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natural monopoly
A monopoly is a firm that is the sole seller of a product without close substitutes and faces barriers to entry. There are three sources of barriers to entry: owning a key resource, government protections like patents, and natural monopoly. A natural monopoly exists when economies of scale mean a single firm can supply a market more efficiently than multiple firms. Utilities like electricity are often natural monopolies. Unregulated, a natural monopoly would produce where marginal revenue equals marginal cost, resulting in deadweight loss from underproduction. Regulated, a natural monopoly could be required to produce where price equals marginal cost, the efficient quantity, but would suffer losses requiring subsidy. Compromises include allowing a normal rate of return to limit profits and incentives problems but
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natural monopoly
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- 3. A firmis a monopoly if . . . ◦ it is the only seller of its product, and ◦ its product does not have close substitutes.
- 4. The fundamentalcause of monopoly is the existence of barriers to entry. Barriers to entry have three sources: ◦ Ownership of a key resource. ◦ The government gives a firm the exclusive right to produce some good. ◦ Costs of production make one producer more efficient than a large number of producers (Natural Monopoly)
- 5. Although exclusiveownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. Example: Diamond
- 6. Governments mayrestrict entry by giving one firm the exclusive right to sell a particular goods in certain markets. Example: Patent and copyright laws are two important examples of how governments create monopoly to serve the public interest.
- 7. An industryis a natural monopoly when one firm can supply a good or service to an entire market at a lower cost than could two or more firms. In other words, natural monopoly is an industry in which economies of scale are so important so that only one firm can survive. Example: delivery of electricity, phone service, tap water, etc.
- 8. A naturalmonopoly arises when there are economies of scale over the relevant range of output. Quantity of Output Average total cost 0 Cost
- 9. Quantity of Output Demand (a)A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve 0 Price Quantity of Output0 Price Demand
- 10. Quantity of Water Price $11 10 9 8 7 6 5 4 3 2 1 0 –1 –2 –3 –4 Demand (average revenue) Marginal revenue 12 3 4 5 6 7 8 Note that P = AR > MR at all quantities.
- 11. Unregulated naturalmonopoly Regulated natural monopoly
- 12. An unregulatednatural monopoly would attempt to maximize profits by producing the quantity of output where marginal revenue equals marginal cost. (MC=MR)
- 14. Exploitation tocustomers Excessive profitability strengthen the monopoly power Inequitable distribution of resources Operational inefficiency, etc If so, How to curve????
- 15. The optimalquantity of output occurs where price equals marginal cost. (P=MC) Thus, marginal social benefit equals marginal social cost.
- 17. Producing theprofit-maximizing output causes a deadweight loss. The deadweight loss is equal to the area between the demand curve and the marginal cost curve for the amount of underproduction. Deadweight loss: The costs to society created by market inefficiency due to inefficient allocation of resources. Price ceilings, price floors, and taxation are all said to create deadweight losses. Deadweight loss occurs when supply and demand are not in equilibrium.
- 19. Monopoly profit Average total cost Quantity Monopoly price QMAX0 Costs and Revenue Demand Marginal cost Marginalrevenue Average total cost B C E D
- 20. Quantity0 Price Deadweight loss Demand Marginal revenue Marginal cost Efficient quantity Monopoly price Monopoly quantity P >MC; monopoly P = MC; optimum The monopolist produces less than the socially efficient quantity P = MC; Profit maximizing
- 21. If anatural monopoly is regulated to produce the optimal quantity of output, the firm will suffer an economic loss. To keep the monopoly firm to survive would require a government subsidy to the firm to eliminate the economic loss. Economic loss: The difference between the revenue received from the sale of an output and the opportunity cost of the inputs used.
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- 23. Loss/Subsidy Quantity0 Price Demand Average total cost Regulated priceMarginal cost Average total cost The ideal public policy is to force the firm to produce Qoptimal and then subsidize for its economic loss. Qoptimal Ideal outcome Compromise outcome
- 25. To avoidthe need for a subsidy, natural monopolies are often regulated to earn zero economic profit (a normal rate of return). But, this leads the following problems: 1. The natural monopoly lacks incentives to control costs. (price may go up as cost) 2. The regulators may not be able to obtain accurate information.
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- 27. To overcomethe monopoly power or the inefficiency of monopoly firm or the inefficient allocation of resources, government can play a significant role to balance the social benefits and the costs through subsidy to the firm or determining the zero economic profit. (Profit constraints – normal rate of return, price ceiling, etc.
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