A monopoly is characterized by one seller, well define product that has no substitutes. For a firm to maintain its monopoly position, it is essential that the barriers to the entry to the market are high. Although, this kind of market structure leads to deadweight loss in the society by producing lower than efficient output, but still there are many instances as in case of natural monopoly, where a society is served better by the monopolist than a competitive market structure.
A natural monopoly exist in a industry where a single firm can produce output such as to supply the market at lower per unit cost than a competitive market structure. In other words, under natural monopoly, the economics of production lead to a single firm supplying the entire market demand for the product. Thus, when there are large economies of scale, it means that the average cost of production decreases as a single firm produces greater and greater output.
Western Power Corporation, for instance, is a natural monopoly holder in Australia distributing Electricity Services in the Western part of the country. Since, fixed cost of electricity production and related equipments to deliver them to the final consumers is quite high, from the point of view of the society, any sort of competition in these industries is undesirable as a group of firms will result in needless duplication of high cost capital equipments and high average cost of production.
Thus, since only Western Power Corporation is working under natural monopoly structure, the marginal cost of providing electricity to an additional home is quite low. Thus, more the electricity is produced, lower is the average cost per kilowatt hour and in this way the interest of the society is benefitted in a better way in the natural monopoly structure than in competitive structure.
The diagram above indicates that since the natural monopoly holder is able to produce the output, Q, at the level MC= MR, where the price fixed is P*, he Is able to earn an economic profit of (P*-ATC)*Q
Since monopolist produce less than the optimal quantity for the society, government regulations are aimed at improving resource allocation by regulating the prices monopolies may charge. Even the public interest theory claims to provide an explanation for government intervention in the monopoly market. As for Australia, Australian Energy Regulator is the agency responsible for the economic regulation of electronic supply and gas pipeline network.
In order to improve the resource allocation in the monopoly market, government regulation may be aimed at improving the resource allocation by regulating the price, which the monopolist may charge. This may be done through, average cost pricing or marginal cost pricing:
Average Cost Pricing:
Average cost pricing is the most common form of regulation in the monopoly market. This would result in the price of Pac and an output of Qac as illustrated in Figure below. It forces the monopolist to reduce the price where the firm’s ATC intersects the market demand curve. This will:
- Increase the output and reduce the prices
- Increase social welfare(allocative efficiency)
- Ensure the monopolist a normal profit since price= ATC
Marginal Cost Pricing:
Marginal Cost Pricing is also referred to as efficient regulation as it forces the monopolist to reduce the price to the point where the firm’s MC Curve intersects the market demand curve, which increases the output and reduces the price but causes the monopolist to incur a loss since the price set is lower than ATC, as illustrated in figure above. However, if marginal cost regulation is introduced, this will require a government subsidy in order to provide the firm with a normal profit and prevent it from leaving the market entirely.