ECO511 Economics For Business

Introduction

A peculiar circumstance when instead of multiple firms, a particular firm tends to fulfil the market needs in a superior manner is referred to as natural monopoly. This situation typically arises on account of the sizable advantage in terms of cost which the current player present in the market enjoys that renders the entry of other players in the market difficult (Samuelson & Marks, 2003).  Natural monopoly may arise due to a host of reasons. The key contributing factor is the reaping of economies of scale which tends to lower the average production cost and provides an entry barrier thus justifying the presence of a single firm only. Theoretically, this player on account of 100% market share should have the lowest production cost which tends to be beneficial in comparison to existence of multiple players. Yet another reason giving rise to the incidence of natural monopoly tends to be the control on certain resources that may be scarce (Nicholson & Snyder, 2011). Due to the limited availability of the resource, the firm that tends to have control over these ensures that the others firm are not able to enter the market as the enabling infrastructure are single handed controlled. At times, natural monopoly exists because of government policies. This is witnessed often in those sectors which have a high setup costs related to enabling infrastructure which is witnessed in avenues such as transmission of electricity and other utilities. Clearly, it lacks economic reason to bring about infrastructure duplication on such a huge scale and hence government barriers are erected (Mankiw, 2014).

Equilibrium Determination

In the absence of any competition and enjoying complete market share, it is normal to expect that in a natural monopoly setting, the concerned firm would be driven by the aim of profit maximisation. This would be apparent in their economic decisions i.e. quantity produced and the price charged. For price maximization, the production of the firm would be carried to the extent that marginal cost (MC) is lesser than price (P). In order to fulfil this, the monopolistic firm causes artificial shortage or scarcity by producing a output level that is lower than the highest possible efficient (Krugman & Wells, 2008). This is apparent from the following graphs (Mankiw, 2014).

The above graph clearly highlights the equilibrium quantity and price charged as Q_m and P_m respectively. A noticeable attribute of the firm operating in the natural monopoly setting is the fact at equilibrium, the average cost does not attain the lowest value. Therefore from a economic efficiency point of view, it would make sense for the firm to increase the output to a point when the average cost curve tends to attain the lowest value. However, at this production level the price charged from the buyers would be lower and therefore the overall profitability of the firm would decline (Mankiw & Taylor, 2011). As a result, the output in a natural monopoly is lower than the output level at which efficiency would be achieved. This tends to have an adverse impact on the public welfare. Also, in industries where economies of scale is high, the monopolist firm can enhance production in order to ward off any competition as increasing the output would tend to lower the unit cost and enhance the competitive advantage of the existing player (Besanko & Braeutigam, 2010). 

Efficiency Considerations

The economic resources have scarce availability and hence it is critical that efficient allocation of these must be done in order to ensure that societal objectives are met. In the absence of any intervention of the government, natural monopoly could be highly inefficient as apparent from the graph shown as follows (Mankiw & Taylor, 2011). 

 

The graph above clearly highlights that for an unregulated monopoly firm, P_m and Q_m tend to highlight the equilibrium price and equilibrium quantity respectively. However, this is in stark variation with the corresponding socially optimal output represented by P_SO and Q_SO which makes a strong case for government intervention. Taking into consideration that the government intervention is in the form of working out a fair price, then P_fr and Q_fr would indicate the equilibrium price and quantity respectively which ensure higher output level and a greater allocative and productive efficiency (Mankiw, 2014).

Further, the inefficiency of an unregulated natural monopoly can also be explained on the basis of the various surplus coupled with the extend of deadweight loss which is illustrated as follows (Nicholson & Snyder, 2011).

The extent of deadweight loss caused is huge that is the result of profit maximisation being pursued by the firm. Hence, it is apparent that natural monopoly requires active government regulation in order to maintain a fine balance between societal benefit and profit maximisation thus allowing for greater efficiency (Pindyck & Rubinfeld, 2001). 

Government Intervention

The low efficiency and the displaced goal of profit maximisation being pursued in the natural monopoly clearly present a strong need for intervention of the government. A host of reasons which tend to support this are as highlighted below (Krugman & Wells, 2008).

• There is the tendency for a firm working in a natural monopoly setting to overcharge based on the existence of no alternative choice which is detrimental to the consumer interest (especially those who lack requisite economic resources) and thus demands government to regulate prices.
• Considering that consumers do not have the choice to shift vendors, it is imperative that quality must be strictly monitored and secured by putting in place the essential quality standards to be met.
• The natural monopoly leads to monopsony power for the firm which can be abused particularly for exploitation of suppliers which demands government regulation to ensure transactions at arm length and fair price.
• In other market structures where competitors are present, regulation takes place automatically but natural monopoly erects natural barriers against such regulation. As a result, government is the only alternative regulation that needs to be provided.

Government Intervention Measures

The host of measures that the government can potentially take along with their relative merits and demerits have been highlighted in the given section.

Price Capping

This is usually adhered to in case of public goods particularly vital utility where price regulation is essential so as to ensure that affordability is ensured even for the lower sections of the society. Certain pivotal utility services are provided by private firms and hence periodic price revisions are enacted in order to adjust for rising costs (Mankiw & Taylor, 2011). The government tends to put in place regulators which tend to ensure the fairness of these increments and simultaneously ensure that only a percentage of cost hikes is compensated in the form of price hike so as to realise efficiency gains. Hence, price revisions are regulated and the increases can only be enacted only after the regulator has approved the same keeping in mind the public interest (Borenstein, 2005).

There are a host of merits with this form of intervention. To begin with, the price hikes are strictly monitoring ensuring that public affordability of key public services is ensures. Further, since the hike approved is less than 100% of the increased costs, thus, there is progressive improvement of efficiency for these firms which reduce the overall costs. Also, returns regulation is not observed which provides indirect incentive for the private players to enhance efficiency. Also, the monopsony power abuse is kept under control (Carrington, Coelli & Groom, 2002).

Despite the merits highlighted above, there are few demerits which need to be considered. To begin with, regulators find it exceptionally difficult to decide on the prices which ensure that a fair balance is maintained and often tend to err especially on the side of the service provider. Also, there are instances when the regulator may be bribed by the firm and hence the regulation tends to safeguard the interest of the firm. Further, as for every hike, the service provider would be expected to exhibit incremental improvement in efficiency, thus the service provider would not be fully efficient from the onset and bring incremental improvements when required (Pindyck & Rubinfeld, 2001).

Service Quality Regulation

As the consumer does not have the choice of switching service provider, the government intervenes through sector specific regulators which define the quality standards which ought to be met. In the absence of this, there is a risk that the service standards may be dropped so as to enhance the profits earned. However, with government regulation this tendency is avoided and also realistic quality standards desired for defined and met by the service provider. Failure in meeting these tends to lead to fines coupled with loss of contract in extreme cases (Krugman & Wells, 2008).

Nationalisation

Considering that natural monopoly is widely practised in case of various vital public services where a pre-requisite infrastructure or network is required, hence there is a case where only a private firm may be providing a particular product or service. Even though the government firstly regulates through price capping and enforcing quality standards, but if there are repeated violation, then in such extreme cases, the government may consider nationalisation so as to safeguard the public interest (Armstrong & Sappington, 2006). This is because in natural monopoly, breaking of monopoly does not make economic sense.  It is noteworthy that this is an extreme measure which is not usually preferred as it adversely dents investor confidence (Besanko & Braeutigam, 2010).

Yardstick regulation

A way to conduct price regulation is yardstick regulation. This method aims at fixing an assured return rate considering the capital investment by the private party and the prices tend to follow the returns that the regulator deems fit. Further, there are price revisions when the cost tends to increase so as to safeguard a constant return (Krugman & Wells, 2008). But a key drawback of this technique is the overstating of cost by private party to get a higher price. Also, this method does not offer any incentive for enhancing efficiency as returns are fixed which leads to public money being wasted. However, with tweaking along with checks and balances, this method can be made to work (Gagnepain & Ivaldi, 2002).

Conclusion

The discussion carried out above convincingly indicates the need of government regulation in case of natural monopoly so as to ensure that economic efficiency is improved and additionally the public interest is safeguarded. An unregulated natural monopoly tends to be driven with the sole objective of profit maximization which leads to an artificial shortage and high deadweight loss. Intervention by the government ensures that efficiency is improved while maintaining affordability and quality coupled with checking abuse of monopsony power. There are a range of mechanisms which are available in this regard and the choice essentially must be driven by the socio-political background of the concerned nations. Further, the government should avoid taking measures like nationalisation which may be detrimental to the global interest of the nation.

References

Armstrong, M. & Sappington, D. (2006), Regulation, Competition and Liberalization, Journal of Economic Literature, 44, 325-366.

Arnold, A.R. (2008). Microeconomics (9^th ed.). Sydney: Cengage Learning.

Besanko, D. & Braeutigam, R. (2010). Microeconomics (4^th ed.). New York: John Wiley & Sons.

Borenstein, S. (2005), Time-Varying Retail Electricity Prices: Theory and Practice, in Griffin and Puller, eds., Electricity Deregulation: Choices and Challenges, Chicago: University of Chicago Press,

Carrington, R., Coelli, T. & Groom, E. (2002), International Benchmarking for Monopoly Price Regulation: The Case of Australian Gas Distribution, Journal of Regulatory Economics, 21, 191-216.

Gagnepain, P. & Ivaldi, M. (2002), Incentive Regulatory Policies: The Case of Public Transit in France, Rand Journal of Economics, 33, 605-629.

Krugman,P. & Wells, R. (2008). Microeconomics (2^nd ed.). London: Worth Publishers.

Mankiw, G. (2014) Microeconomics (6^th ed.). London: Worth Publishers.

Mankiw, G.N. & Taylor, P. (2011). Microeconomics (5^th ed.). Sydney: Cengage Learning.

Nicholson, W. & Snyder, C. (2011). Fundamentals of Microeconomics (11^th ed.). New York: Cengage Learning.

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.