Question

Question 2 – Government Intervention as Natural Monopoly Regulation

Sometimes governments intervene with the markets; the reason for the intervention might be a concern about allocative efficiency, or production inefficiency or some “fairness” issue.

Your task here is to explain the motivation for government allowing only a single firm in naturally monopolistic industries and yet later regulating the price of this firm. Analyze the situation before and after government intervention, and then conclude by referring to the possible reason for intervention.

Answer 1

If government allows natural monopoly to exists then the advantages from it are :

Its average costs are declining,its long run average costs cure is downward sloping,Hence it has benefits of economies of scale.Moreover competition would result in wasteful duplication of resources,one monopoly firm can serve the entire market and reap benefits of economies of scale.

The situation or the need to regulate a natural monopoly arises because:

As they are profit maximizers,hence they produce at the level where MR=MC.There they sel very low quantities at very high prices.Hence this is the pre-intervention situation.Then government intervene and forces them to sell at the price where their price is atleast equal to the average costs (Normal profits) i.e. Price=AC.

Hence a natural monopoly can lead to productive and allocate efficiency if it is regulated.