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Understanding Natural Monopolies Government Regulation

Discuss about the Regulating Natural Monopolies.

In this paper, the researcher seeks to investigate and present a detailed explication behind the rationale for governments to wish to establish the price that natural monopolies charge at the level whereby the demand curve (D=AR=P) intersects the average total cost curve (ATC).

The main challenge with monopolies is that when they are left uncontrolled by the government, they will most probably decide to undertake production at an output level that is far lower and offer products at prices that are extremely higher compared to those from virtuously competitive sector (Berg & Tschirhart, 2010).

A natural monopoly shall produce at point at which the price charged is above he MC, showcasing resources under-allocation towards commodities. The monopoly limits the output and raise its price and in so doing, he is assured a maximum profit, though at a societal cost of less overall consumer welfare or surplus.

Surprisingly, in certain industries, due to vast array of output upon that economies of scale are witnessed, it makes increasing sense sometimes for solely one firm to partake. Those markets remain regarded as ‘natural monopolies’ and certain instances include cable television, along with natural gas besides other industries which have vast economies of scale (Braeutigam, 2015).

Government regulators are trapped in dilemmatic setting in speaking to natural monopolistic businesses like electricity sector. An electricity firm that has a monopoly in a given marketplace shall anchor the price along with output decision on profit maximization law which every unfettered business shall; it shall generate at a point whereby their MR equates their MC.

The challenge is for a natural monopoly since MR is below price charged, that implies that maximizing profit output level (whereby MC=MR), MC will be below price: proof of allocative inefficiency that is never sufficient electricity shall be generated and price shall be extremely abnormal for certain customers to acquire.

In this manner, the need for government regulation arises. The government concerned with acquiring the right quantity of electricity to the right quantity of the individuals (allocative efficiency) might decide to establish a price ceiling for electricity at a level at which the price equates MC of the firm. This, nevertheless, shall probably be underneath ATC of the firm taking in mind that ATC drops over a vast array of output, a setting that will culminate to losses for a business, and might result into collapse.

Reasons for Government Regulation

Therefore, many administrations have established a price ceiling whereby price is equivalent to ATC of a firm, implying a firm shall ‘break even’ solely earning a ‘normal profit’ substantially merely sufficient to enable the firm run the business; this is regarded as ‘fair-return price’.

As show above, government regulation of monopolies is meant to only allow the monopolies to gain the normal profits. It is clear that this can only be achieved at a point whereby administration creates price charged by natural monopolies at a point whereby the demand curve intersects the ATC curve where firms can break even. This will make the monopolies to only obtain the revenues required to cover the monopoly’s total amount of variable and fixed expenses during a given period of time.

The administration might decide to undertake regulation of natural monopoly to safeguard interest of consumers.  For instance, monopolies enjoy market power for establishing higher prices unlike competitive markets. The administration have various options to choose from when regulating the monopolies including price capping, barring the monopoly power growth and yardstick competition.

  • The government will regulate monopoly to bar excess price from being charged by monopolies. In the absence of administration regulation, natural monopoly might place price beyond. This will culminate into allocative inefficiency hence a drop in consumers’ welfare.
  • The government also regulate to ensure better service quality. In case a natural monopoly enjoys a power over a given service provision, it might have less incentive to provide good service quality. The administration will thus regulate to make sure that the monopoly firm meet the minimum service standard.
  • The government will also regulate to control the monopsony power. For a monopoly firm, it will be well placed to abuse the buying power of monopsony. For instance, supermarkets might utilize their overriding market location and hence squeezing farmers’ profit margins.
  • The regulation will also be done to indorse competition. In certain businesses, it is conceivable to promote competition, hence there shall be little sense for regulation by government.
  • The government also regulate due to natural monopolies. Certain sectors are natural monopolies and hence because of huge economies of scale, it will be supremely efficient to only have one firm. Accordingly, there is no need for encouraging competition by the government and hence it is indispensable to regulate firms to bar the exploitation of the power of monopoly.

The government uses price capping to regulate the monopolies from charging the high price above that of a competitive market. For example, for freshly privatized industries like gas, water and electricity, the administration has established regulatory agencies including OFGEM (electricity and gas markets), OFWAT (tap water) and ORR (office of rail regulator) in the United States. These bodies undertake to limit the surges in prices.

The average cost pricing is helpful in this case. This is the regulatory described as the enforcement of a price point for a particular commodity which equals the entire costs sustained by monopoly providing or producing. Such an approach is used by the government to reduce the flexibility of the monopoly which makes sure that monopoly cannot capture the margins beyond and above what is reasonable (Train, 2011).

In this way, the government is able to eliminate the threat that consolidating an industry into one single suppler pose to the free market along with their customers since it limits the manipulation of the price by monopolies through a comprehensive control of the supply. In this sense, the government will minimize monopolization alongside maintenance of competitive equality.

Accordingly, the government will ensure that monopolies do not lower that economic output of a given society and hence its wealth by regulating the prices charged by the monopoly to a point whereby demand curve crisscross ATC curve to bar a natural monopoly from profit maximization rather than fair returns or normal profits (Posner, 2014).

Average Cost Pricing

For a competitive firm, the profit maximization takes place where the MC is equals to price at the market. Nevertheless, because ATC of a natural monopoly drops repeatedly, the MC shall normally be smaller than ATC. This is because the ATC describes average entire costs encompassing vast fixed costs whereas MC is solely additional cost of generating an extra unit. Accordingly, a natural monopoly shall recurrently lose cash in case price charged is restricted to its MC (Loeb & Magat, 2014).

The government comes into play to dictate the better regulated price which would that which permits the monopoly to alter the price denoted as fair-return price sometimes which equates to the monopoly’s ATC or the normal profit as show in the diagram below.

The above price would permit the natural monopoly to endure as a going concern. Nevertheless, it would fail to incentivize the monopoly firm owners to reduce costs. Therefore, this kind of the government regulation of monopolies could be improved by permitting a natural monopoly to maintain certain profits received by decreasing costs (Gómez-Ibáñez, 2013). It is acknowledged that not such a price is beneath price charged by monopoly which maximizes profits, which sets the price equivalent to level at which MC=MR

Conclusion

It is apparent from the deliberation above that certain commodities can be offered at a lower cost by natural monopolies than competing firms. The primary feature of a natural monopoly is that its ATC diminishes continually over any amount demanded by the market. In case the sector has a vast fixed cost, a single firm will offer commodity at a point far lesser cost compared to numerous firms. This is due to the fact that ATC of each firm will be much higher compared to when it is a natural monopoly.

Therefore, a natural monopoly will provide a commodity for a lower price in absence of any competition. Certain examples of a natural monopoly encompass the distribution of landline phone, tap water, natural gas and electricity. The government regulation is, therefore, appropriate to make sure that a natural monopoly only charges the fair-return price or normal profit without reducing costs sat a point at which AR curve intersects ATC curve.

References

Berg, S. V., & Tschirhart, J. (2010). Natural monopoly regulation: principles and practice. New York: Cambridge University Press.

Braeutigam, R. R. (2015). Optimal policies for natural monopolies. Handbook of industrial organization, 2, 1289-1346.

Gómez-Ibáñez, J. A. (2013). Regulating infrastructure: monopoly, contracts, and discretion.

Loeb, M., & Magat, W. A. (2014). A decentralized method for utility regulation. the Journal of Law and Economics, 22(2), 399-404.

Posner, R. A. (2014). Natural monopoly and its regulation. Stanford Law Review, 548-643.

Train, K. E. (2011). Optimal regulation: the economic theory of natural monopoly. MIT Press Books, 1.

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