ECON8069 Business Economics : Public Interest Theory

Introduction

A natural monopoly refers to an industry in which it is most efficient to have only one firm as opposed to several smaller firms providing the same product or service. Due to the high fixed costs, it becomes impractical to have several firms offering the same goods or services in that industry (Pettinger, 2012). Examples of natural monopolies include water and sewerage, natural gas industry, electricity, cable TV, railway lines, among others. In such industries, it defeats economic sense to have several firms laying underground pipes and other infrastructure to provide the same goods or services since the average costs will be much higher than they could be if only one of the firms offered the services in the particular industry (Gallego, 2017).

The regulation is governed by various theories. The first is the Public Interest Theory (PIT) where the government is responsible for promoting social welfare. The next is capture theory where the industries interest is served and lastly the public choice theory where the agencies theory is served.

This paper discusses the scale economies of a natural monopoly and examines the need for regulation of natural monopolies by the government and further the various ways the regulators use to intervene in price setting for natural monopolies. The government may choose the average pricing strategy of the price ceiling strategy Consumers are to benefit most from the information contained in this paper and also students who generally need to understand the importance natural monopolies in specific industries and how the government plays a role in regulating these monopolies.

Economies of Scale for a Natural Monopoly

Natural monopolies are sole suppliers with high level of economies of scale. The term “economies of scale” explain the reason for the existence of a natural monopoly and is used in description of the competitive advantage enjoyed by large firms over small ones which means that the larger a firm is, the lower its costs of production are. An example is when unit production costs decrease with quantity (Amadeo, 2017). Therefore, as explained above, in some of the industries which were identified earlier, it is more efficient to have a single firm in operation rather than several firms. The essence is that due to the high fixed costs, it will not be tenable to have more than one small firms. Figure 1 below is used to explain the economies of scale in a natural monopoly:  

As illustrated in fig (1) above, there are processes when the average production cost reduces over the entire range of demand, thus cementing the fact that one firm can meet the whole demand at lower costs than having several forms. It is at such production processes that a natural monopoly may be born. From the graph above, a natural monopoly may be producing 3000 units at an average cost of £17. However, we can see a reduction in cost from £17 to £9 if the firm’s production rose from 3000 to 10,000 units. The 10,000 units is the maximum output that be produced since the demand curve is equal to the long run average cost. Producing any units lower than 10,000 is inefficient to the natural monopoly as it is on a higher cost. In such an industry, therefore, it is economically sensible to have only one firm to produce all the 10000 units to lower the production costs and at the same time to meet the demand. Competition by other firms would only make the natural monopoly to produce at a higher cost. In additional to the presence of economies of scale, presence of barriers to entry and high start-up capital are also some other contributing factors (Cliffsnotes.com, 2016). For instance the capital for electricity distribution is very high such that entrance to this industry is limited.

Following the above analysis, Gallego (2017) states that natural monopolies are necessitated by economic and technical consideration which include high capital costs, barriers to entry and economies of scale. Gallego proceeds to state that the existence of natural monopolies has nothing to do with legal imperatives. Therefore, it is arguable that the term “natural” implies the absence of such acts as collusion, takeovers or mergers. The main distinguishing characteristics of s natural monopoly are high industry costs with one firm being able to produce and supply the product or service at low costs than smaller competitors (Mankiw & Taylor, 2011).

The advantage of having a natural monopoly is that the only firm will be able to use the limited resources of the industry to produce goods or services at volumes that will service the entire market and at low unit prices. Further, natural monopolies avert the possibility of a highly competitive market and high cost which would be unsustainable. However, as necessary as natural monopolies are, at times, firms that realize this form often tend to exploit their status for their own benefits by increasing prices and lowering output (Investopedia, 2017; Thoma, 2014).

E₁: P=MC; E₂: P=AC; E₃: MR=MC

If unregulated, the natural monopoly may develop a profit maximization policy which would be unbearable to the market. Figure 2 shows the AR, MR, AC and MC curves of a natural monopoly firm. The most efficient allocation of resources is achieved when the price equals marginal cost (P=MC) which means the price for a unit is equal to the unit’s additional cost.

Points E_1, E₂ and E₃ represent the options available for a natural monopoly in price setting. E₁ represents a competitive solution, E₂ represents the average cost pricing solution while E₃ represents the monopoly profit maximization solution. Ghosh (2016) argues that the competitive solution is the most efficient because output oq_c is the largest and price op_c is the smallest whereas the monopoly profit-maximization is the least preferable option because output oq_m is the smallest where price op_m is the highest. Therefore, without regulation, the monopoly would prefer to operate at point E_{3 .}since this is the most profitable level for the monopoly firm.

The Need for Regulation

Various theories have been fronted to justify the need for regulation. In the first instance, the public interest theory holds that regulation is meant to safeguard public interest and therefore officials must act in ways meant to serve the public interest. There is also the capture theory which proceeds that the regulatory agency is susceptible to being controlled by the industry under regulation and regulation may be used to serve the interests of the industry. Finally, the public choice theory holds that regulation serves the government interests and the regulatory agency will choose an approach that will be beneficial to the agency (Den Hertog, 2010).

Pettinger (2012) argues that being uncontestable and by the fact that natural monopolies do not have any real competition, without government intervention, they are likely to abuse their power and inflate product prices. From figure 2 above, if a natural monopoly is left unchecked, it would prefer to operate at point E₃ where MR=MC which is the monopoly profit maximization solution. At this point, the firm will decide to supply very little products or services at very high unit prices. Riley (2015) notes that a natural monopoly raises complications for the competition policy because whereas it is most productively efficient to have only one dominant firm in an industry, there is the temptation that these firms may exploit their market power to raise product prices to make supernormal profits at the expense of the consumers’ welfare.

Welker (2013) argues that a firm in a natural monopoly is given to produce at a point where the product price will be greater that the marginal cost. At MR=MC, the marginal cost will be lower than the price and marginal revenue will be lower than the price charged and thus profit will be made. Consumers will be charged higher prices because the goods or services are limited; this then is indicative of allocative inefficiency where the quantity in demand will not be met while price will be high. Besides excessive prices, it is argued that the firm in a natural monopoly lacks incentive to offer high quality products as services (Minamihashi, 2012). These therefore justifies the need for government intervention in the form of regulations.

Price Regulation for Natural Monopoly

Having noted the foregoing, it is important that due to the substantial threat represented by natural monopolies to the free markets and consumers, the government has to device approaches through which it can regulate the price (Boundless, 2016). The approached regulators can choose to employ include average cost pricing and price caps as discussed in detail below:

Average Cost Pricing

When regulating a natural monopoly, regulators must ensure that the natural monopoly operates at the point where all its costs are recovered. The regulators can choose to employ the method of average cost pricing whereby the regulators ensure that the natural monopoly operates at the point where all its costs are recovered shown in the figure above.

From the figure above, this means that the firm needs to operate at point G where P=AC which is the full-cost pricing solution. The average costing price is R and the corresponding quantity is Z. This therefore means that the price of the product will be equal to the average cost of production (Ghosh, 2016). Average cost pricing therefore compels firms operating as a natural monopoly to reduce product prices to the level where average total cost meets the market demand curve. The consequent effect therefore is that there will be increased production and decreased prices, increased consideration of the social welfare and the generation of normal profits (Stigler, 2008).

Price Caps or Ceilings

Another form of regulatory mechanism that gained traction in the 1980s and 1990s is the price cap regulation. Here, the regulator sets a price to be charged for a product or service over a certain period of years. The caps need to be revised from time to time as economic situations keep on varying. In this case, the firm is at liberty to device ways of reducing costs so as to make more profits. However, in the event that the firm cannot keep up with the caps, it may suffer losses. Based on the firm’s performance, the regulators will set new caps after the fixed period expires. Caution must however be taken because if the caps are set too low, the firm may be doomed to making loses especially if market changes are not in the firm’s favor. The possibility that the firm can earn profits or suffer losses depending on its innovativeness can serve as an incentive for efficiency and innovation (Opentext.ca, 2016). The price cap will cause the natural monopoly to maximize sales now that its not possible to sell at higher prices.

Conclusion

In sum, settled that monopolies are a necessary evil going by the economic and technical consideration which include high capital costs, barriers to entry and economies of scale. The advantage of a natural monopoly is that the single firm is be able to exhaustively use the limited resources in the industry to produce goods or services at quantities that will meet the demand and offer low unit prices and by extension avoid creating a competitive market and inefficiency which would be unsustainable. However, as necessary as natural monopolies are, in the absence of regulation, they may exploit their status. The absence of competition in natural monopoly presents the natural monopoly with the opportunity to lower production costs and increase unit prices. This connotes allocative inefficiency in the market where the quantity in demand will not be met while price will be high. Further, a natural monopoly may lacks incentive to offer high quality products as services. These, among other reasons not considered in this paper, justifies the need for government intervention in the form of regulations.

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