hi everybody natural monopolies such an interesting submerge of monopoly theory brilliant market structure to to investigate and to analyze so 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 monopolies so what characteristics define a natural monopoly market then well fundamentally huge fixed costs especially your startup costs astronomically high fixed costs just a rail track the rail track infrastructure huge fixed costs their water distribution think about the pipework huge fixed cost similar with internet similar with gas electricity ridiculously high cost infrastructure costs here when it comes to start-up 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 is gonna 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 diseconomies of scale would occur where here somewhere impossible can't even see it on our diagram such is 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 undesired 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 for any other firm were to enter later they're not gonna 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 waste for duplication of resources here that is allocated inefficiency but furthermore if there is competition there is not going to be the full exploitation of economies of scale that we would like and we're not going to get down here there is going to be productive and efficiency and that's because with competition naturally firms aren't 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 their competition would result in allocated and productive inefficiency crazy to think what that's competition whereas a natural monopoly one firm dominating here would result in allocated 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 sloping as you would expect for a monopolist so we'll draw average revenue which will look something like this so a R 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 while average revenue is up there and average cost is where 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 has the supernormal 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 now it doesn't stop there and the reason that doesn't stop there is because think about the markets I said before water distribution gas electricity distribution internet distribution Railtrack 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 allocated 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 are operating at competitive outcomes the difference now compared to normal monopoly is because of the markets were talking about here utility distribution Railtrack this is deemed not good enough by regulators regulators will look at this and think you natural monopolist what are you up to what do you do 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 pipe work who are not connected to gas and electricity pipe work not connected to superfast internet that's not good enough either so regulators because of the essential nature of these goods and services for the function of society will now come in and regulate the natural monopolist and where does it make sense to regulate the natural monopolist well to allocated 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 increased a 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 gonna 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 this regulator by regulating us at P star and Q star there it 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 sub normal profit being made here there is a loss there is a loss peen of that but multiply that by all of these units multiplied by all of these units we have a huge area here a huge area of sub normal profit let's label it as such sub normal profit here so the natural monopolist is saying look you're killing us regulator by forcing us to produce an price at the allocated lis 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 be a substantive a B per unit right and that will cover the loss of the natural monopolist and at least allowed 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 monopolist 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 produce 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 would get allocated efficiency and we get productive efficiency benefits whereas competition will result in allocated inefficiency and productive inefficiency very interesting opposite conclusions here once we understand the natural monopolies and how it works it all makes sense thank you so much for watching guys I'll see you all in the next video [Music]