Econ 201 Week 7

1. Econ 201Week 7 Finishing Up Monopolies: Natural Monopolies

2. Natural Monopolies • natural monopoly • one firm can produce a desired output at a lower costthan two or more firms— • there are economies of scale • Having multiple firms providing a good or service is less efficient than if a single firm provided a good or service. • Examples of natural monopolies include railways, telecommunications, water services, electricity, and mail delivery. • An industry is said to be a natural monopolyif only one firm is able to survive in the long run, • result of high fixed costs of entering an industry which causes long run average costs to decline as output expands

3.  FIGURE 13.7A Natural Monopoly A natural monopoly is a firm in which the most efficient scale is very large. Here, average total cost declines until a single firm is producing nearly the entire amount demanded in the market. With one firm producing 500,000 units, average total cost is $1 per unit. With five firms each producing 100,000 units, average total cost is $5 per unit.

4. Market Conditions for a Natural Monopoly • Scale is such that it is cost-efficient for only 1 firm to supply the market, i.e., economies of scale

5. The Regulator’s Dilemma • A couple of alternatives: • No regulation • Firm will price like a monopolist • Set price at ATC • Rate-of-return regulation: sets utility’s prices based on cost-of-service

6. What are the Consequences? • Do nothing • Firm chooses Q at the point where MR = MC • Less than perfect competition • Sets Price > MC • Higher than perfect competition • Higher price and lower Q => deadweight loss

7. What happens if we don’t regulate? Unregulated Monopolist MR = MC ROR: Set P = ATC Ideal Output P=MC

8. What are the Consequences • Rate-of-return regulation: • Set rates such that they cover firm’s cost + normal rate of return • Set price = ATC • Since ATC is falling => MC < ATC • And P = ATC > MC • Still producing too little – would like P= MC at Q*

9. 10 Marginal-cost pricing for a natural monopoly Price Average total cost Average total cost Loss Regulated price Demand 0 Quantity marginal cost is less than average total cost. Requiring a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money. Marginal cost

10. What Do You Do? Rate of Return Price = ATC France P= MC ROR: Set P = ATC -> firm recovers costs; but still produces too little output Fr: Set P = MC -> subsidize loss with tax on some other good(s) or income

11. The European Approach • Assuming LRAC is still falling • Set P = MC • Subsidize the difference between ATC and P MC

12. 10 The French Approach: P=MC + subsidy Price Average total cost Average total cost Subsidy Regulated price Demand 0 Quantity Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, regulator will have to subsidize the “loss” – difference between ATC and price Marginal cost

13. Regulatory responses • doing nothing • setting legal limits on the firm's behaviour, either directly or through a regulatory agency • setting up competition for the market (franchising) • setting up common carrier type competition • setting up surrogate competition ("yardstick" competition or benchmarking) • requiring companies to be (or remain) quoted on the stock market • public ownership • Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecommunications industry is a leading example globally.

14. Telecommunications – an Example • Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable costs. • fixed costs of establishing a national distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small. • average total cost will continue to decline as the scale of production increase, because fixed (or overhead) costs are being spread over higher and higher levels of output • The telecommunications industry has in the past been considered to be a natural monopoly. Like railways and water provision, • existence of several companies supplying the same area would result in an inefficient multiplication of cables, transformers, pipelines etc. • perception of what constitutes a natural monopoly is now changing – • new technology reduces traditional barriers to entry within markets. • telecommunications industry • in the UK, British Telecom has faced increasing levels of competition from new telecommunications service providers during the 1990s - not least the rapid expansion of mobile and cable services. T • this has led to a change in the role of the industry regulator (OFTEL). Its main role now is not necessarily the introduction of even more competition into the telecommunications industry - but a policing role to ensure fair competition between service providers.