Examples of natural monopoly12/10/2023 ![]() In a situation with a downward-sloping average cost curve, two smaller firms will always have higher average costs of production than one larger firm for any quantity of total output. Thus, the economy would become less productively efficient, since the good is produced at a higher average cost. Because of the declining average cost curve (AC), the average cost of production for each of the half-size companies producing 2, as point B shows, would be 9.75, while the average cost of production for a larger firm producing 4 would only be 7.75. Thus, instead of one large firm producing a quantity of 4, two half-size firms each produce a quantity of 2. As a simple example, imagine that the company is cut in half. While unlikely, a second outcome may arise if antitrust authorities decide to divide the company, so that the new firms can compete. Since the price is above the average cost curve, the natural monopoly would earn economic profits. The firm then looks to point A on the demand curve to find that it can charge a price of 9.3 for that profit-maximizing quantity. It determines the quantity where MR = MC, which happens at point P at a quantity of 4. In this case, the monopoly will follow its normal approach to maximizing profits. The first possibility is to leave the natural monopoly alone. However, we have rounded some of the price values in this table for ease of presentation.) ![]() ![]() Table 11.3 Regulatory Choices in Dealing with Natural Monopoly (*We obtain total revenue by multiplying price and quantity. Table 11.3 outlines the regulatory choices for dealing with a natural monopoly. Points A, B, C, and F illustrate four of the main choices for regulation. What then is the appropriate competition policy for a natural monopoly? Figure 11.3 illustrates the case of natural monopoly, with a market demand curve that cuts through the downward-sloping portion of the average cost curve. The Choices in Regulating a Natural Monopoly Before the advent of wireless phones, the argument also applied to the idea of many different phone companies, each with its own set of phone wires running through the neighborhood. The same argument applies to the idea of having many competing companies for delivering electricity to homes, each with its own set of wires. Installing four or five identical sets of pipes under a city, one for each water company, so that each household could choose its own water provider, would be terribly costly. It would make little sense to argue that a local water company should be divided into several competing companies, each with its own separate set of pipes and water supplies. Public utilities, the companies that have traditionally provided water and electrical service across much of the United States, are leading examples of natural monopoly. As a result, one firm is able to supply the total quantity demanded in the market at lower cost than two or more firms-so splitting up the natural monopoly would raise the average cost of production and force customers to pay more. This typically happens when fixed costs are large relative to variable costs. A natural monopoly arises when average costs are declining over the range of production that satisfies market demand. A natural monopoly poses a difficult challenge for competition policy, because the structure of costs and demand makes competition unlikely or costly. Contrast cost-plus and price cap regulation.Interpret a graph of regulatory choices.Evaluate the appropriate competition policy for a natural monopoly.By the end of this section, you will be able to:
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