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Natural Monopoly Chapter 11 Key Concepts Natural monopoly Economies of Scale Cost subdivision Sustainability of natural monopoly Welfare loss due to marginal cost pricing Multi-part tariffs Self-selection Ramsey pricing Natural Monopolies: Efficiency versus DWL Natural monopolies produce at the lowest cost (compared to e.g. two or more firms) However, natural monopolies are also charging higher prices, which results in deadweight losses for the society What should the regulatory agency do? Cost Curves of Natural Monopoly Sustainability of Natural Monopoly When demand is low at DD, the natural monopoly is sustainable When demand grows to become D1D1, the natural monopoly will have to compete with the entrants Examples: Railroads Phone call service Temporary Natural Monopoly Economies and Diseconomies of Scale Subadditivity and Multiproduct Mo A multiproduct monopoly Electricity during and off-peak hours Intercity or international phone calls Economies of scale exist until output level Q’ Subadditivity refers to whether it is cheaper to have one firm For outputs less than Q’, one firm is the cheapest solution, and therefore cost is subadditive in this output range produce total industry output or whether additional firms yield lower total cost Minimum Average Cost Curve for Two Firms Average Cost Curve for Two Firms For least cost production firms must: Produce the same level of output Produce at the same marginal cost (why?) The intersection of AD and AC2 defines the range of subadditivity (i.e. it is cheaper to have only one firm producing the output) Even though diseconomies of scale obtain between Q’ and Q*, below Q* one firm is the cheapest solution Economies of Scale and Subadditivity Sustainability of Natural Monopoly Sustainability of Natural Monopoly For demand DD, the natural monopoly is not sustainable since positive profits will induce entry We have to assume that the incumbent will keep his previous price level P0 A sustainable monopoly would obtain when demand intersects the average cost curve to the left of Q’ Correcting NM Inefficiency Doing nothing Ideal pricing solutions Linear marginal cost pricing Nonlinear pricing Ramsey pricing Marginal Cost Pricing Marginal cost pricing can be efficient and at the same time result in a loss for the monopolistic firm Subsidizing the firm would be one possible solution Where do subsidies come from? Taxes that result in DWL Marginal Cost Pricing Causing Losses Problems with Lump Sum Taxes Sometimes the good should not be produced at all: in the graph total costs (AOQB) are greater than total consumer benefits (DOQB) Soft budget constraints (subsidies) result in lack of incentives to produce efficiently Distributional grounds: why should nonbuyers of monopolistic products pay for the subsidy? Natural Monopoly with Costs Exceeding Benefits Pricing So As To Cover Costs Linear pricing means a buyer pays single price per unit (alternatively, a buyer’s expenditure is proportional to the consumption volume) Linear pricing implies that prices must be equal to average costs if total revenues are to be equal to total costs The resulting welfare loss (consequence of the departure from marginal cost pricing) is given by the triangular area Welfare Loss with Linear Pricing Nonlinear Pricing: a Single TwoPart Tariff A two-part tariff consists of a fixed fee (regardless of consumption) and the price per unit If price per unit is equal to marginal cost, it is possible to have efficient prices and cover costs with revenues For example, the loss due to marginal cost pricing can be distributed across consumers in the form of the fixed fee Non-Linear Pricing—Self-Selection However, efficiency losses can occur if some consumers get excluded from the market If the subsidy exceeds consumer surplus due to the nonlinear tariff, some consumers get “kicked out” of the market The loss of consumer surplus due to these excluded consumers will constitute a welfare loss to the society Discriminatory two-part tariffs are a solution to this problem Ideally, for each consumer type we should have an individual two-part tariff The design of this type of tariff structure has to be such as to make consumers to Consumers will self-select the tariff that fits them the best by sticking to the lower bound of the tariff options self-select Multi-Part Tariff for Phone Calls Self-Selection by Consumers Multiproduct Case: Ramsey Pricing Marginal cost pricing, although efficient, can generate welfare losses in the case of a multiproduct monopolist as well Ramsey pricing is essentially the pricing method that allows for revenues to cover costs at the same time minimizing the deadweight losses Ramsey Pricing: a Two Product Case Consider the case of two goods the demands for which are independent Marginal costs are each equal to $20 and fixed costs are $1800 Prices must exceed marginal costs for revenues to cover costs Ramsey Pricing and Demand Elasticities Prices must exceed marginal costs for revenues to cover costs Solution 1: raise prices above marginal costs so as to cover all costs Product Y contribution: CEFD Product X contribution: CEJK The sum of the two rectangles is $1800, or the fixed cost DFH+JKH=DWL Solution 2: Same price increases produces more contribution in terms of cost coverage from product Y compared to product X since the demand for product X is more inelastic Hence it would be better to raise price of X rather than to raise price of Y Ramsey pricing rule: raise prices in inverse proportion to the products’ demand elasticities Proportionate Price Increase versus Ramsey Pricing Market Demands for Two Goods Ramsey Pricing Ramsey Pricing: Smaller DWL Welfare losses are minimized by charging $40 for good X and $30 for good Y DWL for good X is MTV DWL for good Y is NTV Combined DWL is smaller compared to the DWL given by the “proportional” pricing method