Natural Monopolies Price Regulation-Free-Samples for Students

Questions: Explain how and why Governments may want to regulate the Price setting of a Natural Monopoly. Answers: Introduction There are different types of market structures; perfect competition, monopolistic competition, oligopolies and monopoly markets. It is argued by most economists that competition is present in the perfect competitive markets because the number of sellers are many, small in size and price takers. However, when we consider the case for monopolies, this is a market whose supplier is a sole supplier who is large in size. There is no competition in the monopoly markets and the sole supplier is the price maker. The government is always against the presence of oligopoly and monopoly markets since they are inefficient in price and outputs. The role is promoting competition in an economy by the government is achieved through monopoly pricing regulation. Being driven by the objective of maximizing profits, monopoly markets produced less output than would be for a competitive case and then sell this at a high price. The goods produced by the monopolies allow for the higher price charges since there are no close substitutes; the consumers have no other option than to accept the price offered no matter how high it becomes (Textbook Equity Edition, 2014). The natural monopoly is a special kind of monopoly existing due to the presence of high startup costs and fixed costs. Hillman (2007) noted that all pure public goods fall under a natural monopoly and it shall be seen on the analysis that its more efficient to supply pure public goods through a natural monopoly than by duplication (Economicsonline.co.uk (2017). There are two important theories that explains price regulation for a natural monopolist. These are the Average cost pricing and the marginal cost pricing (Greer, 2012). The first one is the pricing made on the basis of average c ost while the other one is the pricing made on the basis of marginal cost whether regulated or unregulated. It is expected that the natural monopolies should be maintained in the economy for some goods to be provided at a lower price. Analysis A pure public good like water is best supplied by the natural monopoly because the production costs associated to the supply falls as the number of users increase. These natural monopolies have increased economies of scale (Linfo.org, 2006). Duplication would lower the economies of scale and the competitors would fight for prices which would make the prices charged to be higher (Textbook Equity Edition, 2014). Natural monopolies are present in the case of electricity distribution. The production of electricity is not such expensive and can be done by many investors. However, the infrastructure used to get the electricity to the final users is very expensive. There are many examples of natural monopolies like the water distribution and the postal services. According to Hu?tcher (2011), the pressure on pricing on natural monopolies is very high which makes it difficult for competitors to survive in this market. According to Regulationbodyofknowledge.org (2017), natural monopolies have market powers and when a business recognizes that it falls under a natural monopoly, it limits its output level and raises its prices; the prices are set above the marginal cost. This unlike in the competitive markets results in a reduced social welfare (Tutor2u, 2017). Since most of the times the commodities offered by a natural monopolists are basic goods, such as water, electricity and communication, people cannot avoid their consumption even if prices were raised. Social welfare is lost in that the extra income used could be used in the demand for some other goods or services. The role of the government therefore is to make sure that such prices are not charged and that the monopolists charge fair prices. However, scale economies prevents this marginal cost pricing from being the optimal choice (Mankiw, 2011). The price for a natural monopoly is set by the government at the best-price for a single product; it is set equal to the marginal cost (MC) of production. Hu?tcher noted that the setting of the price by the government is with an aim of ensuring that the social welfare is maximized. However, the first-best price which is equal to MC will not apply in all the cases; sometimes the fixed costs may be higher compared to the variable costs. This would mean that Average cost (AC) would exceed the marginal production cost. For this reason, the government is forced to set the second-best price at a level higher than the first-best price, at the point where it is equal to the AC. Many natural monopolies produce many goods and services and these are priced differently. This creates a challenge for the AC to be the optimal basis for pricing; the challenge is on determining the optimal combination that would result in the lowest dead weight loss. There therefore has to be another optimal basis fo r pricing. This bring about the idea of Ramsey pricing. Ramsey noted that the reason by the government regulate natural monopoly prices is to prevent the consumers from suffering from the high monopoly prices. His idea therefore was to maximize social surplus by reducing the prices for the monopolys unique goods. Fig: Dead weight loss for unregulated Monopoly Source: Faculty.winthrop.edu (2017) The graph shows that unregulated monopolistic strategy of producing at MR = MC is resulting in a high level of deadweight loss equal to the shaded region. This is interpreted to a reduced consumer surplus and an increased producer surplus. However, deadweight loss cannot be avoided in the case for natural monopolies since the consumers are charged a price higher than the competitive price would be. The governments interest is to ensure that the smallest dead weight loss is incurred. QUN is the quantity produced from free operation, QOPT is the maximum (optimal) output that could be produced at the competitive level. Fig: Pricing options for a natural monopoly The competitive level of production is 14 units and at a price of $4; this is at the intersection of demand and the MC; this is if the natural monopoly is regulated to produce at this point. At this point, the AC can be observed to be very high and the monopoly could only make losses. The maximization of profit level for a natural monopolist is at 6 units at a price of $10; this is at the intersection of the MR and the MC; then where this solution level cuts the demand curve; this happens if the natural monopolist is left alone without any regulation (Haworth, 2017). At this point, it is also observed that the AC is below the price charged. So this natural monopoly is making abnormal profit. The breakeven point for a natural monopoly is thus at producing 10 units and selling at a price of $8; this happens if regulated to produce at a price equal to the AC. This is the point where the social surplus is maximized and the price charged is lower than what would otherwise be offered by th e unregulated monopoly; the output level is also higher (Welker, 2013). Thus at this level, the resources are allocated efficiently. The reason for regulation is observed from the graph; lets assume that the regulators allowed the division of the market into two such that each firm produces 3 units, at 3 units, the AC of production rises and thus the price for the goods rise to $11. The natural monopoly is producing at a lower AC than it would be the case for many suppliers. The price charged should be regulated to be on maximum equal to the average cost. Any price below the Ac even if the regulators push for it is not achievable unless the regulators could offer subsidies for the losses to be incurred. The subsidies help in ensuring that even after selling at the lower price below the AC, the supplier is able to break even. There is no way a regulator with an aim of improving social surplus can push for the price to be above the AC; therefore all prices above the AC are not possible unless the supplier was let to operate with no regulation. Under regulation by the government, the quantity produced is higher than for the unregulated monopoly and lower than for the competitive market. One of the solution proposed by many economies on resolving the problem of pricing the natural monopolies is to ensure that all the private natural monopolies transfer their ownership to the government. This could improve efficiency as the losses the government makes will be catered for in its budget. This would help in skipping all the pricing challenges for natural monopolies. The other solution is fragmenting the markets and then allowing for marginal costing. This is the realization of the fact that consumers ability to pay are different. Price discrimination would ensure that lower prices are charged in the markets for low income consumer brackets with no profit interest; the compensation for this is achieved by charging higher prices in the markets for high income bracket consumers. Through this, the government goal of improving social surplus is achieved. The government need to ensure that there is sufficient supply of the good produced by the natural monopoly. This is why the government do not allow these firms to charge a price equal to marginal cost since losses would put these firms to a risk of closing down. For a single-product monopolist, average pricing is the best regulation strategy as it ensures a breakeven point for the natural monopolist in addition to improving the consumer surplus. Conclusion The government has to consider all the production costs in setting their prices for a natural monopoly. The first-best price is not always the best price for a natural monopoly as it could lead to the natural monopoly making losses if the variable cost is small and a very high fixed cost. The average cost is the cost that determines the breakeven point of a natural monopoly; at the price where the price is equal to the average cost. There should be no natural monopoly that could be making losses. Social welfare is maximized at the price which is equal to the marginal cost. Since the natural monopoly is not able to break even at this price, the government should subsidize the difference between average cost and marginal cost for the price equal to the marginal cost to make the monopoly breakeven and at the same time maximize social welfare. It is difficult for the government to determine the true AC for a natural monopoly and thus misinformed decisions may be made by the government since these supplier report more than the true value of AC so as to be allowed to sell at a higher price and gain some profit. This can be resolved by introducing a proper strategy of estimating such costs by the government. Otherwise the goal of maximizing social welfare cannot be reached. The natural monopolists are only expected to make normal profits at the price that is equal to AC. It can therefore be concluded that there is no possibility for a natural monopolist to be left to operate freely and thus the regulators are important in restricting their prices References Economicsonline.co.uk. (2017). Natural monopolies exist when one firm dominates an industry. Economicsonline.co.uk. Retrieved 27 August 2017, from https://www.economicsonline.co.uk/Business_economics/Natural_monopolies.html. Faculty.winthrop.edu. (2017). Natural Monopoly. Faculty.winthrop.edu. Retrieved 27 August 2017, from https://www.google.com/url?sa=trct=jq=esrc=ssource=webcd=2cad=rjauact=8ved=0ahUKEwiEzs-dmvrVAhUsJMAKHUXuB9cQFggvMAEurl=http%3A%2F%2Ffaculty.winthrop.edu%2Fpantuoscol%2Fecon.215%2Fnatural%2520monopoly%2520slides.pptusg=AFQjCNHlaQFV0ul04cHGqNV4GzqkSXT2ew. Greer, M. (2012). Electricity marginal cost pricing: Applications in eliciting demand responses. Waltham, MA: Butterworth-Heinemann. Haworth, B. (2017). Natural Monopolies and Pricing Policy. Econpage.com. 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Principles of Economics Volume 1 of 2. [S.l.]: Lulu com. Tutor2u. (2017). Explaining Natural Monopoly. Tutor2u. Retrieved 28 August 2017, from https://www.tutor2u.net/economics/reference/natural-monopoly. Welker, J. (2013). Monopoly prices to regulate or not to regulate, that is the question! Economics in Plain English. Retrieved 28 August 2017, from https://welkerswikinomics.com/blog/2013/03/04/monopoly-prices-to-regulate-or-not-to-regulate-that-is-the-question/