Question

Describe an example of a real-world industry or market that would be considered by economists to be a natural monopoly.

1. What characteristics of the industry make it a monopoly?
2. What is the impact of the monopoly power on its customers?
3. Why might government want to regulate natural monopolies?

How might such regulation be structured?

Answer 1

There are several characteritics of what a natural monopoly is :

1. It occurs when one large business can supply the entire market at a lower price than two or more smaller ones
2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices
3. It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale
4. An industry where the long run average cost curve falls continuously as output expands
5. Private utilities are natural monopolies in local markets.

A monopoly's potential to raise prices indefinitely is its most critical detriment to consumers. Because it has no industry competition, a monopoly's price is the market price and demand is market demand. Even at high prices, customers will not be able to substitute the good or service with a more affordable alternative.

As the sole supplier, a monopoly can also refuse to serve customers. If a monopoly refuses to sell an important good to a company, it has the potential to indirectly shut down that business. If the supplier sells to consumers, it can refuse to serve areas that have lower profit potential, which could further impoverish a region.

Natural Monopolies can Reduce Costs

A natural monopoly, like the water and sewage system, can prevent the duplication of infrastructure and thus reduce potential costs to consumers. Natural monopolies that are run by non-profit organizations and local governments can afford to keep prices low enough to provide services to the majority of the public. When monopolies are privately owned by for-profit organizations, prices can become significantly higher than in a competitive market. As a result of higher prices, fewer consumers can afford the good or service, which can be detrimental in a rural or impoverished setting.

Economic Repercussions of Monopolies

Some argue that monopolies are beneficial because highly-profitable companies tend to pump more funds into research and development. Because the monopoly is in a dominant position, it can comfortably bear the risks associated with innovation. However, a highly-profitable monopoly also may have little incentive for improvement as long as consumers still demonstrate a need for their current product or service. In comparison, businesses in a competitive market can compete by making changes to existing products and services and lowering prices.

Monopolies ensure there are high barriers to entry and thus no free riding or adaptations to their current patents. The labor force in a monopolized industry may also be significantly less than that of a competitive industry.

Dismantling a Monopoly

One option for policy makers would be to dismantle the monopoly. This can be accomplished by splitting the monopoly into two companies, divide their bundled products or services, or separating services into smaller competing regional services. The monopoly's separation will lower the barriers to entry for new companies. The new competition will eventually provide a wider variety of options and most likely lower prices for consumers.

For example, in the 1980s the US experienced nation-wide deregulation in the telecommunications industry. While four of the seven "Baby Bells" are back under the AT&T umbrella, the breakup is still considered a great success. Competition in the telecommunication industry again is increasing as start-ups begin using mobile technology to disrupt the cost structures of the telecom companies.

Lowering Prices with Policy

Another option for policy makers would be to focus on lowering prices instead of breaking apart a monopoly. Regulators can set pricing controls called price caps in order to prevent the company from setting unreasonable prices. Price capping is a way to reduce the price benefit of being a monopoly as the price lowers to that of a competitive market. Once competition increases in the industry, policy makers can reduce or remove the price caps.

According to The Energy Journal, all US electricity independent system operators have price caps. Similarly, setting rate-of-return price regulations can help reduce artificially high utility prices. The government can also opt to nationalize natural monopolies to ensure that utility prices are in the best interest of the public.

The government may wish to regulate monopolies to protect the interests of consumers. For example, monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through:

• Price capping – limiting price increases
• Regulation of mergers
• Breaking up monopolies
• Investigations into cartels and unfair practises
• Nationalisation – government ownership.

Why the Government regulates monopolies

1. Prevent excess prices. Without government regulation, monopolies could put prices above the competitive equilibrium. This would lead to allocative inefficiency and a decline in consumer welfare.
2. Quality of service. If a firm has a monopoly over the provision of a particular service, it may have little incentive to offer a good quality service. Government regulation can ensure the firm meets minimum standards of service.
3. Monopsony power. A firm with monopoly selling power may also be in a position to exploit monopsony buying power. For example, supermarkets may use their dominant market position to squeeze profit margins of farmers.
4. Promote competition. In some industries, it is possible to encourage competition, and therefore there will be less need for government regulation.
5. Natural Monopolies. Some industries are natural monopolies – due to high economies of scale, the most efficient number of firms is one. Therefore, we cannot encourage competition, and it is essential to regulate the firm to prevent the abuse of monopoly power.

Government can regulate natural monopolies by :

1. Price capping by regulators RPI-X

For many newly privatised industries, such as water, electricity and gas, the government created regulatory bodies such as:

OFGEM – gas and electricity markets

OFWAT – tap water.

ORR – Office of rail regulator.

2. Regulation of quality of service

Regulators can examine the quality of the service provided by the monopoly. For example, the rail regulator examines the safety record of rail firms to ensure that they don’t cut corners.

In gas and electricity markets, regulators will make sure that old people are treated with concern, e.g. not allow a monopoly to cut off gas supplies in winter.

3. Merger policy

The government has a policy to investigate mergers which could create monopoly power. If a new merger creates a firm with more than 25% of market share, it is automatically referred to the Competition and Markets Authority (CMA). The CMA can decide to allow or block the merger depending on whether it believes it is in the public interest.

4. Breaking up a monopoly

In certain cases, the government may decide a monopoly needs to be broken up because the firm has become too powerful. This rarely occurs. For example, the US looked into breaking up Microsoft, but in the end, the action was dropped. This tends to be seen as an extreme step, and there is no guarantee the new firms won’t collude.

5. Yardstick or ‘Rate of Return’ Regulation

This is a different way of regulating monopolies to the RPI-X price capping. Rate of return regulation looks at the size of the firm and evaluates what would make a reasonable level of profit from the capital base. If the firm is making too much profit compared to their relative size, the regulator may enforce price cuts or take one-off tax.

A disadvantage of the rate of return regulation is that it can encourage ‘cost padding’. This is when firms allow costs to increase so that profit levels are not deemed excessive. Rate of return regulation gives little incentive to be efficient and increase profits. Also, rate of return regulation may fail to evaluate how much profit is reasonable. If it is set too high, the firm can abuse its monopoly power.

6. Investigation of abuse of monopoly power

In the UK, the office of fair trading can investigate the abuse of monopoly power. This may include unfair trading practices such as:

• Collusion (firms agree to set higher prices)
• Collusive tendering. This occurs when firms enter into agreements to fix the bid at which they will tender for projects. Firms will take it in turns to get the contract and enable a much higher price for the contract.
• Predatory pricing (setting low prices to try and force rival firms out of business)