Natural Monopoly

Definition

• A natural monopoly occurs when a single firm can supply the entire market at a lower cost than multiple firms.
• Common in industries with decreasing costs or increasing returns to scale.

Key Concepts

Returns to Scale

• Refers to how output changes as production scales up or down.
• Increasing Returns to Scale:
  • Larger production quantities reduce average costs due to cost-cutting measures available at large scales.
  • Extreme case: Average costs continue to fall as firm size increases.
  • Examples: Public utilities (electricity, gas, internet) where a single firm provides at lower cost.

Marginal and Average Costs

• Low and Constant Marginal Costs:
  • Marginal cost doesn't change with the quantity produced.
• High Fixed Costs:
  • Average cost starts high and falls towards marginal cost.
  • Average cost won’t rise until marginal costs rise.

Pricing and Regulation

Demand and Marginal Revenue

• Demand is likely inelastic; few substitutes available.
• Profit-maximization occurs where marginal revenue equals marginal cost.

Price Setting

• Natural monopolies might charge high prices due to limited quantity produced leading to deadweight loss.
• Governments regulate to avoid high pricing by setting price ceilings.
  • Price Ceilings:
    • In competitive markets, price is driven to marginal cost.
    • Price ceilings set marginal revenue by limiting maximum chargeable price.
    • Increase in quantity demanded where demand meets the price ceiling (at marginal cost).

Market Efficiency

• Efficient market outcome occurs when monopoly provides quantity at marginal cost, eliminating deadweight loss.
• Issue: Price ceiling below average cost leads to negative economic profits, potential shutdown.
• Solution: Set price ceiling at the point where demand crosses average cost for zero economic profit.
  • This point still incurs some deadweight loss, but less than without regulation.

Government Regulation

• Often regulates utility companies by setting price ceilings to provide normal accounting profit.
• Aim to achieve zero economic profits.

Strategies to Reduce Deadweight Loss

• Subsidizing consumers can eliminate deadweight loss.
• Price discrimination (second and third degree) to further reduce deadweight loss, employed by utility companies.