Price Setting in Natural Monopoly-Free-Samples-Myassignmenthelp

Question: Explain how and why governments may want to regulate the price setting of a natural Monopoly. Answer: Introduction A monopoly refers to a market structure where there is only one provider of a service or a product without any close substitutes or competitors. Riley (2015) notes that in such a setting, the market must not be necessarily nationwide but the term monopoly can be used in reference to a territorial market. Having noted the foregoing, attention is given to the term natural monopoly. It is noted that the term natural monopoly is not in any manner used in actual reference to the actual number of providers of the same service or product in a particular market setting. Instead, refers to the interconnection between demand for a service or a product and the supply technology employed to avail the service or a product to the consumers. A natural monopoly therefore refers to a situation where either one of the firms in a particular industry is able to meet the demand of a common product or service at the lowest cost where otherwise it would be costly for two or more firms to meet (Riley, 2015) . A natural monopoly presents a dilemma to public policy. This is in the sense that whereas they imply production efficiency, at the same time, the lack of competition presents the monopoly firm the opportunity to exploit consumers for profit maximization. In a natural monopoly market where there are two or more firms, two outcomes are likely. In the first instance, the firms are likely to merge or they will fail and leave one dominating the market. In this case, competition in such a market will be short lived. In the second instance, the two forms may continue to operate parallel to each other, in which case the high cost of production will consume more resources which will be an inefficient operative standard (Minamihashi, 2012). On this front, one can argue that to ensure efficiency, competition in a natural monopoly is not a viable regulatory mechanism. Rather, the adoption of direct controls as a viable regulatory mechanism should be considered. This paper examines in great detail the economics of scale for a natural monopoly and briefly presents the advantages and disadvantages of a natural monopoly market structure. The need for the regulation of prices and means of regulation are then discussed before drawing a general conclusion. The information contained in this research shall be beneficial to the consumers, the public and students, all of whom need to appreciate the importance of natural monopolies and the economic considerations to be noted when dealing with a similar market structure. Analysis A monopoly market is characterized by entry barriers which present obstacles to other firms intending to break ground into the industry or market dominated by the monopoly firm. This allows the dominant firm to continue operation as a sole provider of the product or service in the industry and in turn make supernormal profits as shown in figure 1 below. These barriers come in the form of patents, licenses, high start-up capitals, economies of scope, product differentiation, among others. Of particular interest in this research is the barrier of economies of scale where unit cost reduction is dependent on output size. This barrier is discussed in detail below. Economies of Scale for a Natural Monopoly As noted above, monopolies present a challenge of having the latitude to produce products at lower output levels such that the end product is priced higher than it would in a competitive market setting. In essence, the restricted output levels maximize profits without taking into account consumer welfare (Welker, 2013). However, due to economies of scale, it is most economically sensible when only a single firm operates in a certain market such as is the case in the natural gas industry, cable TV, water and sewerage, electricity, among others. In a natural monopoly, the monopoly holder sets the product price and output levels based on the profit maximization rule. This rule holds that unregulated firms produce at the level where marginal revenue equals marginal costs. The challenge with this rule is that for such firms, marginal cost and average cost is lower than the price charged and therefore, if the profit maximization rule is applied, this would result in allocative inefficiency whereby the product will not be affordable to some consumers (Opentextbc.ca. 2016).The diagrams below illustrate the economies of scale in a natural monopoly: Fig (1): Pricing in a monopoly market Source: Tejvan (2016) MR- Marginal Revenue, MC- Marginal Cost, Qm- monopoly output, Pm- Monopoly price From the above illustration, the natural monopoly will endeavor to maximize profits at output and price by achieving a level where marginal revenue equals marginal cost. From the above diagram, the red shaded area represents the supernormal profits while the blue area represents the deadweight welfare loss in a competitive market structure. Fig (2): Economies of scale Source: Tejvan (2016) From figure 2 above, it is illustrated that if a firm produces at Q2, the average cost will be AC2. Therefore, a monopoly can increase the output to Q1 in order to draw benefit from lower average cost (AC1). Therefore, the conclusion is that it is more economically efficient to have a monopoly in high fixed cost industries as opposed to having several smaller firms. Advantages and Disadvantages of Natural Monopoly The economic theory holds that everyone is motivated by self-interest (Thoma, 2014). This simply means that everyone is assumed to be more focused on self-preservation. Applying this theory to a natural monopoly, one would then argue that a monopoly is likely to be focused on improving its products and where possible lower costs. Due to the advantage of supernormal profits, a natural monopoly is able to invest in research, development and technology to achieve its objective. By being able to reap the benefits of such investment, firms are provided with the incentive to do further research and development and to patent their ideas. This mutually benefits the firm, the market and the economy (Agarwal, 2017). The other advantage is that from the economies of scale, increased output translates into decreased production costs and this can ultimately be beneficial to the consumer in the form of low prices and quality. On the down side, a monopoly market structure is likely to focus on profit maximization by producing lower output and charging high prices. This is likely to result in a deadweight welfare loss and a decline in surplus as illustrated in Figure 1 above. The high prices may result in allocative inefficiency and supernatural profits and ultimately, it is the consumer who will lose. Further concerns include the fact that as a monopoly gets bigger, it may experience lower average costs (Agarwal, 2017). Price Regulation As noted earlier in the introductory part of this research, natural monopolies present regulatory dilemmas to the government. This is so because there is the concern that where there are two or more firms, the firms will either merge or one will fall and the consequences are that there will be no competition in the market as idealized for a perfect market setup or alternatively, if the two firms continue parallel operation, there will be a high cost of production which will consume more resources and lead to inefficient operative standards. From the foregoing, it is therefore imperative that only one firm can operate as a natural monopoly in certain industries, some of which were identified earlier. The challenge with this market structure is that an unregulated monopoly will certainly strive to live by the profit maximization rule which might result in undesirable outcomes such as allocative inefficiency. It is for these reasons that the need for government intervention will be necessary in the form of regulation. This can be achieved by employing direct controls as the most viable mechanism of regulation (Arnold, 2008). Below is a discussion of some of the regulatory options that are adopted to keep natural monopolies in check: Price Caps or Ceilings Stigler (2008) argues that regulators should be allowed latitude to set prices at levels likely to induce productive and allocative efficiency. If the government is concerned about getting the right product quantity to the right number of consumers and maintaining allocative efficiency, it will have to set a price ceiling for the particular product or service to ensure the price of the product equals the marginal cost of the monopoly firm. However, if this cap is below the firms average total cost (as it is in most cases) it would mean that the firm will suffer loses and may eventually shut down. To avoid such a scenario, the government would set a price cap at the level where the price equals the average total cost. This ensures that the firm will only earn a normal profit, enough to keep it a going concern and this is referred to as the fair-return price (Welker, 2013). Price Discrimination Simshauser Whish-Wilson (2015) argue that it is demonstrated that allocative efficiency can be enabled by charging consumers different prices even when production and supply costs remain constant. This approach employs the Ramsey pricing method which, taking into account the price elasticity of goods, allows for the setting of the price closer to the marginal cost. However, caution must be taken to avoid predatory discrimination through severe prices. Peak-load Pricing In the economic world, there arise variances in demand and supply. The theory of demand and supply is alive to the fact that at certain periods, demand is likely to be high and low during others, which in turn affects supply. Peak-load pricing can be used to attain marginal cost pricing during such periodic cycles. The idea is that since marginal cost increases with the output, the variation of price creates an opportunity for it to reflect the high costs, the demand cycle can therefore be moderated and capacity used more effectively (MBASkool.com, 2008). Conclusion In sum, it is agreed that natural monopolies present regulatory dilemmas to the government which must be navigated to maximize on the economies of scale. Without regulation, a natural monopoly will endeavor to maximize profits at output and price by achieving a level where marginal revenue equals marginal cost. This, at the very least, is likely to result in a deadweight welfare loss and a decline in surplus. Conversely, the high prices may result in allocative inefficiency and supernatural profits and ultimately, it is the consumer who will benefit least. The lack of competition in natural monopoly (and the fact that it would be productively inefficient to have two firms operating in a natural monopoly) leaves the firm with the latitude conduct its business with the aim of profit maximization. It is for these reasons that the need for government intervention will be necessary in the form of regulation which must be in the form direct controls as the most viable mechanism of regulation as opposed to competition. The various modes of price regulation include price caps or ceilings, price discrimination and peak-load pricing as discussed in detail above. Besides price setting, the readers are encouraged to explore other alternatives to price setting as a mode of regulating the monopoly industry. These include the contestable market theory which states that string constraints are exercised by an incumbent monopoly where there is a threat of a potential entrant and thereby, pricing is more likely to be maintained closer to cost. Other options include entry regulation, auctioning and public ownership of monopoly firms (Moszoro, 2014). Bibliography Agarwal, P. (2017).Monopoly Market Structure.Intelligent Economist. Retrieved 30 August 2017, from https://www.intelligenteconomist.com/monopoly-market-structure/. Arnold, R. (2008).Microeconomics(8th ed., pp. 213-216). Thomson Learning Inc. MBASkool.com. (2008).Peak Load Pricing Definition | Operations Supply Chain Dictionary. MBA Skool-Study.Learn.Share. Retrieved 30 August 2017, from https://www.mbaskool.com/business-concepts/operations-logistics-supply-chain-terms/2084-peak-load-pricing.html. Minamihashi, N. (2012). Natural monopoly and distorted competition: Evidence from unbundling fiber-optic networks. 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(2013).Monopoly prices to regulate or not to regulate, that is the question!Economics in Plain English. Retrieved 30 August 2017, from https://welkerswikinomics.com/blog/2013/03/04/monopoly-prices-to-regulate-or-not-to-regulate-that-is-the-question/.