Economics Business Price Regulation and Natural Monopoly

Question: Discuss about the Economics Business for Price Regulation and Natural Monopoly. Answer: Introduction Natural monopoly exists in an economy when the operation of a single firm in a market is socially optimal. Efficiency in production and resource allocation are both achieved in a natural monopoly (Nowotny, Smith, Trebing, 2012). There are high amount of fixed cost in some industries, where a single firm can operate efficiently. The size of the market, cost of operation, availability of resources, and market structure of the industry naturally restricts the entry of other firms in the industry. A single firm can obtain economies of scale during single operation. Production by multi firm is costly in this market. John Stuart Mill advocated for government regulations in the natural monopoly market (Crozet, Nash, Preston, 2012). The study analyses different types of costs exist in a monopoly market and price determination strategy in the natural monopoly market. Natural monopoly in an economy exists in the sectors such as railways, telecommunication and infrastructure. There is a tendency of the natural monopolists to exploit the market charging higher prices. Hence, government often takes initiative to control price in natural monopoly to bring efficiency and correcting market failure. This essay analyses costs and benefits of natural monopoly in a specific market structure. Benefits of natural monopoly It is generally seen in the economy that increase in competition brings operational efficiency by increasing supply and keeping downward pressure on the market price of a product. Firms gain allocative efficiency also regarding resources. However, in some cases it is seen that market demand is not much to necessitate operation of more than one firm in the market (Joskow Wolfram, 2012). The rationale behind existence of single firm is that multiple firm have higher average cost compared to the average cost of a single firm at a given scale of operation. A single firm with large scale can operate on the falling portion of the total average cost curve, where economies of scale exist. Natural monopoly is commonly seen for the services such as water supply, electricity, railways, garbage cleaning in cities (Minamihashi, 2012). Economies of scale exists firm operates at the falling segment of average cost curve. Cost per unit of production decreases over a long range of output. Average total cost falls as the fixed cost remains same and the variable costs decreases due to increasing returns to scale. Baldwin, Cave, Lodge (2012) mentioned that natural monopoly is a problem for the economy if it is unregulated. A firm in a natural monopoly framework may charge a higher price for a smaller output if it is unregulated. Government thus intervenes in the market to bring social optimality in price and output decision. The above diagram depicts that average cost is falling continuously over the production. Average total cost curve lies above the marginal cost curve. Economies of scale exist on the falling segment of LRAC curve. Natural monopoly is generally seen in the market for necessary goods, which requires expensive infrastructure and high fixed cost for production (Crew, 2012). Therefore, entry in this market is not easy. A firm is a price setter in a monopoly market. A natural monopolist wants to maximise profit by producing at the level where marginal cost curve cuts the marginal revenue curve and sets price equalling with its average revenue. At this level, price is P1 and quantity production is Q1. P1AFC1 is the economic profit of the firm. In this situation, if price is unregulated, profits are excessive and more than the competitive profit. High level of profit is charged by producing little output. It indicates both production and resource allocation inefficiency. Role of government and costs of natural monopoly In order to correct the production and allocation inefficiency, regulators can choose any of the two options such as average cost pricing or marginal cost pricing. Average cost pricing is adopted to gain allocative efficiency. P = average revenue = MC is the level, where price is much less than that is charged by a monopolist. Quantity is also greater in this case. At this point, as P ATC, firm makes economic losses. Average cost is above the marginal cost. However that price is socially desirable, when thinking about consumer welfare (Williams, 2016). A firm cannot be able to continue production by incurring loss in long run. In that case, government has to provide subsidy to keep the firm in business. Large amount of subsidy increases government expense. It is not optimal to finance a loss making firm for long term. Therefore, P= LRMC is not welfare maximising price. Government has several options to minimise the extent of monopolisation such as average cost pricing, taxes and subsidies, price ceiling. Marginal cost pricing is associated with some extent of welfare loss and requires government assistance (Makholm, 2015). Therefore, government has another option such as average cost pricing. This is similar to the competitive pricing. Firm produces output at the level Q* and is able to set price at P* level, where price is equal to the average revenue like a competitive firm. At this level, firm incurs only normal profit. This is a optimal solution from both consumer and producer end as the firm does not make any loss and the total output in the market is Q*, which is greater than monopoly output and less than marginal cost pricing output (Numa, 2012). Regulation is required in the market to correct the market failure. Firm in a monopoly market behaves to maximise profits. Profit maximisation leads to increase in price lowering output. In the view of (Poudineh Jamasb, 2014), monopoly price leads to transfer of wealth from consumers to sellers. As the seller charges a higher price to the consumers, some consumers leave the market without buying the product. Therefore, deadweight loss is created in the market leading to the welfare loss. A part of the consumer surplus, which is lost but not appropriated by the suppliers (Westphal, 2014). The triangle ABD is the deadweight loss in the market. Example of natural monopoly The analysis can be done using the example from Australian economy. There are controversies regarding the presence of natural monopoly nature in the telecommunication model in Australia. It has been argued that as per structure of the geographical area of Australia, every house and business premise in Australia requires single electrical connection and water pipe line. Therefore, single telecommunication connection is enough for residents. LeMay (2014) stated that National Broadband Network provides telecommunication infrastructure such as electricity cables, water, gas, sewerage pipes. In this given infrastructure and demand, multiple telecommunication connection may lead to inefficient use of societys resources. Wastage of resources has some economic cost. Wastage of resources has some opportunity costs as the wastage resources could have been used in other productive purpose. However, (Hilmer, 2014) stated that NBN in Australia is not a natural monopoly and this body is under government regulation. The argument is that natural monopoly does not require any legislative protection. NBN has potential competitor in the market such as TPG telecom. Therefore, in order to keep this monopoly power of NBN, government support is required. The practice of cross subsidy prevails in Australia economy in case of telecommunication services. As per the cross subsidy, urban users have to pay more of cost of providing telecom services. On the other hand, rural users pay less than the cost. This is a kind of price discrimination applied by monopolists to hold the market share. Cross subsidy make the monopoly power weaker to allow potential competitors (Preston, 2012). Hence, government often impose price ceiling to restrict market price to fall further. Ramsey pricing is a type of price discrimination seen in natural monopoly. Effect of technology and need for government regulation Hiriart Thomas (2013) cited that technology has changed much in the production process of telecommunication industry. Development of microwave and satellite technology has provided strong substitute for the traditional cable network. Technological progress generally reduces production cost or brings innovation in existing products. Innovation in product or service creates economies of scope for the monopolists. According to classical argument, a monopolist has less incentive to promote technological progress and hence investment in the research and development for innovation. As the main aim of the monopolist is profit maximisation, technological innovation may reduce the profit level by reducing price. However, Nowotny, Smith Trebing (2012) argued against this view by saying that technical progress brings production efficiency and reduces cost of operation. Moreover, product differentiation due to product innovation creates economies of scope for the firm such as NBN Co in Austral ia. A natural monopolist can make huge profit by setting price equating with average revenue and producing at the level where MC cuts Mr Curve. However, this price is not social welfare maximising as discussed above. Moreover, in the view of (Minamihashi, 2012), a natural monopolist firm may not introduce new product or service unless the marginal cost of production is than that of previous product or service. In the presence of external forces, a natural monopolist can feel pressure for spending time and money on RD in order to gain competitive advantage as seen in case of NBN of Australia. In this situation, where there is scope of free entry, natural monopolist may be feared to lose market share in an unregulated market (Baldwin, Cave, Lodge, 2012). At this stage, regulation in the form of average pricing may be effective to restrict entry of new firm in the market. At the average cost pricing level, natural monopolist earns only normal profit, where average total cost equals to average revenue. Hence, all the costs are covered with the total revenue earned. Firm gains no super normal profit. Therefore, there is no incentive for external firms to enter into the market. It can be said from this analysis that in the presence of technological progresses, government regulation and average cost pricing can correct market failure. Price regulators need to set price at the level, where both allocative and productive efficiency achieved. Conclusion The above study has discussed on the price regulation policy in a natural monopoly market. Natural monopoly is created in a market automatically due to presence of economies of scale and the market structure. In this type of market structure, fixed cost is very high. Therefore, a single firm with huge potential can operate in this market to supply products or services as per demand. The firm achieves economies of scale after the start of production process as average cost is falling continuously over a long range of output. Average cost falls due to increasing returns to scale in production. The nature of a monopolist is to produce output at the level, MR = MC. However, it sets price equating with average cost. This price output combination is not social optimal as most of the consumers surplus is appropriated by the monopolist. Therefore, regulation in this market is required to bring efficiency in resource allocation and production. Government has two options such as marginal cost pricing and average cost pricing. MC pricing is beneficial for consumers. However, at this level, firm incurs loss in long run. Therefore, no firm can sustain in the market by making loss. In this situation government has to provide subsidy at a large scale. Subsidy often distorts market by creating inefficiency. Therefore, average cost pricing is optimal for society. Firm gets normal profit by charging a competitive price and producing output greater than unregulated monopoly and less than marginal cost pricing. References Baldwin, R., Cave, M., Lodge, M. (2012). Understanding regulation: theory, strategy, and practice. Oxford University Press on Demand. Crew, M. A. (2012). Competition and the Regulation of Utilities (Vol. 7). Springer Science Business Media. Crozet, Y., Nash, C., Preston, J. (2012). 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