Hi everybody, natural monopoly, such an interesting sub-branch of monopoly theory, brilliant market structure to investigate and to analyze. Let's take some real-life examples of natural monopoly markets. Your utilities are a great example, especially the distribution side of utilities. Water distribution, gas electricity distribution, internet distribution, but also rail track providers, great examples of natural monopoly.
So what characteristics define a natural monopoly market then? Well, fundamentally... Huge fixed costs, especially your startup costs.
Astronomically high fixed costs. Just take rail track, the rail track infrastructure, huge fixed costs there. Water distribution, think about the pipe work, huge fixed costs.
Similar with internet, similar with gas electricity. Ridiculously high cost infrastructure costs here when it comes to startup. But if there is one benefit of having ridiculously high fixed costs, and therefore very high total costs, it means that to minimize your average cost, you can reduce your cost.
is going to take a huge quantity, huge quantity. And that means there is enormous potential for economies of scale when there is a natural monopoly market. If we skip straight to the diagram down below, the long run average cost curve for a natural monopolist is going to be downward sloping for a huge quantity range. And that is because to minimize the average will take a ridiculously high quantity. And therefore, the minimum efficient scale point, where all economies of scale are fully exploited, will occur at a very very high quantity level and that shows here with a constantly downward sloping long-run average cost the huge potential for economies of scale that a natural monopolist has.
Dis-economies of scale would occur wherever you are somewhere impossible can't even see it on our diagram such as the high level of quantity to produce before just full economies of scale are exploited here so that's one benefit there of having such high costs such high fixed costs huge potential for economies of scale as well Look at number three and number four. These are very interesting characteristics. It makes rational sense for only one firm to supply the entire market. In fact, we can say competition is undesirable here. Unbelievable thing to say.
Competition not desirable? And even deeper, why is that the case? Well, because competition would result in a wasteful duplication of resources.
Why? That's because the first firm into the market, the first mover, has got the economies of scale advantage. So if any other firm were to enter later, they're not going to have the same economies of scale advantage as the first firm, and eventually therefore they're going to be priced out of the market. As they leave the market, all of their infrastructure, all their resources are going to be left idle. What a waste, what a wasteful duplication of resources here.
That is allocative inefficiency. But furthermore, if there is competition, there is not going to be the full exploitation of economies of scale that we would like. We're not going to get down here. There is going to be productive inefficiency. And that's because with competition, naturally, firms are going to be of the greatest size possible compared to if they were dominating the market.
Smaller firms are not going to be producing the same kind of quantity as one firm dominating the market. And therefore, economies of scale are not going to be fully exploited. There is going to be productive inefficiency as well.
So what a strange conclusion there. Competition would result in allocative and productive inefficiency. Crazy to think. What?
that's competition whereas a natural monopoly one firm dominating here would result in allocative efficiency and productive efficiency as long as the natural monopolist is regulated that's the conclusion how do we get there let's understand that now you can see i've started with the cost curves for a natural monopolist downward sloping continuously given the enormous potential for economies of scale that these firms have We're now going to draw our revenue curves, which are normal downward slothing as you would expect for a monopolist. So we'll draw average revenue, which will look something like this. So AR, which is demand and marginal revenue to be twice as steep looking something like that. This firm is a profit maximizer. So they're going to produce where marginal revenue is equal to marginal cost.
That's over here. Let's call that quantity Q1 and let's call the price P1 reading it from the AR curve. So there's the price of P1 there. At quantity Q1, let's work out the level of profit being made. To do that, we have to compare average revenue and average cost.
Well, average revenue is up there, and average cost is way over here. The vertical difference between the two is the unit supernormal profit, because average revenue is greater than average cost. But if we multiply that by all of the units being produced and sold here, we get an area of total supernormal profit.
So let's label that area. as the super normal profit being made. Fantastic, well that's given us the same kind of outcomes as a normal monopoly, just with downward sloping cost curves, because of the economies of scale, right? But no, it doesn't stop there.
And the reason it doesn't stop there is because think about the markets I said before. Water distribution, gas electricity distribution, internet distribution, rail track. Think about the outcomes now.
We are seeing very high prices. and we are seeing low quantities. How do we know that? Because compared to allocative efficiency, which is where price equals marginal cost, which is there, we can see that quantity is much lower and price is much higher than it would be if firms were operating at competitive outcomes. The difference now compared to normal monopoly is because of the markets we're talking about here, utility distribution, rail track, this is deemed not good enough by regulators.
regulators will look at this and think, you natural monopolist, what are you up to? What are you doing? You're charging excessively high prices.
Well, that's not good. That means people can't afford to get water. People can't afford to get gas, electricity. People can't afford to use rail.
That's not good enough. And quantity is very, very low. That means there are people out there, households, who are not connected to water pipework, who are not connected to gas and electricity pipework, not connected to super fast internet. That's not good enough either.
So regulators, because of the essential nature of these goods and services for the function of society, would now come in and regulate the natural monopolist. And where does it make sense to regulate the natural monopolist? Well, to allocative efficiency levels down here.
So the point of regulation would be here, let's call that quantity Q star, and the price to be way down here of P star. So we can see the big reduction in price. and the big increase, the huge increase in quantity as a result of this regulation.
Fine, we understand the rationale for regulation, but the story doesn't stop there. The natural monopolist is going to say, well, look, I understand the rationale for regulation here. I understand why you've done it and why you've done it there.
But hang on a minute, you're killing us regulator. By regulating us at P star and Q star, there makes no sense for us to be in this market because look, at Q star, it's clear to see. Average revenue is at the blue dot, but average cost is way up there. And that tells you if average cost is higher than average revenue, there is subnormal profit being made here.
There is a loss. There is a loss per unit of that. But multiply that by all of these units, multiply by all of these units.
We have a huge area here, a huge area of subnormal profit. Let's label it as such, subnormal profit here. So the natural monopolist is saying, look, you're killing us, regulator, by forcing us to produce and price at the allocatively efficient point.
That's not good enough. That's not fair for us. If you want us to continue producing, you've got to do something.
In which case, you often see, when there is a private natural monopolist, subsidies given by the regulator to make sure that the loss is covered. And the subsidy would be equal to the loss per unit. So in this case, if we label that A and we label that point B... the subsidy given by the regulator is going to be equivalent to a b a subsidy of a b per unit right and that will cover the loss of the natural monopolist and at least allow them to make normal profit but you can see the end conclusions of this is even though we get society desirable outcomes there is very little incentive for a private natural monopolist which is why a lot of the industries i talked about will have state-run natural monopolies instead Where you do see private natural monopolies, like with water distribution in the UK, you will often see big subsidies as well as big regulation to make sure that these firms can continue producing. So that's how a natural monopolist works.
Very interesting to see that if there is one firm dominating here, as long as it's regulated, we will get allocative efficiency and we get productive efficiency benefits. whereas competition will result in allocative inefficiency and productive inefficiency. Very interesting opposite conclusions here. Once we understand the natural monopoly and how it works, it all makes sense.
Thank you so much for watching, guys. I'll see you all in the next video.