the term “natural
monopoly.” It is noted that the term natural monopoly is not in any manner used in actual
reference to the actual number of providers of the same service or product in a particular market
setting. Instead, refers to the interconnection between demand for a service or a product and the
supply technology employed to avail the service or a product to the consumers. A natural
monopoly therefore refers to a situation where either one of the firms in a particular industry is
able to meet the demand of a common product or service at the lowest cost where otherwise it
would be costly for two or more firms to meet (Riley, 2015).
A natural monopoly presents a dilemma to public policy. This is in the sense that whereas
they imply production efficiency, at the same time, the lack of competition presents the
monopoly firm the opportunity to exploit consumers for profit maximization. In a natural
monopoly market where there are two or more firms, two outcomes are likely. In the first
instance, the firms are likely to merge or they will fail and leave one dominating the market. In
this case, competition in such a market will be short lived. In the second instance, the two forms
may continue to operate parallel to each other, in which case the high cost of production will
consume more resources which will be an inefficient operative standard (Minamihashi, 2012).
On this front, one can argue that to ensure efficiency, competition in a natural monopoly is not a
viable regulatory mechanism. Rather, the adoption of “direct controls” as a viable regulatory
mechanism should be considered.
This paper examines in great detail the economics of scale for a natural monopoly and
briefly presents the advantages and disadvantages of a natural monopoly market structure. The
need for the regulation of prices and means of regulation are then discussed before drawing a
general conclusion. The information contained in this research shall be beneficial to the
consumers, the public and students, all of whom need to appreciate the importance of natural

Natural Monopoly Market Structure 3
monopolies and the economic considerations to be noted when dealing with a similar market
structure.
Analysis
A monopoly market is characterized by entry barriers which present obstacles to other
firms intending to break ground into the industry or market dominated by the monopoly firm.
This allows the dominant firm to continue operation as a sole provider of the product or service
in the industry and in turn make supernormal profits as shown in figure 1 below. These barriers
come in the form of patents, licenses, high start-up capitals, economies of scope, product
differentiation, among others. Of particular interest in this research is the barrier of economies of
scale where unit cost reduction is dependent on output size. This barrier is discussed in detail
below.
Economies of Scale for a Natural Monopoly
As noted above, monopolies present a challenge of having the latitude to produce
products at lower output levels such that the end product is priced higher than it would in a
competitive market setting. In essence, the restricted output levels maximize profits without
taking into account consumer welfare (Welker, 2013). However, due to economies of scale, it is
most economically sensible when only a single firm operates in a certain market such as is the
case in the natural gas industry, cable TV, water and sewerage, electricity, among others. In a
natural monopoly, the monopoly holder sets the product price and output levels based on the
profit maximization rule. This rule holds that unregulated firms produce at the level where
marginal revenue equals marginal costs. The challenge with this rule is that for such firms,
marginal cost and average cost is lower than the price charged and therefore, if the profit
maximization rule is applied, this would result in allocative inefficiency whereby the product
will not be affordable to some consumers (Opentextbc.ca. 2016).The diagrams below illustrate
the economies of scale in a natural monopoly:

Natural Monopoly Market Structure 4
Fig (1): Pricing in a monopoly market
Source: Tejvan (2016)
MR- Marginal Revenue, MC- Marginal Cost, Qm- monopoly output, Pm- Monopoly price
From the above illustration, the natural monopoly will endeavor to maximize profits at
output and price by achieving a level where marginal revenue equals marginal cost. From the
above diagram, the red shaded area represents the supernormal profits while the blue area
represents the deadweight welfare loss in a competitive market structure.
Fig (2): Economies of scale

Natural Monopoly Market Structure 5
Source: Tejvan (2016)
From figure 2 above, it is illustrated that if a firm produces at Q2, the average cost will be
AC2. Therefore, a monopoly can increase the output to Q1 in order to draw benefit from lower
average cost (AC1). Therefore, the conclusion is that it is more economically efficient to have a
monopoly in high fixed cost industries as opposed to having several smaller firms.
Advantages and Disadvantages of Natural Monopoly
The economic theory holds that everyone is motivated by self-interest (Thoma, 2014).
This simply means that everyone is assumed to be more focused on self-preservation. Applying
this theory to a natural monopoly, one would then argue that a monopoly is likely to be focused
on improving its products and where possible lower costs. Due to the advantage of supernormal
profits, a natural monopoly is able to invest in research, development and technology to achieve
its objective. By being able to reap the benefits of such investment, firms are provided with the
incentive to do further research and development and to patent their ideas. This mutually benefits
the firm, the market and the economy (Agarwal, 2017). The other advantage is that from the
economies of scale, increased output translates into decreased production costs and this can
ultimately be beneficial to the consumer in the form of low prices and quality.
On the down side, a monopoly market structure is likely to focus on profit maximization
by producing lower output and charging high prices. This is likely to result in a deadweight
welfare loss and a decline in surplus as illustrated in Figure 1 above. The high prices may result
in allocative inefficiency and supernatural profits and ultimately, it is the consumer who will

Natural Monopoly Market Structure 6
lose. Further concerns include the fact that as a monopoly gets bigger, it may experience lower
average costs (Agarwal, 2017).
Price Regulation
As noted earlier in the introductory part of this research, natural monopolies present
regulatory dilemmas to the government. This is so because there is the concern that where there
are two or more firms, the firms will either merge or one will fall and the consequences are that
there will be no competition in the market as idealized for a perfect market setup or alternatively,
if the two firms continue parallel operation, there will be a high cost of production which will
consume more resources and lead to inefficient operative standards.
From the foregoing, it is therefore imperative that only one firm can operate as a natural
monopoly in certain industries, some of which were identified earlier. The challenge with this
market structure is that an unregulated monopoly will certainly strive to live by the profit
maximization rule which might result in undesirable outcomes such as allocative inefficiency. It
is for these reasons that the need for government intervention will be necessary in the form of
regulation. This can be achieved by employing “direct controls” as the most viable mechanism of
regulation (Arnold, 2008). Below is a discussion of some of the regulatory options that are
adopted to keep natural monopolies in check:
Price Caps or Ceilings
Stigler (2008) argues that regulators should be allowed latitude to set prices at levels
likely to induce productive and allocative efficiency. If the government is concerned about
getting the right product quantity to the right number of consumers and maintaining allocative
efficiency, it will have to set a price ceiling for the particular product or service to ensure the
price of the product equals the marginal cost of the monopoly firm. However, if this cap is below
the firm’s average total cost (as it is in most cases) it would mean that the firm will suffer loses
and may eventually shut down. To avoid such a scenario, the government would set a price cap
at the level where the price equals the average total cost. This ensures that the firm will only earn
a normal profit, enough to keep it a going concern and this is referred to as the “fair-return
price” (Welker, 2013).

Natural Monopoly Market Structure 7
Price Discrimination
Simshauser & Whish-Wilson (2015) argue that it is demonstrated that allocative
efficiency can be enabled by charging consumers different prices even when production and
supply costs remain constant. This approach employs the Ramsey pricing method which, taking
into account the price elasticity of goods, allows for the setting of the price closer to the marginal
cost. However, caution must be taken to avoid predatory discrimination through severe prices.
Peak-load Pricing
In the economic world, there arise variances in demand and supply. The theory of
demand and supply is alive to the fact that at certain periods, demand is likely to be high and low
during others, which in turn affects supply. Peak-load pricing can be used to attain marginal cost
pricing during such periodic cycles. The idea is that since marginal cost increases with the
output, the variation of price creates an opportunity for it to reflect the high costs, the demand
cycle can therefore be moderated and capacity used more effectively (MBASkool.com, 2008).
Conclusion
In sum, it is agreed that natural monopolies present regulatory dilemmas to the
government which must be navigated to maximize on the economies of scale. Without
regulation, a natural monopoly will endeavor to maximize profits at output and price by
achieving a level where marginal revenue equals marginal cost. This, at the very least, is likely to
result in a deadweight welfare loss and a decline in surplus. Conversely, the high prices may
result in allocative inefficiency and supernatural profits and ultimately, it is the consumer who
will benefit least.
The lack of competition in natural monopoly (and the fact that it would be productively
inefficient to have two firms operating in a natural monopoly) leaves the firm with the latitude
conduct its business with the aim of profit maximization. It is for these reasons that the need for
government intervention will be necessary in the form of regulation which must be in the form
“direct controls” as the most viable mechanism of regulation as opposed to competition.
The various modes of price regulation include price caps or ceilings, price discrimination
and peak-load pricing as discussed in detail above. Besides price setting, the readers are
encouraged to explore other alternatives to price setting as a mode of regulating the monopoly

Natural Monopoly Market Structure 8
industry. These include the contestable market theory which states that string constraints are
exercised by an incumbent monopoly where there is a threat of a potential entrant and thereby,
pricing is more likely to be maintained closer to cost. Other options include entry regulation,
auctioning and public ownership of monopoly firms (Moszoro, 2014).
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