If one of the two firms grows larger than the other, it will have lower average costs and may be able to drive its competitor out of the market. In addition, the antitrust authorities must worry that splitting the natural monopoly into pieces may be only the start of their problems. 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 being 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 each producing 2, as shown at point B, 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. Since the price is above the average cost curve, the natural monopoly would earn economic profits.Ī second outcome arises if antitrust authorities decide to divide the company, so that the new firms can compete. 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, some of the price values in this table have been rounded for ease of presentation. *Total Revenue is given by multiplying price and quantity. Regulatory Choices in Dealing with Natural Monopoly Table 1 outlines the regulatory choices for dealing with a natural monopoly. The most likely choice is point F, where the firm is required to produce a quantity of 6 and charge a price of 6.5. However, if the firm is required to produce at a quantity of 8 and sell at a price of 3.5, the firm will suffer from losses. The regulators might require the firm to produce where marginal cost crosses the market demand curve at point C. If antitrust regulators split this company exactly in half, then each half would produce at point B, with average costs of 9.75 and output of 2. This monopoly will produce at point A, with a quantity of 4 and a price of 9.3. A natural monopoly will maximize profits by producing at the quantity where marginal revenue (MR) equals marginal costs (MC) and by then looking to the market demand curve to see what price to charge for this quantity. Regulatory Choices in Dealing with Natural Monopoly. Points A, B, C, and F illustrate four of the main choices for regulation.įigure 1. So what then is the appropriate competition policy for a natural monopoly? Figure 1 illustrates the case of natural monopoly, with a market demand curve that cuts through the downward-sloping portion of the average cost curve. 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 broken up 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 seems to make competition unlikely or costly. Contrast cost-plus and price cap regulation.Evaluate the appropriate competition policy for a natural monopoly.
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