Discuss about the Monopoly of Cengage Learning System.
Natural monopoly refers to a situation when a single firm is in a better position to serve the market in comparison with two or more firms. Typically in a natural monopoly due to the significant cost advantage that is enjoyed by the existing player, the other players have no chance with regards to entering the market (Samuelson & Marks, 2003). There are various reasons which can give rise to a natural monopoly. One of these is economies of scale which essentially refers to a situation where there is a decrease in the overall cost as the production output increases. As a result, the existing firm owing to the large output tends to have a cost advantage which a new entrant would not be able to match and this acts as a natural entry barrier against any competition (Mankiw, 2014). Another key reason contributing to a natural monopoly is in the form of control over scarcely available resources. This may be in the form of network or existing infrastructure which related to railway lines, transmission lines of telephone etc. Thus, the player which has control over the above resources tends to act as the sole supplier and the new firms cannot enter the market without the same resource. Further, another reason for existence of natural monopolies is in the form of government intervention and policies. This is typically the case in various industries where the upfront costs are exceptionally high such as electricity transmission, gas pipeline etc. In such cases, it makes sense not to cause duplication of this immense infrastructure and thereby confining the market to only one player makes sense (Nicholson & Snyder, 2011).
Natural Monopoly – Determination of Price and Quantity
The monopolistic firm would tend to take economic decisions with the objective of maximising profit. As a result the firm tends to produce till the price is greater than the marginal cost. This would lead to the available resources being under-allocated. This is because the corresponding output is lower than the comparable output expected in perfect competition while the price charged is significantly higher. The equilibrium for the monopolistic firm is indicated below (Besanko & Braeutigam, 2010).
The corresponding quantity produced by a monopolist firm is indicated by Qm while the price charged by the firm is indicated by Pm. It is noteworthy that the firm tends to produce at a level where the AC or Average cost is not at its lowest point. Hence, in order to maximise efficiency ideally, the firm should produce at a point where the AC is at the lowest point. However, increasing the production and corresponding lowering the price would not enable the firm to maximise profits (Krugman & Wells, 2008). Thus, a firm in the natural monopoly tends to under-produce as the efficient output level would be higher. Additionally, if theoretically some competitor does try to entry to market, the monopolist firm can enter the production quantity thus lowering the cost further and reducing the price, thereby ensuring that the competitor would have to quit the market (Mankiw & Taylor, 2011).
Natural Monopoly – Efficiency
Considering that resources are scarce, it is essentially that these should be allocated and utilised in a manner so that the productive and allocative efficiency is maximised. This does not happen in case of natural monopoly especially if there is no intervention from the government. The analysis of the efficiency in monopoly can be reflected in the diagram indicated below (Nicholson & Snyder, 2011).
In the above diagram, it is apparent the when a natural monopoly is unregulated, then the respective price charged and quantity supplied are Pm and Qm respectively. The social optimal pricing is obtained at PSO with a corresponding output of QSO. Alternately if the government intervenes and sets a price for either break even or a fair return, then the respective price charged and quantity supplied would be Pfr and Qfr respectively. It is apparent from the above diagram that unregulated monopoly is highly efficient (Mankiw, 2014). As a result there is a huge deadweight loss and the consumer surplus is highly diminished which is demonstrated below (Mankiw & Taylor, 2011).
The above graphs clearly reflect the need for the regulation of the natural monopoly so that efficiency can be enhanced or else without any competition; the firm would aim at making profits while using resources in an inefficient manner (Krugman & Wells, 2008).
Natural Monopoly – Case for government intervention
From the above discussion in relation to efficiency and also the market power available with the monopolist, it is apparent that there is a need for government regulation. The various reasons in this regards are summarised below (Pindyck & Rubinfeld, 2001).
- The government intervention is required in order to check prices as an unregulated monopolist would charge excessive prices that would lead to inefficiency and loss decrease in consumer welfare.
- It is quite possible that the quality of the product or service provided by the monopolist firm may fall over time as there is no competition. Hence, government intervention ensures that minimum quality standards are upheld.
- Considering the monopolist is the only provider of a particular product or service, it is likely that the suppliers may face a difficult time as there is only buyer of their goods with 100% market share. Thus, regulation by the government would ensure that monopsony power is not deployed for exploitation of suppliers.
- While in case of monopoly, there may be the case of increasing competition to keep the monopolist under check, but in case of a natural monopoly, it is not possible for any competitor to enter and hence the regulation has to be performed by government only as no alternative to the same may be available.
Natural Monopoly – Methods of government intervention
While the need for government regulation through intervention is established in the previous section, this section aims at highlighting the various means that the government deploys in order to ensure the same. Further, the operating mechanism of each of these government measures along with their respective pros and cons has been discussed.
The pricing capping is commonly practiced for key utilities such as electricity, water, gas where it is essential that the consumers tend to receive these vital services at affordable costs. This is especially the case when a public utility may be privatised. In that case, the government appoints regulators for the various sectors which tend to limit price in case of inflation. Usually, the monopolistic firm would be allowed to increase the firm by a value which is lower than inflation which would ensure that efficiency gains are also realised. This provides the incentive to the private firms to enhance efficiency in order to safeguard profit margin in an inflationary environment. Further, the upward revision of pricing is allowed with prior approval from regulator after the approval is granted (Mankiw & Taylor, 2011).
This mechanism has a host of advantages. Firstly, the price increases are monitored by the regulator that can take into consideration various factors including public welfare. Secondly, this system of price capping provides incentive to the monopolistic firm to improve efficiency for maximising the respective profits. This is because the returns are not regulated, only the price is and also the regulator which deciding on the price increases also expects some amount of efficiency gains. Thirdly, this practice helps in curbing the abuse of monopsony power (Pindyck & Rubinfeld, 2001).
However, there are certain disadvantages which are associated with this approach. Firstly, maintaining a balance between profitability of the firm and public welfare is difficult to achieve for the regulator and usually there is a drift to either side from the optimum equilibrium, Secondly, there may be collusion between the regulator and the monopolistic firm which allows the firm to earn supernormal profits on a sustainable basis at the cost of public welfare. Thirdly, the firm has incentive to be little inefficient to that in every incremental price increase, it can increase the efficiency (Krugman & Wells, 2008).
Quality of service regulation
When a natural monopoly exists for a public utility, then it is imperative for the regulator to define the minimum service standards or the firm may try to maximise the profit or price by intentionally maintaining poor quality and charging a premium for good quality services. In order to avoid this, government regulation is essential. However, it is essential that regulators must also specify a minimum service standard that can be realistically met (Besanko & Braeutigam, 2010).
In extreme cases, there may be breaking of the monopoly in order to increase the competition. For the natural monopoly, it is possible that geographical spin off is possible into different entities rather than being part of a single huge entity. Additionally, the government may buy a stake in the firm which would ensure that the management has government representatives and the public welfare is better served. In extreme cases, there may be nationalisation of the firm and suitable compensation may be provided (Arnold, 2008). However, this may dent the investor confidence and usually is refrained from and external regulation is practiced. But as a measure, this is available if there is a need. Over the long time nationalisation of the firm may lead to inefficiency and hence is not preferred (Nicholson & Snyder, 2011).
This is another means of achieving price regulation besides price capping. In this regulation, instead of capping the price, the regulator taking into consideration the amount of capital deployed may offer a fixed rate of return and thereby ensure prices in accordance of this objective. Thus, the underlying prices are decided in line with ensuring fixed returns to the monopolist firm. However, one major issue with this method is that the private player would tend to overstate the cost in order to increase the price set by the regulator (Krugman & Wells, 2008). Further, in this method, there is no incentive for the private player to ensure that the operations are run efficiently as the same would lead to lower prices bring set by the regulator. Besides, it may also be difficult to ascertain a reasonable rate of interest which satisfies both the regulation and the firm (Mankiw, 2014).
Based on the above discussion, it would be fair to conclude that in a natural monopoly, there is potential danger of inefficiency and public interest not being served since the form could be driven by the profit motive and hence would tend to maintain an artificial scarcity while maintaining the prices high. In order to ensure that monopoly position is not abused, efficiency gains are realised, quality of services is maintained and price is affordable, government intervention is required. There are various mechanism through which the government can intervene and it depends on the underlying political and socio-cultural factors which tend to determine the best way forward. Also, the extreme measures such as nationalisation or monopoly breaking should be practised only in extreme scenarios when the other solutions fail to give desired results.
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Mankiw, G. (2014) Microeconomics (6th ed.). London: Worth Publishers.
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Nicholson, W. & Snyder, C. (2011). Fundamentals of Microeconomics (11th ed.). New York: Cengage Learning.
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