Explain how and why governments may want to regulate the price setting of a natural monopoly.
In economic terms, market represents exchange relation between buyers and sellers. Depending on several aspects of market such as how many buyers and sellers presence in the market, what type of product the specific market sold, size of the market determines specific category of market. Most commonly used market classification is based on the buyers and sellers in the market. Efficient allocation of resources depends on specific structure of the market. The less is market power the more efficient is allocation. In this regard, market power is highest for a seller operating in a monopoly market, a market characterized by a single seller and numerous buyers. A monopoly market in its general form is less efficient than a competitive market.
A related form of pure monopoly is natural monopoly. The difference between pure monopoly and natural monopoly is that in the presence of a pure monopolist, competition is more preferred to a single seller. However, in a natural monopoly market the presence of single seller entails maximum efficiency. This is because the natural monopolist operates at a point in average cost curve, such that scale benefit can be enjoyed. In the natural monopoly market, need for government regulation is realized to ensure an efficient pricing.
Monopoly and perfect competition
In a standard monopoly market, equilibrium combination of price and quantity is derived from the profit maximization condition. In the monopoly market, control of price is in the hand of monopolist. The point where revenue from selling marginal quantity matches with the cost of producing marginal quantity is considered as profit maximizing point (Currie, Peel, & Peters, 2016). Price in the monopoly market exceeds marginal cost generating profit for the monopolist. Figure 1 shows condition in the monopoly market. Profit of the monopolist is shown by the shaded region.
The mechanism in a competitive market is opposite. Price and output in the competitive market is determined by the with free market supply demand condition. The demand curve here is identical with marginal benefit curve and marginal social cost is identical with market supply curve (Askari, Iqbal & Mirakhor, 2015). Therefore, matching of supply and demand shows parity between marginal social benefit and marginal social cost and hence is socially efficient.
The supply curve or marginal social cost curve is the marginal cost curve the monopolist. Price and quantity in the monopoly market is Pm and Qm and that of a competitive market is Pc and Qc respectively. It is clearly seen from the diagram that Pm>Pc and Qm<Qc. The loss to the society in operation of monopolist and resulted low output and high price is indicated as the deadweight loss to the society (Wang, 2016).
From the earlier discussion, it is clear that the position of a single seller in the monopoly market is not socially desirable. The status of a single supplier is retained by creating entry barrier in the market. Natural monopoly is a market where natural barrier restricts entry of new seller in the market (Yang & Ng, 2015). The natural barriers refer to conditions where other firms itself do not take interest to enter in the market because of a very high fixed cost. Government often crates regulatory barriers to entry in order to retain the efficiency of the market with a single supplier.
Average fixed cost and average variable cost together constitute average total cost. If fixed cost is high then with increase in output level it falls at a faster rate because fixed cost does not increase with an increase in output. As a result, average total cost falls with an increase in the range of output (Barreto, 2013). This is exactly the situation in a natural monopoly market. The natural barrier exists in terms of high fixed cost. With a high fixed cost, total average fixed cost is rapidly falling. This generates benefits of economics scale for the monopolist. In the presence of economics of scale the monopolist can operate anywhere in the falling part of average cost curve.
The single seller in the natural monopoly market has scope for maximizing profit as like a pure monopolist. The profit can be much greater for natural monopolist because of scale efficiency. The natural monopolist here charges same price output combination as is obtained for a general monopoly market. This gives rise to the need for regulatory price in a natural monopoly market. Socially efficient price is that price obtained from the pricing condition similar as that in a competitive market (Cowing & McFadden, 2015). However, it is not possible always to go with a competitive price as this imposes an additional burden of loss. Henceforth, the regulators chose next best alternative strategy.
Natural Monopoly Pricing and regulation
There are three types of pricing option in a natural monopoly market. First, the natural monopoly market without any regulation is considered. When there is no administrative control over the prices charged in the market, the monopolist is free to choose profit maximizing output level and charge price higher than otherwise situation (Shahriar, 2017).
Without any regulatory framework, natural monopolist choose the equilibrium point where gain from addition sells expressed by marginal revenue curve matches with the cost for that additional unit expressed by marginal cost curve (Rubinfeld & Pindyck, 2013). Point E shows such a price output combination. Profit of the unregulated natural monopolist is the area showing the difference between total revenue and total cost.
In an unregulated situation, the natural monopolist may deceive buyers who are solely dependent o the monopoly supplier by serving them a low output at a very high price. It is the responsibility of regulators to ensure that an optimum quantity is sold at an affordable price in the market. First best choice for the society is to choose price by rule of marginal pricing. In a competitive market, price is determined by the level of marginal cost (Basso, Figueroa & Vásquez, 2017). As marginal cost curve is the social benefit curve, price is actually equals to the social benefit received and hence is socially optimal. In competitive market, price thus derived is only sufficient to recover total cost of production and generates only normal profit. The situation is however different for natural monopoly market.
A distinguishing feature of natural monopoly market is the falling average cost. At the falling ranges of average cost marginal cost is always below the average cost. Therefore, if price is determined with marginal cost price rule then it is not possible for the monopolist to recover total cost of production with earned total revenue. Therefore, this type of pricing results in a loss for the monopolist (Belleflamme & Peitz, 2015). The loss area is shown in figure 4. Marginal cost pricing though efficient but ends with a loss to the monopolist.
If regulators forced the monopolist to implement this pricing rule then the loss should be accounted and some alternative should be offered to fulfill loss. The monopolist may sort to a price discriminatory strategy. Price discrimination is also called two part pricing. Under this strategy, the monopolist charges two different prices in two parts of the market. The buyers having a lower elasticity are offered the good at a high price whereas consumers with a higher elasticity are served with a high price (Crapis et al., 2016). Two part pricing maximizes monopolist’s revenue as the monopolist here is able to grab maximum consumer and producer surplus. Another alternative policy the monopolist can chose is to charge a fixed fee, which the buyers have to pay once. After paying the fixed fee, price is charged equal to the marginal cost (Dahl, 2015).
However, leaving the monopolist to recover loss itself is again subject to inefficiency. Hence, for charging marginal cost pricing proper support from government is needed to cover loss. The government or regulator has to make direct payment to the monopolist an amount equivalent to loss called subsidy. Payment for subsidy is made out of government revenue. Therefore, to make subsidy payment government has to increase the tax rate. Increasing tax rate crates distortion in the society (Ifrach, Maglaras & Scarsini, 2011).
Sometimes it may happen that the distortion crates from increase taxation are greater than the deadweight loss resulted in an unregulated monopoly market. In this situation, regulation is proved highly inefficient. The next best alternative is to charge price following average pricing rule. Here, price is determined by equating it with average cost of production. Since, natural monopolist makes production to the left of average cost curve, marginal cost never equals average cost. When price is set equals to the average cost then revenue earned from total sales exactly matches with the total cost of producing these units. The monopolist here can only earn normal profit as like competitive firm (Holzhacker, Krishnan & Mahlendorf, 2015). Therefore, this can be also considered as an efficient operation point. Corresponding price and quantity under such a scenario is indicated as Pr and Qr respectively. As shown from the figure, the area of total revenue and total cost are same and there is only normal profit for the monopolist.
Regulating price by using average cost seems to have efficiency over marginal cost pricing, as there is no additional burden on government budget generated from the loss because of operating at a point lower than the average cost. The regulation based on costs of the monopolist is known as the cost plus regulation. The general method here is to have a record on the cost of the market. The regulators face challenges in implementing cost plus regulation because the monopolist never reveals true production cost. The general tendency of the monopolist is to reveal an overestimated figure of cost. In addition, when pricing is dependent on the estimated cost, then the monopolist bothered least about high cost. The burden of high cost can easily transfer to customers in terms of a high price (Revesz, 2017). In recent days, application of cost plus regulation has reduced. Regulators now rely on an alternative price setting mechanism know as price cap regulation. As the name suggests, it is a mechanism where a cap or ceiling is set on market price. The price is set for a certain period. In order to increase profit share within the caped price, the monopolist has to reduce cost. To increase profit the cost saving advanced technologies are employed in the production by the monopolist, which enhances production efficiency (Sappington & Weisman, 2016). Additionally, more investment is made for innovation and installing advanced technology. Here lies the efficiency of price cap regulation. However, in cost plus regulation price is determined based on the estimated cost and hence, only cost information is required here. For price cap regulation, setting an appropriate price becomes a difficult task. The ceiling price should neither be too high nor be too low. The price should be a realistic one so that no parties face loss from the transaction and an efficient exchange is made in the marketplace.
The essay discusses different pricing strategy that can be undertaken in a natural market. Some inherent characteristics of natural monopoly market distinguish it from a pure monopoly market. The natural monopoly market is known for exhibiting scale of production in the market operation. However, when left regulated the natural monopolist can take advantage of its monopoly power and charges a high price. Then regulation becomes necessary to ensure efficiency in the market. The regulators have two pricing strategies. One is marginal or socially efficient pricing and other is average pricing rule. Regulation under cost plus mechanism is dependent on monopolist cost and often fails to ensure efficient pricing. An alternative means of regulation is regulating price by setting a ceiling on it known as price cap regulation.
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