Natural monopoly - YouTube

In this video we’ll break down the concept of natural monopoly.

We’ll look at why they exist and discuss some examples.

After we have established their characteristics, we’ll analyze the diagram and consider how

they may be regulated.

If you have questions at any point in this video, leave them in the comments and I’ll

try to respond.

To understand the concept of natural monopoly let’s take the case of a city planning on

building a new subway system.

After the plans have been made, the project begins.

It requires the purchase of subway cars, the digging of subway tunnels, laying down tracks

and establishing a safe subway network.

The start up costs of such a project are very high.

This brings us to our first characteristic….high fixed costs.

Think about the city of Beijing with a population of over 20 million people.

A subway system that could serve that many people would be very costly to design, build

and maintain.

The high start up costs would also act as a deterrent to the entry of new firms.

Think about the financial capital they would need to have to start such a project.

In China specifically, this kind of project is only undertaken by the government.

The high fixed costs that the single firm faces are averaged out over a larger quantity

of production.

That is our second characteristic…potential for economies of scale at very high levels

of output.

The firm is able to achieve the lowest average costs by serving the entire market.

There is a greater benefit to society of having one firm as it can achieve such low average

costs and provide the consumer with a lower than if the market were competitive.

But let’s suppose for a moment that another firm does enter the market.

Why would the introduction of competition result in higher prices for consumers?

To see why this is the case, let’s look at the long-run average costs for such a firm.

If it produces quantity Q* of output, which corresponds to the very high level of output

we discussed earlier – then their average costs of production are C*.

The demand curve shows the level of demand at each price.

However, if two firms serve this market, the situation changes.

If we introduce the new demand curve as a result of some consumers choosing the new

alternative firm, this shifts the demand curve inwards for the incumbent firm.

Assume output is cut in half as two firms are present in the market.

This results in higher average costs of C1 as each firm produces an output of Q1.

Therefore, the economies of scale are best exploited by the presence of one firm only.

The presence of additional firms would result in a wasteful duplication of resources and

higher prices for consumers.

Ultimately, this means that competition actually reduces the welfare of consumers and that

the market is more efficient with the existence of one firm.

We’ll see why as we work our way through the diagram next.

Let’s look at the diagram a little further.

The long run average cost curve continues to slope downwards at increasingly higher

levels of output.

Thus, marginal costs are also decreasing as the firm increases the size of their production.

The demand curve intersects the long run average cost curve while it is downward sloping and

marginal revenue is derived from the original demand curve.

This is our basis for starting our analysis.

Next we need to determine how a profit maximizing firm would behave in this situation.

They would maximize profits where marginal revenue equals marginal cost, so let’s find

that point.

If this firm produces at its profit maximizing level of output, it will charge P* for quantity

Q*.

Its cost per unit is C*.

In this case, the firm is earning supernormal profit.

In the case of natural monopolies, the government is likely to intervene or regulate in the

interests of consumers.

In our subway example, there is a market failure as social welfare is not maximized and a small

number of people are taking the subway relative to the allocatively efficient level of output.

Society would best be served by price Ps, which would result in a quantity Qs being

consumed.

However, at this price, the firm’s costs per unit are Cs, resulting in subnormal profit,

or an economic loss.

Traditional theory suggests that the firms should leave the market at this point.

This would be worse than charging a higher price.

So what is the solution?

The government could offer this firm a subsidy of XY to help it cover its loss.

The reason they may be willing to do that is due to the higher social benefits of greater

consumption of this good.

With more people on the subway, there are less people driving, taking buses or walking

to work.

There are many other benefits of a subway system that are not included in simple cost

and revenue calculations.

Therefore the cost of the subsidy, XY times Qs, results in an outcome in which societal

welfare is improved overall.

Allocative efficiency is achieved because price is equal to marginal cost.

Productive efficiency is achieved because the firm is producing at its lowest average

cost of production.

The most common examples of natural monopolies given are public utilities companies that

provide gas, water and electricity.

These are generally necessities for consumers, so the government would want a situation in

which the largest amount of people have access to them at lower prices than if these firms

operated strictly for profit.

Social welfare is improved as a result of this regulation or intervention, or at least

the aim is to achieve that.

While I gave the example of subsidies in my analysis, there are other methods of regulating

natural monopolies such as price capping and nationalization.

We’ll look at these further in future videos.

You should now have a better understanding of natural monopolies, why they exist and

how to analyze the diagram as well.

If you have any questions, leave them below or email me at [email protected].