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Natural Monopoly

A "natural monopoly" is a monopoly where the average total cost curve is always
downward sloping as illustrated below. So far we have studied monopolies with
small fixed costs and rising marginal costs.

In contrast, natural monopolies typically have large fixed costs but negligible
marginal costs associated with producing succeeding units of output. The average
total cost declines as the large initial cost is spread out over a larger quantity of
output. Most utilities tend to fit into this pattern such as sewage, Internet, or phone
service. Once the telephone lines in a city are installed and the switching equipment
is ready to go, the marginal cost associated with one more customer or call is
negligible.

When a natural monopoly exists, we can minimize costs by letting one large firm
produce everything. But with just one firm we cant rely on competition to ensure
low prices and an efficient quantity of output.

Thus, the social problem of natural monopolies is trying to get the low cost
production while avoiding the high prices and deadweight loss. There are several
traditional approaches:

1. The government could produce the product. The government could own the
telephone system, for example, or the post office. This has upsides and
downsides that are beyond the scope of Ec10.

2. The government could contract with a private firm to provide the product.
Here, competition among firms occurs during the bidding process, but once a
particular firm has been awarded the contract, it's the only one doing the

production. The MBTA commuter rail and, in theory, military contracting

work like this.

3. The government could allow one firm to do the production and regulate the
price or prices that it can charge. Public utilities and insurance often fit into
this category. There are regulatory commissions, often called public utility
commissions, that can approve or disapprove rate requests; in effect, these
commissions set prices. Once they are set, the natural monopoly is obligated
to sell as much output at the regulated prices as consumers want to buy.

In the following well analyze two pricing strategies that a regulatory commission
might choose. The different strategies are evaluated in terms of their efficiency and
their sustainability.

The efficient output level is the one which maximizes social surplus, i.e. the quantity
so that P = MC since we are assuming no externalities.

A sustainable output level is one where the firm does not lose money and go out of
business, e.g. .

Finally, remember that a declining ATC implies that MC < ATCthe marginal cost is
pulling down the average. As a result, a natural monopoly will always have cost
curves like those shown below with MC < ATC.

Typical Natural Monopoly Cost Curves



1. Average Cost Pricing (often abbreviated P = ATC)

Here, the commission sets the price at the point where the ATC curve cuts the
demand curve (P*) and the firm must sell output to any consumer who is willing to
pay that price (Q*). Since P* = ATC* the firm is not losing money so this pricing
scheme is sustainable. Unfortunately, Q < QEFF so this pricing scheme is inefficient.
The DWL associated with average cost pricing is shaded in the diagram below.

Average Cost Pricing for a Natural Monopoly

2. Marginal Cost Pricing (often abbreviated P = MC)

Here, the commission sets the price at the point where the MC curve cuts the
demand curve (P*) and the firm must sell output to any consumer who is willing to
pay that price (Q*). This leads to the efficient level of output by design since we set
P* = MC*, but with MC < ATC we can see P* < ATC* and the firm is losing money.
Marginal cost pricing is not sustainable.

Marginal Cost Pricing for a Natural Monopoly

In summary, average cost pricing is sustainable but inefficient while marginal cost
pricing is efficient but unsustainable. As you can guess, it is (basically) impossible
for a natural monopoly pricing scheme to be both efficient and sustainable.