9.3 - Signposting

Question 1

Natural Monopoly Characteristics

Answer 1

1. A natural monopoly market occurs when there are huge fixed costs in production
2. The first firm in the market has an overwhelming cost advantage due to the massive economies of
   scale that can be exploited
3. It therefore makes no sense for firms to compete with an incumbent natural monopolist
4. For this reason competition is not desirable. Competition 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

Question 2

Natural Monopoly - Firm Behaviour

Draw Diagram

Answer 2

• 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.