Definition of Natural Monopoly
Based on the number of buyers and sellers, markets are classified in separate category. The market with a single seller is called a monopoly market. In the monopoly market, the single seller grabs maximum profit and the entire surplus in the market by exploiting its market power. The monopoly market when compared to a competitive market always seems inefficient in terms of resulting in a deadweight loss. A special form of market similar to a monopoly market is natural monopoly. It is a market that is best operated by a single seller than two or more.
In a natural monopoly market, the seller enjoys a cost advantage and able to produce goods at the falling part of average cost curve. Examples of natural monopoly market include electricity service, public water company and public utilities. Question of regulation comes when the natural monopolist starts taking operation decision like a pure monopolist. In such a situation, the monopolist chooses profit-maximizing level of output where a lower quantity is supplied at a high price. In such a situation, government has taken pricing decision by either following an socially efficient pricing strategy.
Perfect competition is a market scenario where there are numerous participants in market exchange operation. Market equilibrium occurs at a point where demand and supply curve matches with each other. The presence of large number of buyers and sellers in the market makes it impossible for a single buyer or seller to affect price or output. Therefore, efficient point is reached without any intervention (Hovenkamp, 2015). The market condition with competition among the sellers is described below.
Figure 1: Perfectly competitive market
(Source: As created by the Author)
Supply curve in the market coincides with marginal social cost and marginal benefit curve is the same as market demand curve. Socially efficient point is reached where marginal social benefit (MSB) is matched with marginal social cost (MSC). In perfect competition, it is same as free market equilibrium where market demand equals market supply. Hence, equilibrium in competitive market is efficient as here MSC = MSB (Belleflamme & Peitz, 2015). In the market, consumer enjoys considerable surplus that is the difference between consumers willing price and actual market price. Consumer surplus is shown as the area under the demand curve lying above price.
In contrast, the monopoly market is inefficient as here price is greater than social marginal cost. The monopoly determines its own price and is not a price taker as like a competitive firm. Because of its market power, the monopolist always chooses profit- maximizing level of price and supply a lower quantity as compared to competitive market. The welfare loss because of a high price charged is shown by the triangle of deadweight loss. Figure 2 explains this.
Market Structure Efficiency
Figure 2: Inefficiency of the monopoly market
(Source: As created by the Author)
The consumer surplus is now reduced to a small triangle. Some portion of the reduced surplus is transferred to the monopolist as producer surplus. The transferred surplus is not considered as loss to the society (Schmidt, Spann & Zeithammer, 2014). The rest, which is received neither by the consumer nor by the producer, is an actual cost to the society.
One of the key features of a monopoly market is that entry of a new supplier is completely restricted in the market. Barriers can be of several forms. Ownership barrier, legal barriers or natural barriers are some types of barriers ( Weimer & Vining, 2017). When entry is restricted with a natural barrier then it is called natural monopoly. The goods or services offered in the natural monopoly market usually have an abnormally high fixed cost. As a result, with increase in the plant size or output average cost decrease entailing the benefit of economies of scale to the seller. When there is more than one supplier then such scale benefits are reduced and results in market inefficiency (Vikharev, 2013).
Figure 3: Natural Monopoly Market
(Source: As created by the Author)
As shown in figure 3, the monopolist makes market operation with a decline in its average cost. The optimum price and quantity here are P* and Q*. However, more firms enter in the market then they fail to reach the efficient point and may supply a lower quantity (Q1) at a high price (P1)
With a restricted entry, natural monopoly business seems to be a lucrative business for earning huge economic profit. In the absence of any regulation, line of difference between natural monopolist and that of a pure monopolist becomes blurring (Andrade, 2014). Same like a monopoly market with its pure form, here also standard condition for profit maximization is used to determine price and output in the market. The economies of scale enjoyed here, enables the monopolist with a much higher profit (Saglam, 2017).
Figure 4: Unregulated Natural Monopoly
(Source: As created by the Author)
In an unregulated situation, maximization of profit requires Marginal revenue equalizes with Marginal Cost (Shughart II, & Thomas, 2015). Above figure shows such an unregulated natural monopoly market. The operation point of the monopolist is point E. The unregulated price and quantity are Pf and Qf respectively. Profit to the monopolist is shown by the shaded region in the figure.
Perfect Competition Market
The high price and low quantity in an unregulated monopoly brings the need for regulation in a natural monopoly market. Market regulation refers to set of rules by which government administered over different aspects related to market such as quantity, price, entry or exit condition and the like. There are two prevalent theories explaining basic working mechanism of regulation (Rifkin, 2014). First is Social interest theory and the second one is Capture theory. Under the social interest theory, regulatory authority seeks to find the root cause of inefficient outcomes and then takes step to correct the inefficiency and maximize welfare. Capture theory explains a regulatory framework where producer manages to manipulate the regulator in serving self-interest.
Natural monopoly, created with natural condition of demand and cost often result in market outcome lower than efficient outcome. Role of the regulator here is to secure efficient price output combination.
Efficient point is obtained at a point where price and marginal cost are equal. It is a point that balances Marginal social cost and marginal social benefit. Here, MSB curve is the demand curve and MSC curve is the marginal cost curve or supply curve (Tietenberg & Lewis, 2016). Efficient regulation sets price at PE and Quantity at QE, shown in figure 5.
Figure 5: Different pricing strategy in natural monopoly market
(Source: As created by the Author)
Under efficient regulation though best outcome is obtained for the society, however it causes the monopolist to incur a loss from the market operation. The natural monopolist operates at the left of the minimum point of average cost. From the relation between average cost and marginal cost at the falling part of ATC, MC is less than the ATC. Thus for the whole range of output, MC lies below the average cost (Puller, 2013). Therefore, when price is equals to the marginal cost then average cost is above the set price and leads to a loss to the monopolist as shown by the shaded region in the above figure.
Without compensating for the loss, the production cannot be carried out. The monopolist might be allowed for price discrimination to cover average cost. Alternatively, the monopolist can consider charging a one-time fixed fee. As maximum portion of the average total cost is fixed cost, the fixed fee helps to recover loss from efficient pricing (Borenstein, 2016).
Another alternative to the regulator is to give direct payment as subsidy equals to economic loss. To provide subsidy government has to increases its revenue. The only source of government revenue is direct and indirect taxation. Increasing tax rate is not a viable option because tax itself is associated with a welfare cost or deadweight loss.
Inefficiency of Monopoly Market
Therefore, the second best alternative is to revise the marginal pricing rule settle price at the level where the monopolist can just cover its average cost. It is called average pricing rule. Under average cost pricing rule, price is set equals to the average total cost. Equilibrium is determined at the point where demand curve intersects average total cost (Zhang, Ge, & Xu, 2013). Price and quantity denoted as Pr and Qr corresponds to average pricing rule. Here, total revenue earned by the monopolist is just equal to the total cost. Only normal profit is realized here.
The regulation decision is made considering the cost and benefits of different policy option. In selecting between two pricing rule, the regulators needs to compare between dead weight losses from two strategies. Smaller the dead weight loss more efficient is the policy. Either of the policy depends on the cost of the monopolist. Any pricing regulation based on firm’s cost is known as cost plus regulation. Cost plus regulation lacks transparency. The monopolist once come to know that prices are going to be determined based on the computed cost, the general tendency then is to overestimate cost (Bös, 2014). The monopolist becomes least aware of reducing production cost rather involves in activities that impose additional cost. The burden of high cost transfers to the buyers in terms of high price. Hence, the regulators might fail to set efficient price.
Realizing challenges of the cost plus pricing regulation a preferred alternative is Price cap regulation. It is similar to the policy of price ceiling. Here government sets a maximum price for the market. The monopolist cannot charge price above the ceiling price. The price is set for a few years. After some times, the regulators considering the market condition again revise price (Czerny & Zhang, 2015). Generally, a declining trend in revised price is observed. To earn a handsome profit here the monopolists has to focus on reducing cost. This increases market efficiency. Unlike in cost plus regulation where the monopolist has tendency to increase unnecessary cost burden here the monopolist reduces cost with own effort.
When selecting the ceiling price, proper evaluation of market is needed. Any unrealistic price hampers the market operation. In case the price cap is too low then the monopolist fails to sustain in the market and close down operation. As the natural monopolist mostly offers necessary goods like electricity, water sudden close down of operation creates trouble (Engel & Heine, 2017). While making price revision effect of shocks should also be considered so that the policy can be carried effectively.
Regulation of Natural Monopoly
Conclusion
The essay aims at explaining regulation in a natural monopoly market. In a monopoly market, a single sellers control all the market power. The price and output are inefficient as compared to competitive market. Natural monopoly is a special form of monopoly where a natural barrier is imposed on the entry of a new firm. In this form of market, there is an unusually high fixed cost, which results in a reduction of total average cost. When average cost reduces with increasing plant size or output then the producer reaps the benefit of economic scales. This scale benefits allows the producer to supply a relatively large amount of goods at a price lower than if there are competition between two or more sellers. The position a sole producer in the market tempts the natural monopolist to behave like a pure monopolist. Therefore, unregulated natural monopolist never supplies efficient quantity at an efficient price. The situation needs to be corrected using regulation.
There are two pricing option for the regulators. One is the marginal cost pricing that is socially efficient pricing strategy. Because of monopolist’s operation at the falling portion of average cost marginal cost is below the average cost for the entire output range. As a result, the marginal pricing rule results in economic loss for the monopolist. The loss can be recovered either by direct government subsidy or by allowing the monopolist to charge a fixed fee or discriminate in the market. Another alternative is to set the price by average pricing rule. Here, the monopolist earns only economic profit. Price cap regulation is the best alternative to setting price for the natural monopoly market given executed efficiently.
References
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