53) Monopoly Regulation

• A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve.

• The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied.

• A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the

• lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency.

Efficient Regulation of a Natural Monopoly

• An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Q_m and sets a price of P_m. There is a deadweight loss.

• A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Q_mc and sets a price of P_mc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss.

• If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

• An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Q_ac and sets a price of P_ac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated.

• Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.

• Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.