Reasons For Regulating Natural Monopolies And Methods Of Regulation

Explain On May Want To Regulate Natural Monopolies?

In every economy, natural monopolies play a significant role. Primarily, a monopoly refers to a market in which when only one firm operates and dominates an entire industry (Beggs, 2016). On the other hand, a natural monopoly is a specific type of monopoly that arises when a single find firm dominates the market due to extremely high startup capital and fixed costs associated with Operations in the market. Mainly, natural monopolies exists where there are high fixed costs of production and distribution, thereby necessitating economies of scale. A perfect example of a natural monopoly is the electricity company. It is characterized by high costs of infrastructure in terms of grids and cables for electricity supply.   Thus, the efficient number of firms in the industry is one. It is noteworthy that a natural monopoly market differs from a perfect competition in terms of competition, entry and exit requirements, and number of sellers. In a perfect competition, there is free entry and exit of firms while there are high barriers to entry in natural monopoly markets. There is also no form of competition in natural monopolies whereas there is high competition in perfect competition markets.  Thus, the structure of natural monopolies provides room for consumer exploitation and governments may want to regulate monopolies to ensure that they produce high quality, fair priced goods at efficient levels. 

High Monopoly Market Power

One of the major reasons as to why the government may seek to regulate natural monopolies is due to their market structure. As such, the market structure of a natural monopoly necessitates that various measures must be initiated to control firms from exploiting their customers. In a nutshell, a natural monopoly operates as the sole producer of a given product (Arkani, 2010). The firm is also a price maker. Usually, firms limit the quantity they produce in order to push their prices upwards. Furthermore, the market is also characterized by high barriers to entry into the market caused by high capital requirements (“Monopoly,” n.d.). There are also high legal barriers in the market. For this reason, the firm has a high market power and influences the market. Therefore, the government may step in to limit the market power of natural monopolies to ensure that they do not exploit their customers.

As noted earlier, natural monopolies do not face any form of competition in their market. Therefore, they possess a high market power, and are able to control the quantity of goods. In turn, they have the power to set their own prices. In most cases, natural monopolies abuse their market power and set high prices for their goods and services, higher than the price they would have charged if the firm operated in a competitive market structure (Welker, n.d.). For this reason, governments may want to regulate them in order to preserve consumer welfare.

Reasons for Regulation

According to economic theory, monopolies set their prices at a point that maximizes their profits. Normally, firms manufacture goods at the point where their marginal costs of production equals the marginal revenue. However, they charge the price determined by the demand curve. For this reason, the price they charge is usually high than the marginal cost of production. Consequently, this allows them to obtain high profits at the disadvantage of their consumer’s welfare.  

From the graphs above, the MC curve intersects with MR curve at point a (Pettinger, 2012). However, instead of setting its price at this point, the firm locates the demand curve for the product, thereby setting its price from point b (Pettinger, 2012). At this pricing, the price is higher than the Average total costs incurred in the production of the good. Thus, the monopoly makes a profit equal to P^m-ATC (Pettinger, 2012). In contrast, a firm operating in a competitive market sets its prices at the point where the demand and supply curve intersect. Thus, unlike natural monopoly, the price is optimal and there is no deadweight loss associated with its pricing.  Therefore, in this regard, the natural monopoly makes supernormal profits and reduces the welfare of consumers. Thus, the government may find it necessary to step in and regulate the pricing level.

n addition, governments regulate natural monopolies in order to enhance their level of efficiency. It is worth noting that monopoly firms are associated with various forms of inefficiencies. As noted earlier, natural monopolies do not experience any form of competition. The weakened market forces guarantees that consumers lack other alternatives from which to purchase the product or service (Beggs, 2017). Thus, the firm does not worry about the possibilities of losing customers due to their poor quality goods or services. For this reason, they lack the incentive to improve their level of innovativeness to improve the quality of their commodities. Subsequently, it translates to wastefulness production of goods and services. Therefore, in this case, the government seeks to protect consumers against poor quality services and products by setting and regulating quality standards.

Furthermore, natural monopolies also lead to inefficiencies as they reduce the level of producer and consumer surplus (Beggs, 2017). When compared to the competition market structure, the total surplus associated with the monopolistic firms is smaller. Mainly, this can attributed to the fact that monopolies tend to limit the quantity of goods and services they produce in order to influence prices to move upwards. Thus, a reduction in quantity and an increase in price of the product shrink the consumer as well as the producer surplus. In this regard, the management opts to regulate monopolies in order to raise the total surplus to the society.

Methods for Regulation

Given the reasons above, it is important for the government to regulate the conduct of natural monopolies within its economy. Mainly, regulation can take the form of price ceilings, average cost pricing, rate of return regulation and the formulation of regulatory bodies to oversee and control the conduct of monopolies within the country (Beggs, 2015).

First, government may employ rate of return policies to control natural monopolies in the country. Primarily, this technique involves the government setting a particular percentage net profit that a company must not exceed. Usually, it takes into consideration the size of the firm and determines a reasonable level of profit from its initial capital. Therefore, in order to ensure compliance, a firm must ensure that its percent net profit is lower that the set threshold. Thus, the firm’s rate of return on the invested capital is kept below the maximum rate set by the policy. Consequently, this ensures that firms set their prices at a point that ensures its rate of return on initial investment is low. In turn, the prices are set at low levels to ensure compliance. It is noteworthy that this measure ensures that consumers of that given product are protected from increases in the price of that particular product.

Notably, this is one of the major forms of regulation that the government can put in place to regulate monopolies. In a nutshell, price ceilings pertain to the setting of a maximum price that a firm can charge for its goods and services (Beggs, 2015). It is strategy that states that a particular product cannot be sold for above a specified price (Beggs, 2015).  Thus, firms cannot set a higher price than the one designated by the government. This way, the government is able to limit the prices charged by firms for their products, thereby protecting them from exploitation by natural monopolies.  

                                                                             Source: (Osborne, 1997).

Suppose the government sets a price ceiling for the monopoly’s product at P^r.  Under normal circumstances, the firm would set its price at the point P^m. However, due to the proposed ceiling, the firm is forced to reduce its price down to P^r (Osborne, 1997). Therefore, the government is able to spare consumers an amount equal to Pm-Pr through the price cap. Indeed, this form of regulation allows the government to regulate firms and improve consumer welfare.

The government may also use regulatory bodies to regulate natural monopolies in the economy. Fundamentally, these bodies are created to examine the quality of products produced by natural monopolies (The Conversation, 2012).  The qualities of the products produced are compared to a set of quality standards to ensure that consumers purchase quality goods and services. In addition, these bodies regulate the price level of services and commodities manufactured by natural monopolies within the country. This way, they are able to limit firms from charging consumers exorbitant prices.

Apart from assessing quality and controlling pricing levels, regulatory bodies also investigate cases when monopolies are suspected to practice predatory pricing and price fixations (The Conversation, 2012).  In the event that a firm is found guilty, the regulatory body takes strict actions and measures against it. As a result, natural monopolies are discouraged from practicing hostile production and market practices (The Conversation, 2012). What is more, these mechanisms guarantee consumer protection and welfare. It also ensures an increase in the efficiency of firms.

It is imperative to note that the government may also initiate policies that require natural monopolies to set their prices equal to their average cost of production. By and large, this policy involves setting its price level equal to or below the cost of manufacturing the product. In most cases, natural monopolies maximize their profits by setting price at the point where the marginal cost curve intersects with the demand curve for the product (Reed and LaFaive, 1997). As a result, firms make excessive profits at the expense of the consumer. However, when this policy is implemented, natural monopolies will be forced to trim their prices to equal the cost of production (Reed and LaFaive, 1997). The policy guarantees that the price charged by firms does not exploit their customers. Besides that, it ensures that firms operate at efficient levels to achieve profits.

Just like average cost pricing rules, the government may use marginal cost rules to regulate natural monopolies. Basically, this policy requires that natural monopolies set their prices equal to the marginal cost incurred in producing their product (Reed and LaFaive, 1997). In turn, it ensures that monopolies do not charge excessive prices for their commodities. In addition, it guarantees that monopolies do not make surplus profit at the disadvantage of the consumer.

In Australia, the government has set various bodies to act as a watchdog and control the conduct of natural monopolies within the economy. The Energy Regulatory Commission (ERA), for instance, has the mandate to oversee and regulate the price of electricity in the country. As a result, the price of electricity in the country remains affordable to the people of Australia.

Conclusion

Therefore, everything taken into consideration, it is important for the government to set up measures that ensure the regulation of monopolies in the country. By and large, natural monopolies operate as the sole producer of a particular good or service. As a result, they face no form of competition in the market of their goods and services. This creates a platform for monopolies to exploit their customers through offering poor quality products or high prices. They also lack the incentive to operate under efficient conditions. For this reason, the government is tasked with the responsibility of regulating natural monopolies to ensure they offer fair prices, produce quality goods and services, and operate under efficient conditions. In order to achieve these goals, the government may set up various measures and mechanisms among them average cost pricing measures, rate of return policies, price ceilings, and monopoly regulatory bodies. Consequently, the successful implementation of these measures will ensure that the government controls the pricing, quality and efficiency of natural monopolies in the country.

References

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