Regulating a Natural Monopoly



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Regulating a Natural Monopoly



Natural Monopoly = A firm whose LRATC curve is downward sloping over the relevant range of output.
That is, as Q increases, LRATC continues to fall. An example would be a power company like CPS. If they add one more customer, their total cost will not increase very much. The big costs for CPS are the power plants, trucks, workers, etc. Adding one more customer only requires a few lines and some time by the work crew. As they add more customers (or Q increases), they spread the big costs of things like the power plant over more and more customers.
Recall that
ATC = TC/Q
So if Q keeps rising and TC does not go up much, ATC will fall. This is called economies of scale. Recall also that economies of scale is considered a barrier to entry. Let’s see why.
The graph below shows the LRATC for a natural monopoly. As Q increases, LRATC falls.

This actually keeps competitors out. Why? Suppose that we have one firm in this industry already, the “old firm (O).” Since they have been in the industry for a long time, their sales (Q) will be high. So their ATC will be low.


If a “new firm (N)” tries to enter, their ATC will be will be high because, as a new firm, they will not have high sales (Q).

To make a profit (or at least avoid losing money), a firm needs P > ATC. But the new firm will always have a higher ATC than the old firm. The new firm could lower the price to as low as



P = ATCO. If the new firm tried to lower their price to stay competitive, their price would be far below their ATC (ATCN). They would go out of business.
So, as soon as a new firm enters, the old firm could simply lower the price and drive the new firm out of business. Then we are left with just one firm. And, as we saw earlier, we get less social welfare with monopoly. No firms will ever enter this industry since they know the old firm has this big cost advantage. We would be left with a monopoly, which does not maximize social welfare.
But if the government regulated the price, we could get more social welfare. The question is, what is the best price to pick?
The two options
1. Make the natural monopoly charge a price equal to their ATC. This is called average total cost price regulation. We find it in the graph below where the demand line is crossed by the ATC line (PATC).
2. Make the natural monopoly charge a price equal to their MC. This is called marginal cost price regulation. We find it in the graph below where the demand line is crossed by the MC line (PMC).


At first glance, it looks like marginal cost price regulation is the best choice since we get the lowest price and the highest quantity. And, we know from earlier that when P = MC, social welfare is maximized.


But there is a problem. At QMC, the firm’s ATC > P. With marginal cost price regulation, the firm will lose money and go out of business. In that case, we get no social welfare. We can see in the graph below that at QMC, the firm’s ATC > P.

The government could pay the firm a subsidy equal to the amount of money that they are losing to keep them in business (this would mean the firm makes a normal profit, just like if P = ATC). But a subsidy would require tax dollars. Would it be worth the cost to subsidize the firm to get the higher social welfare under marginal cost price regulation?


It will be. That is what the next example is about.

To see which policy is the best, average total cost price regulation or marginal cost price regulation, we need to calculate the social welfare in each case.


The way this example is set up, with both average total cost price regulation or marginal cost price regulation, all of the social welfare will be consumer surplus. There will be no producer surplus.
If we have average total cost price regulation, the price will be 8.
If we have average total cost price regulation, the quantity will be 8.
What will the social welfare be (it will all come from consumer surplus)?
Look at the graph below.

The red trianlge above is the social welfare if we have average total cost price regulation. The social welfare will be



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