Discuss the Regulation of Natural Monopolies by Government (Essay Sample)

Regulation of Natural Monopolies by the Government
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Regulation of Natural Monopolies by the Government
Explain why governments may want to set the price charged by natural monopolies at the level where the demand curve cuts the average total cost curve.
A monopoly refers to the business organization which maintains exclusivity when it comes to the provision of particular commodity or service to the consumers. Monopoly can develop based on the form of the market or naturally. A natural monopoly refers to a kind of monopoly where the supplier through economies of scale comes up with the lowest cost of production. (Boundless, 2016). It is usually argued in most cases that one of the ways of increasing efficiency and reducing prices of commodities in the market is through competition. Competition compels the firms to come up with various tactics to retain and at the same time increase the number of customers.
One of the techniques being an efficient use of the company's assets to reduce average total cost. But what if the existing market demand doesn't permit an extra firm to enter the market? That is, what if an additional entry of another company into the market will cause an increase in the overall average total costs in the industry? Such a situation exists in the case of natural monopolies. Examples of natural monopolies include water, sewerage, and electric power suppliers. Under natural monopoly, it is not practical to have more than one company providing similar utilities. For example, it is unreasonable to have say three companies supplying electric power to the households and commercial businesses.
The reasons we can't have them is because of high initial capital required to initiate a national system or network of power lines. Apart from the large initial expense, it will not be prudent to have more than firm providing water since it will lead to duplication of resources and the average cost of production will also be high. The figure below illustrates what will happen if one and three companies provide utilities to the consumers. If the total demand in the industry is 10,000 units and one firm provides the 10,000 units, the average cost also known the price will be equal to £9. But if we have three companies, each will produce 3,000 units which will increase the average total cost to £17. Therefore, we can conclude that this industry requires one firm.
The main problem or issue with natural monopolies is that if they are not controlled, they will end up producing goods or services which fewer compared to the required amount and charge high prices hence making supernormal profits. For example, if electricity supply is unregulated, the supplying company will produce its output following the rule of profit maximization where the marginal revenue is equivalent to marginal cost i.e. MR=MC. Marginal revenue refers to an extra income brought about by selling an additional unit of the output. (Gans, 2014). Marginal cost, on the other hand, refers to an additional charge which the producer incurs in the production of an additional unit of output. This means that if the income as a result of sales is equal or greater than expense which a firm incurs in production, then the trade can take place.
The firm will produce the output at a point where the marginal revenue is less compared to the price charged. This will result in an increase in deadweight loss. Deadweight loss refers to an economic loss which occurs as a consequence of the inefficient allocation of resources. (McEachern, 2012). It is likely to happen in a situation where there is disequilibrium between the supply and demand. From the figure below, deadweight is represented by the area between the marginal cost curve and the demand curve which represents underproduction.
Consumers usually feel that price charged for a good or service is not reasonable compared to the product's perceived benefits. (Mankiw, 2014). This wrong perception makes the consumers shun away from the product, and this leads to lower sales. This means that the marginal cost incurred during production will be less than the price which is an indicator of inefficiency in relation to resource allocation. Inefficient allocation of resources means that the firm is producing much less output than the required amount and at the same charges high prices which translates to earning of supernormal profits.
In another scenario, the natural monopolist can decide to produce the output to a point where the price of the commodity equals the marginal cost i.e. P=MC. At this point, the marginal social benefit is equivalent to marginal social cost. To the consumers, this is the best option since the price of the goods and services is low, and there are no deadweight costs. This can be illustrated by the graph below.
Based the graph above we can observe that a consumer will be charged POPT which is far below the average total cost at the given quantity. When the average total cost is below price, the firm will lose the income and the only way business in this type of situation can be redeemed and survive is through government subsidies. This calls for government intervention through control of output and the price. The government might decide to set up a price ceiling for the utilities at the point where the price is equivalent to the company's marginal cost. However, this will lead to a scenario where the price is less than the average cost, and this can result in terrible losses. A better-controlled price under this type of market is where the firm is allowed to charge a fair-return price. A fair-return is a price which is equivalent to the total average total cost of the enterprise. In economics, this is the price which will enable the business to earn a normal profit. Most governments have come up with better strategies to regulate the natural monopolies.
One of most popular strategy is setting up a price where the average cost of a natural monopoly is equal to its demand. This means that the company will earn a normal profit which is enough to keep the business going. The earning of normal profits will imply efficient allocation of resources and increase in the welfare of the consumers. After government intervention, the natural monopolist company will sell its goods or services to the customer at the intersection point between the average cost (AC) and demand (D). This means that the user will be paying for the goods and services at Pac as shown in the figure above. Setting up a standard price by the government to the natural monopolies ensures that the companies follow or adhere to specific standards of quality. (Arnold, 2010). Sometimes firms operating under the monopolies may fail to observe quality in the provision of goods and services due to less incentive. But through government intervention, such a company can provide quality products and services.
Apart from regulating the natural monopolies through pricing, the federal government can also control the natural monopolies through other means such as through output control. Sometimes the natural monopolies may lower the quantity of the production or reduce the quality of the goods or services and charge high prices leading to earning of abnormal profits. But the government will ensure that the right output is available and correct price is charged to the consumers. It is crucial to note that the control of the monopolies by the government does not turn out the way it is supposed. The control of the natural monopolies either through pricing, output or profits distorts the incentives for the individuals operating the natural monopoly. For example, if the government decides to control the profits and ensure that the company doesn't earn the economic profits and instead gets normal profits, then the firm will have little or no incentive to reduce the costs.
Additionally, contr...