Natural Monopoly Identification and Regulation

Question: Discuss about the Natural Monopoly Identification and Regulation. Answer: Introduction: According to Vikharev (2013), a natural monopoly exists in an industry when the only firm experiences are decreasing cost condition over a long range of output due to economies of scale. In this situation, if the market is divided among more than one firm, then average cost (AC) will be higher. Therefore, from the point of view of cost minimization, it is better that only one firm should exist in such an industry. From the point of view of Stiglitz Rosengard (2015), it can be notified that natural monopoly exists in public utility services such as transport, communication, and supply of electricity, fuel, water and much more. In this perspective, the government of the concerned country intervenes in the market and regulates the market price at that point where the demand curve cuts the average total cost curve. The main reason behind the fact is that it covers the unwanted loss in the economy. As argued by Nizovtseva (2013), the cost-benefit analysis is the main motive of the government. In this research essay, the regulation of the government in the natural monopoly has been critically analyzed along with the cost-benefit approach. Discussion: To critically analyze the reason of government regulation in the natural monopoly, the researcher needs to consider the equilibrium condition and profit maximization point of the monopoly market. According to Minamihashi (2012), a monopoly is said to prevail if there is a single seller in the market for a product which has no close substitutes and there are barriers to entry and exit. Apart from this, sometimes the size of the market may be such as not to support more than one firm of optimum size (Saglam, 2016). The examples are transport, electricity, telephone, fuel and water. There are substantial economies which can be reaped at a large scale of output. A single firm can supply the desired output at a lower cost than two or smaller forms can. These types of firms are known as natural monopolies (Soda Carlone, 2013). In the monopoly market, the short-run equilibrium of a monopolist occurs at the point where Marginal Revenue (MR) = Marginal Cost (MC) and the slope of MR is less than the slope of MC. As per this figure, the short-run equilibrium point under monopoly market is E at which the above stated two conditions are satisfied. As a result, the equilibrium price is p* and the equilibrium quantity is q* under the monopoly market. On the other hand, as per this figure, the ATC is less than the equilibrium price of monopoly (p*). Thus, the rectangular area p*cdf represents the profit of the monopoly firm under short-run. In this situation, both the MC and ATC is upward rising, and the monopoly firm attains the supernormal profit. Therefore, the government has no power to regulate its equilibrium price and quantity (Wang Yang, 2012). In the case of long-run also, monopoly firm achieves the profit, and there is no need to government regulation for setting the price according to its opinion. According to this figure, the long-run equilibrium is at the point E at which MR = LMC = LAC = SMC = SAC and change in MR are less than the change in MC. The rectangular area p*cEd represents the profit of the monopoly under long-run. In this perspective, it can be notified that the amount of long-run profit is much higher than the amount of short-run (Yang, Tang Nehorai, 2013). On the contrary, the above situation is slightly differed in the case of natural monopoly. According to Nizovtseva (2014), a natural monopoly is a firm that can produce the entire output of the market at a cost which is lower than what it would be if there were several firms. This situation usually arises when there are strong economies of scale (Belousova, Bushanskiy, Livchits Vasilieva, 2015). As a result, the Long Run Average Cost falls (LAC) over the entire range of output and in this respect, LMC always lies below in LAC. In short, both the LMC and LAC curves are downward sloping. Now, given the market demand curve and corresponding MR curve, the equilibrium price and output are p* and q* respectively. In the context of the above figure, if the firms are unregulated, then, it would produce the potential output at q* level and charged the price at p*. The monopoly equilibrium point is E at which the equilibrium conditions are satisfied. However, if the monopolist is a private producer, then the government of a country attempts to control the price and output. As opined by Khan (2014), the main reason behind the fact is that the motive of the private producer is to earn a profit. On the contrary, in the case of natural monopolies, public utility services such as communication, infrastructure, and transport, the supply of electricity, water and fuel are not profit earning projects. As a result, government intervention is needed to eliminate the dead weight loss from the economy (Carvalho Marques, 2014). If the government wants to fix the price equal to MC which is same as the competitive price, then the equilibrium price will be reduced, and output will be increased. Now, the equilibrium point is at E1 at which the corresponding price is P1, and the quantity is Q1. On the contrary, as per this figure, at the equilibrium point E1, the monopolist will incur a loss. In this situation, the price could not cover the LAC. At the point E1, P = LMC LAC. The loss is represented by the rectangular colored area P1C1C2E1. As a result, as per the view of Belousova, Bushanskiy, Livchits Vasilieva (2015), to avoid the pure economic losses, the firm would go out of business. Thus, to make it stay in business, the concerned government of the country should provide a subsidy to the monopolist. This subsidy also compensates the pure economic loss. However, in the words of Hawley (2015), the provision of subsidy from general tax revenue involves the increased government expenditure. As a result, the government may not adapt such a policy always. As per the view of Carvalho Marques (2014), this policy is known as Marginal Cost Pricing (MC Pricing). On the other hand, the concerned government may set the price at P2 which is equal to LAC. In this case, the equilibrium is achieved at the point of E2 where the AR curve and the LAC curve intersect to each other. The equilibrium level of output is much less than the amount of output in the case of MC pricing. Moreover, at the same time, the price will be higher than MC. In this figure, the price is P2 under AC Pricing which is much higher than the price level, P1 under MC pricing. In this perspective, as per the view of Guha (2016), the monopoly firm neither earns any monopoly profit nor suffers losses. The achieved amount of output, Q2 is large enough as it can exist without driving the firm out of business. According to Preston (2012), it is known as Average Cost Pricing (AC Pricing). It can be pointed out that there is, of course, some dead weight loss in the economy, but the amount of dead weight loss is less than the dead weight loss under monopoly pricing. In other words, as per the view of Wang Yang (2012), both the equilibrium price and output under AC pricing are less desirable than those under MC pricing. Furthermore, under AC pricing there will be some loss in the welfare of the buyers. On the contrary, in the words of Yang, Tang Nehorai (2013), to avoid the extra expenditure, the concerned government may adapt the AC pricing. In this perspective, it may be noted here that to adapt a proper pricing policy for controlling the natural monopoly, the associated market demand curve and the cost function of the private producer who is the monopolist must be known to the government (Starc, 2014). In the absence of such knowledge, control of natural monopoly by the government is not possible. As a result, the government in most of the cases supplies such services so that the private monopoly does not exist (Vikharev, 2013). In this consequence, it can be notified that under monopoly market situation, the firm faces some dead weight loss and both the price and output are not so much significant compare to the price and output under perfect competition (Stiglitz Rosengard, 2015). According to this figure, the firm under the monopoly market faces a high price, and low level of the output compare to the firm under the perfect competition. With the help of cost and benefit analysis of consumer surplus and producer surplus, it can be pointed out that the triangle are b and c are the dead weight loss in the economy. The sum of these triangles (b + c) indicates the pure economic loss of the economy. As a result, the concerned government intervenes in the market to correct and regulate the market so that the economic loss is eliminated (Nizovtseva, 2014). By referring to the above analysis, it can be inferred that the primary motive of the government is to eliminate the dead weight loss from the economy. Now, in the case of natural monopoly, public utility services are delivered. The private producer, as well as the monopolistic firm, cannot be able to produce the socially optimum level of output alone (Soda Carlone, 2013). The public utility services such as telephone companies, gas pipelines, railroads, electric services, fuel, and water are not instant profit earning projects. Moreover, in the words of Nizovtseva (2013), the Marginal Private Benefit (MPB) is lower than the Marginal Social Benefit (MSB) which can be mitigated by the regulation of the government of the country in the form of subsidy. Now, in the case of MC pricing, P = MC which indicates that if demand increases, the electricity utility cannot be able to supply the desired quantity demanded (Saglam, 2016). Therefore, it ensures to increase the price to the point at which the existing capacity is equal to the quantity demanded. Now, in that situation, LAC is greater than P. Therefore, a huge amount of loss is incurred which is borne by the government (Minamihashi, 2012). Thus, to get rid of this unwanted burden, the government prefers to choose the AC pricing. Though there is some dead weight loss, the pure economic loss can be eliminated. Conclusion: Based on the above analysis of the regulation of natural monopolies, it can be concluded that AC pricing is more preferable than the MC pricing. One of the drawbacks of monopoly market is that it incurs dead weight loss compare to the perfect competition market structure. As a result, the government wants to regulate its price as well as quantity to eliminate the dead weight loss. In this perspective, a natural monopoly is that type of firm which experiences the decreasing cost condition over a long range of output. This can be done due to the presence of economies of scale. Moreover, the cost minimization process is better if the only one firm exists in the market rather than more firms. In short, the natural monopolies serve the public utility services. In this perspective, the private producer cannot be able to achieve the socially optimum level of output during the production of this type of service. Thus, the government regulation is needed efficiently to control both the price and quantity. If the government sets its price at the point of MC pricing, then a huge amount of pure economic loss is incurred which is unwanted. 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