Governments Set Natural Monopolies Prices At The Intersection Of Demand And Average Total Cost Curve In Essays.

Explain why governments may want to set the price charged by natural monopolies at the level where the demand curve cuts the average total cost curve?

The place where sellers and buyers meet to deal with the transaction of varied goods and services is known as market. The market can be segmented into several parts depending upon some pre-specified paradigm (Lavoie, 2013). The paradigms are: the total number of peoples involved in transaction, hindrances posed on exit and entry, etc.

Through this essay, it has been tried on our part to draw an inference about the government’s choice of quoting the price at the intersecting point of demand curve and average total cost curve. In monopoly market, the sellers or producer has the upper-hand in quoting the price of goods and services. But in case of natural monopoly market it has been seen that the higher authority always controls the price. This behavior can be explained by using few economic terms like total cost, marginal cost and marginal revenue (Geng, Ji, & Fan, 2014).

This essay initially highlights the basic concepts of the subject economics and a short discussion on the various markets to get a better perceptive about the situation in which trade occurs. The rationale behind the opinion of the government and its interference in the decision process of the natural monopolist has been discussed henceforth (Browning & Zupan, 2014). The essay takes the help of different concepts like costs, benefits, choices in highlighting the government’s decision.

Demand and supply are the two pillars of the subject economics. The subject entangled with complicated mathematics, hypotheses, theories and complex process involved in decision-making tries to find out ways in which the equilibrium can be maintained and restored within the economy. The business sector in the economy can be segregated into few segments namely, monopoly, perfect competition, oligopoly, monopolistic, oligopolistic and monopsony markets. A short outline regarding the 4 most well recognized market has been drawn and then the main market of natural monopoly has been elucidated while answering the given question.

The two extreme types of market namely perfect competition and monopoly are utopian situations (Makowski, 2014). Yet the market of perfect competition is the ideal situation that can exist in the economy from consumer’s viewpoint.  The market with a few sellers who individually has the power to influence the transaction pattern of trade is known as oligopoly market (Weyl & Fabinger, 2013). Monopolistic market also consisting of a few sellers face minimum barrier in ingress and egress (Nikaido, 2015). The final and 4^th type of market, monopoly is discussed below.

Monopoly Market: The term ‘monopoly’ is given to the market where only one seller is responsible to meet the entire demand generated in the society. The seller being free from any rivalry dominates the market and is responsible for quoting the price of the services and goods. The structure itself indicates the fact that other sellers are debarred form entering the market (Scitovsky, 2013).

Natural Monopoly: The natural monopoly is the market in which ingress of other producer is restricted as it is associated with lofty cost. In pure monopoly, the other firms are restricted from entering the market but in case of natural monopoly no other firm tries to enter due as they would require to borne huge cost whereas they can remain sure that they won’t get equivalent revenue (Stiglitz & Rosengard, 2015). Example: The market for railway service can be cited as an appropriate example of natural monopoly. Railway is one of the cheapest and fastest methods of communication in the world.

The important characteristics of this market are as follows:

Scale economies: This feature implies that with the increase in the number of total output the marginal cost incurred decreases and hence the company always tries to produce their service in bulk.

High fixed cost: The cost borne by a company can be divided into two parts. They are: Fixed cost and variable cost. The burden that any producer needs to bear even if there is no production in the company is called fixed cost.

Low variable cost: The cost that fluctuates depending on the total production of the company is known as variable cost. In the natural monopoly market the ups and downs of production cannot create a big difference in fluctuation of this component.

The comparison drawn below the two intense type of market structure can help in better understanding of the inefficiency of the natural monopoly market. The diagram below clarifies the situation.

Figure 1: Difference between Perfect Competition & Monopoly

Source: Created by the Author

The diagram above shows both the monopoly market and perfect competition together. The diagram on the left shows the market of perfect competition where Pc and Qc are the respective price and quantity that exists in the market as a result of interaction between the supply and demand curve. The demand is perfectly elastic. On other hand the figure on the right side depicts the scenario of monopoly market. The equilibrium is obtained by equating the marginal cost and marginal revenue curve. Here Pm and Qm depicts the price and quantity respectively. From both the diagram it can be summarized that the monopolist charge greater price for a service than the perfect competition market. Also the quantity of goods and service produced in the market is reduced in the monopoly market (Yurukoglu & Lim, 2014). As the price charged by the monopolist is much greater than the prices in other market, hence there it is obvious that the buyers are left with a reduced amount of consumer surplus. At the same time the seller gets a hike in their producer surplus. But overall there is a lack of efficiency in the market that leads to the failure of the market (Eaton, Allen, & Eaton, 2012).    The way in which natural monopolies behaves if the price is quoted at the juncture of average total cost curve and the average revenue that is the demand curve has been observed from three different perspective and discussed below with the help of diagram:

Figure 2: Price determination in Monopoly Market

Source: Created by the Author

The diagram above shows that if complete power is bestowed in the hands of the monopoly firm then they will offer the service at a price as high as Pm. At such a high price only a few consumer will be able to use the service. Only Qm quantity of goods and services will be provided in the market.

The benefit of the monopoly firm: The profit making motive of the monopoly producer always thrives to find a way through which they can extract the maximum possible consumer surplus from consumer’s hand and convert it into the producer surplus. This can only be done by setting the price at high level (Stigler & Mencken, 2016). From the diagram above it can be seen that at Pm the producer earns a profit as shown by the uppermost rectangle in the figure. Hence, the firm is being benefitted as it can successfully yield some amount of super-normal profit that in turn induces them to continue their operation at that juncture itself (Salvatore, 2012). But if the firm keeps on operating at this situation, then both the firm and the society have to face some severe consequences which are discussed in the next stanza.   

Cost on monopoly firm and on the society: Since the firm operates at such a high price, therefore it reduces the scope of the firm to cater a large mass of people. Hence, losing some potential consumer is the cost that the firm has to borne at the given situation. On other hand, from the consumer’s perspective as many of them cannot get the service due to the extreme high cost associated with the same, they are forcefully deprived. The society as a whole faces some dead-weight loss which has been depicted by the triangle ABC in the diagram above. The monopoly firm faces the grave problem of allocative efficiency (Geng, Ji & Fan, 2014). Allocative efficiency is the situation where there is balance in the society’s production and consumer’s demand and it occurs when marginal cost and average revenue gets equated. Under such circumstances the government needs to intervene and minimize the society’s welfare loss. 

Government Intervention: The government tries to balance the extreme effects and make the firm operate at a level where both the producers and the consumers can sustain in the market. The diagram below clarifies the measures taken by the regulatory authority.

Figure 3: Government intervention in Monopoly Market

Source: Created by the Author

The ideal situation is the scenario where the price is above Ps that is price quoted under perfect competition and below Pm that is the price in monopoly market.  The place where the average total cost curve of the monopoly firm and the demand curve of the same intersect is chosen by the government as the ideal price (Krugman, Obstfeld, & Melitz, 2015). It is the government who has the duty to provide proper feasible services to its people. The government can regulate the market in three different ways. They are:

Direct regulation: The government itself provides the service and goods in the market discarding the existence of private sector.

Price regulation: It may put a ceiling on the price of the goods and services. In such a situation the monopoly producer cannot charge any price above that pre-declared price.

Quota or quantity regulation: The government can also force the producer to produce a minimum amount of goods in the market. The minimum amount that the government decides is given by the same intersecting point of demand curve and average total cost curve (Browning & Zupan, 2014). If the government fixes the quota of Qg amount of goods then the price of the goods and services will automatically get reduced to Pg level. This is because if the producer keeps price at Pm but quantity produced at Qg, then there is going to be a surplus which is equivalent to (Qg- Qm) in the market. So automatically by the natural laws of the market the price gets reduced. On other hand the total loss of welfare also decreases as shown by the smaller triangle EFG. A real example below depicts the huge cost of natural monopoly and government’s intervention in the same market.

Railway networks falls under natural monopoly in countries like India and Australia and are operated by the government themselves. Fiber optic markets also enjoy the status of natural monopoly in many countries (Minamihashi, 2012). The Australian Rail Track Corporation is responsible for providing railway service in the country (Nash, 2015). The Australian government during 2003 proposed to design an inter-state network within the country with an investment of over $ 872 million (Miller, 2016)

Conclusion:

The writing can be wrapped up by connoting few facts one again. The market for monopoly comes up with the problem of market failure. On other hand the most desirable market is nothing short of being utopian phenomenon. The society requires certain large scale services and goods in order to sustain in the market. It is seen that often those large scale services can be provided efficiently only if they are operated under natural monopoly. On other hand allowing the private sector to operate freely with monopoly power will create a distortion between the desired level of service at certain price and the original provision of the same. Hence, the government being a controlling authority is left with two feasible options under this circumstance. The government can either become the supplier of that particular service or it can intervene in the private sector and control the price of the goods and services by debarring the price to rise above the intersecting point of the demand curve and total cost curve of the private firm. There can be a third option open for the government as well which requires a lot of time. It is improving the situation by encouraging research and development. Only a havoc escalation in technology can create a condition capable of reducing the production cost and thereby efficiently catering the market.

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