Question

Give an example of a natural monopoly (derived from economies of scale).

a. What is the motivation behind regulating natural monopolies?

b. Discuss the difficulty that the government faces when trying to regulate natural monopolies. Discuss the pros and cons of Average Cost Pricing and Marginal Cost Pricing.

c. How might the shortcomings of these methods (from (b) be overcome? Explain.

Answer 1

A Natural Monopoly occurs when the industry involved has extremely high fixed costs. (Fixed costs are those that remain the same regardless of the number of goods or services produced.) examples Electricity requires grids and cables, water services and gas both require pipelines which involves extremely high fixed cost.

a)In Natural monopolies firms have no real competition. Therefore, without government intervention, they could abuse their market power and set higher prices. Therefore, natural monopolies often need government regulation

b)  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.

Other ways by which government regualate monopoly are-

Marginal-cost pricing, in economics, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labour

Disadvantages-
1 The method is completely unacceptable for long-term price setting, since it will result in prices that do not capture a company's fixed costs.
2 If a company routinely engages in marginal cost pricing and then attempts to raise its prices, it may find that it was selling to customers who are extremely sensitive to price changes, and who will abandon it at once.

Advantages
1 If a company is willing to forego profits in the short term, it can use marginal cost pricing to gain entry into a market.
2 If customers are willing to buy product accessories or services at a robust margin, it may make sense to use marginal cost pricing to sell a product on an ongoing basis, and then earn profits from these later sales.

Average cost pricing is one of the ways the government regulates a monopoly market. Monopolists tend to produce less than the optimal quantity pushing the prices up.

Advantage
Average cost method automatically adjust the effects of random price hikes and dips especially near the end and start of the period.

Disadvantage
The average cost calculation often give cost per unit in long decimals that are rounded for record purposes. Such approximation differences may become material collectively by the end of the period especially if it involves large volumes of transactions

c) The shortcomings of these methods can overcome by using cost-plus pricing method.In cost plus method the selling price is determined by adding a specific markup to a product's unit cost