Understanding Natural Monopoly, Government Intervention - An Essay.

Natural Monopoly

In general, monopolies are distinguished by high investment cost and high fixed cost. A natural monopoly is different in context to the existing concept of monopolies. It is characterised by a condition where a single firm is in a better position to serve in the market in comparison to two or more firms. In other words, where a single large business can serve the entire market at a lower price than other two or more smaller firms. The term, “natural monopoly’’ doesn’t refer to the actual number of sellers in the market but relation between demand & technology of supply.

 In this scenario, the actual cost & prices might increase as there is only one efficient provide of a good. If it contains more one industry than either the firms will constrict to one through mergers or failures or the production will continue to consume more resources than required (Posner, 1968)

There are various reasons which can lead to this situation. One of them is where there is decrease in the overall cost as the production output increases thereby giving the advantage to the existing firm owing to the large output which a new firm cannot match and eventually this stands as a barrier ( Mankiw, 2014). The other reason would be the control over the less available resources e.g. railway lines, power supply, telephones line etc. Hence, the key player which have the hold over the scarcely available resources becomes the only supplier which makes the entry of other firms difficult without the same resources. Government intervention and policies also contributes to the natural monopolies. This type of scenario arises in several industries where the starting or the upfront cost is too high. For instance, electricity transmission, transmission lines of telephones, oil or natural gas etc. One cannot think of replicating the same due to the exceptionally high cost which leads to only sole player having all the control over the market.

The firm falling under monopolistic takes decisions with an aim to maximize the profits which ultimately leads to situation where marginal cost is lesser than the price, as the firm keep producing resulting in under allocation of available resources. This is only occurs as the corresponding output is lower than the comparable output which is expected in perfect competition while the price charged is significantly higher. The same can be explained below in the diagram:

The quantity produced by a monopolist firm is represented by QM & the price charged by PM. It is apparent that the firm tends to produce until the average cost (AC) is at its lowest point. Thus, to maximize the profit, a firm need to produce until average cost is at its lowest possible point. In other way by increasing the production & corresponding lowering the price will never maximize the profits (Krugman & wells ,2008). So, the firm under natural monopoly produces less as the efficient output level would be higher. If a new entrant tries to enter the market in this scenario then the monopolist will increase the production quantity to lower the price compelling the new firm to exit the market ( Mankiw & Taylor, 2011).

Knowing the available resources are scarce, it is evident that the resources should be assigned or utilised in way to maximise the production & efficiency of these resources. The same never happens in natural monopoly unless there is government intervention. The same can be explained below with the help of a diagram:

When a natural monopoly is not under regulation, Pm represents the price charged and Qm is the quantity supplied.  At Pso the social optimal price is obtained with corresponding output of Qso. If government steps in and sets the price for either break even or a fair return, then Pfr and Qfr would be the price charged & quantity supplied respectively. From the above diagram, it is evident that a non-regulated monopoly is very highly efficient in comparison to a regulated one. Hence the consumer supply is highly diminished & give rise to huge deadweight loss. The same can be depicted in the form of a diagram:

The above statement is again verified by the diagram that there is a need of government intervention or else without any competitor the firm will maximize the profit by using the available resources inefficiently (Krugman and wells, 2008)

The above instances have already confirmed the need of government regulation. The same is explained below (Pindyck & Rubinfeld, 2001):

To check the prices are under control, a government intervention is required as a non-regulated monopolist can charge higher from the consumer as there is no competitor and which will also lead to inefficiency and decrease in consumer trust.

The quality of product or service under a natural monopolist may degrade as it is only the sole provider in the market. Hence there must be some kind of standard set by the government to ensure the quality standards are followed.

Being the only provider in the market, the suppliers might face the challenges as there is only buyer of their goods with all market share. Hence an intervention by the government should be there to ensure monopolist power is not deployed for exploitation of suppliers.

As in case of monopoly there ought to be some cases of competition to keep the monopolist under check but in natural monopoly as it difficult for a new entrant because of huge investment and fixed cost, there has to be a government intervention or regulation to ensure smooth functioning of the industry.

As in the previous section we came to know there has to be a government regulation through intervention in order to keep the monopolist under check. The various ways by which the government can exercise the same is explained below. Also, the operating mechanisms along with its positives & negatives has been briefed.

Efficiency of Natural monopoly

The price limit imposed by the government on a product is known as price capping. In general, it is exercised on the essential utilities such as electricity, gas, telecom services where it is important that the consumer can utilise these services at an affordable and fair price. This type of case arises when a public utility may be privatised. In this case, the government send its officials for the different sectors who limits the price in case of inflation. Normally, the monopolist is permitted to increase the value which is lower than the inflation to ensure the efficiency which are gained is also realised. This gives added advantage to the private firms in terms of incentive to enhance efficiency in order to have the profits margin even in an inflationary environment. Also, the re revision of pricing is permitted with prior approval from the government regulators once the approval is granted (Mankiw and Taylor,2011).

This practise has a lots of pros. The first being the, the increase in prices are always being monitored by the officials or the government regulators who keep consumer welfare in their mind while exercising this process. The second pros are the practice of price capping also provides advantage to the monopolist firm to improve their efficiency in terms of productions or services to maximize their profits. This happens because only the prices are monitored not the returns and the regulators while checking the price rise also expects some kind efficiency gains. Lastly, this helps in reducing the exploitation of monopolist power.

The practise also has its negatives sides. Firstly, having the equilibrium between the profitability of the firm and consumer welfare is quite difficult to achieve for the regulator. Hence there comes a situation where there is drift to the either side from the optimum equilibrium. Secondly, there may be tussle between the government regulators and the monopolist firm which allows the firm to earn supernormal profits on a regular basis at the cost of consumer well-being. Lastly, the monopolist firm, has the incentive to be less efficient to that in every incremental price change, it can increase the efficiency (Krugman and wells,2008).

Another way it can be regulated by price ceiling which is by the enforcement of a maximum potential price being charged. This regulatory strategy ensures by stating a specific product or service cannot be sold above a certain price.

When there is a natural monopoly for a public utility, then it is evident for the regulator to define the minimum criteria or the standards or the firm may try to maximize the profit by intentionally producing low standard products and charging premium price for the same.to regulate this government intervention is essential. Also, it is necessary that the government regulators must set the minimum standard that can be practically made (Besanko and Braeutigam, 2010).

Cases of Government Intervention

In order to increase the competition, it is necessary to break the monopoly in extreme cases. Here the possible solution is geographical spin off into different entities rather than being part of single large entities. The government can also play major by buying a stake in the firm ensuring that there are government representatives in the management and the consumer wellbeing is better served. Nationalization of the firms by providing fair compensation can also be implemented in extreme scenarios (Arnold, 2008). Although these types of practice may lower the confidence of the investors and that is why it is usually refrained and external regulation is practiced. Nationalization of the firm over the long run is inefficient and thus it is not practiced (Nicholson and Snyder, 2011).

When there is no direct competition for the utility suppliers, the regulators can pressurise those firms by bashing their prices in terms of cost performance of comparable firms. In this type of regulation instead of price capping, the regulator considers the amount of capital deployed which may offer a fixed rate of return ensuring the prices in accordance of this objective. Hence, the prices are set by in line by ensuring fixed returns to the firm. The main drawback with this regulation is that the private firm would tend to window dress the cost for the sake of increasing the price fixed by the regulators (Krugman & wells, 2008). Thus, concluding as there is no added incentive for the private party to ensure the operations are smooth & efficient in every way as the same might lead in lower the prices set by the regulator (Mankiw, 2014)

As a last major, a government can regulate the natural monopoly by imposing higher taxes on larger firms and providing subsidies to the smaller firms. In other words, government can provide financial support to the smaller firms in the form subsidy to the new entrant so that there is healthy and equitable environment.

Conclusion

We can lastly summarise that in order to have consumer friendly environment there must be government regulation which should be favourable for the firms too. In the absence of the same, there might be consequences which may hamper to the overall growth of the country and its people on the whole. The government regulation should ensure that the consumer interest is being served both in terms of price and quality of services. The various mechanisms through which the government can act depends upon the socio-cultural or underlying political conditions which tend to decide the best possible way forward. Lastly, the nationalisation of the firm or breaking of monopoly should only be exercised in extreme scenarios when the rest of the measures failed to give the desired results. 

References

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

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

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

Samuelson, W. & Marks, S. (2003). Managerial Economics (4th ed.). New York: Wiley Publications.

Pindyck, R. & Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall Publications.