9.3 Natural Monopoly

Question 1

What is a natural monopoly market?

Answer 1

A natural monopoly market occurs when there are huge fixed costs in production, such as the significant costs of infrastructure and machinery needed to supply the market, and one firm has an overwhelming cost advantage due to the massive economies of scale that can be exploited.

Question 2

What is the significant advantage of the first firm in a natural monopoly market?

Answer 2

The first firm in a natural monopoly market has an overwhelming cost advantage due to the massive economies of scale that can be exploited, which leads to the minimisation of a firm’s average costs. Given the height of the fixed costs, this requires a great quantity of output to be produced, implying that the LAC curve for a natural monopolist will be downward sloping over a much larger output range than a normal monopoly with the MES point occurring at a very large level of output.

Question 3

Why does it make no sense for firms to compete with an incumbent natural monopolist?

Answer 3

It makes no sense for firms to compete with an incumbent natural monopolist as the economies of scale differential is so great that the incumbent will simply price the new firm out of the market using predatory pricing or a short term pricing strategy that will easily out compete a newer firm, driving them out of the market.

Question 4

Why is competition not desirable in a natural monopoly market?

Answer 4

Competition is not desirable in a natural monopoly market because it would reduce the growth potential of businesses with the huge economies of scale not being exploited fully, and it would also lead to a wasteful duplication of resources with competitor firms being driven out of the market, leaving their resources idle. This is allocative inefficiency, an outcome that is not in society’s best interests.

Question 5

Natural Monopoly - Firm Behaviour

Draw Diagram

Answer 5

• A private profit maximising natural monopolist will produce where MC=M with quantity Q1 and price
  P1. Supernormal profits indicated by the shaded rectangle are being made but these outcomes are not socially desirable attracting the attention of regulatory bodies who intervene on the grounds that the service produced is essential for the function of society, for example water distribution. Prices are being charged in excess of marginal cost and quantities produced are far below the social optimum where some households are either not getting water or are excluded from receiving water.
• Regulators step in and force the natural monopolist to switch production to the allocatively efficient level where P(AR)=MC. This reduces prices from P1 to P2 and increases quantity from Q1 to Q2 promoting social welfare. However the natural monopolist suffers from losses as AR<AC at 02, with regulators having to offer a unit subsidy equivalent to the unit loss for the firm to continue producing at normal profit at this socially optimum quantity. The end result is socially optimum outcomes with high economies of scale exploitation without the wasteful duplication of resources and allocative inefficiency that would result from competition.