Question

What is the market problem with a natural monopoly? What would you recommend to do about it? Why?

Answer 1

A monopoly is a market situation in which there is a single seller who is selling a product which has no close substitute.

A natural monopoly is a type of monopoly which exists due to high costs of setting up or due to large economies of scale. It might be the only provider of a particular good or service in a particular geographical location.

Examples: water board, electricity board

Problem with natural monopoly: The main aim of natural monopolies is to maximise profit so they charge a very high price that is where MR=MC. i.e at a price of Pm in the figure below and output of Qm. This is bad for the economy becuase it is less than the socially efficient output of Qs, which is derived when AR=MC at a lower price of Ps.

In this figure,

Pm= price which the monopoly wants to charge

Qm= quantity which the monopoly wants to produce

Ps= socially efficient price

Qs= socially efficient output quantity

Cs= cost to the monopoly

Recommendations to solve this problem.

1. Introducing Price Ceiling: Price ceiling means setting a legal maximum price. The government can apply this ceiling and tell the monopoly to charge a lower price than what it actually would have so that welfare can be increased. This price should be set very cautiously because if it is set at Ps, the monopoly would incur huge losses and if it is set at Cs, the welfare won't be maximum.

2. Government Ownership of Monopoly: If government takes the ownership of monopoly firms, then the government can itself set whatever price it wants and expand welfare on its own will by earning less profits.