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Natural Monopoly
Chapter 11
Key Concepts
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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
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Natural monopolies produce at the lowest
cost (compared to e.g. two or more firms)
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However, natural monopolies are also
charging higher prices, which results in
deadweight losses for the society
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What should the regulatory agency do?
Cost Curves of Natural Monopoly
Sustainability of Natural Monopoly
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When demand is low at DD, the natural
monopoly is sustainable
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When demand grows to become D1D1, the
natural monopoly will have to compete with
the entrants
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Examples:
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Railroads
Phone call service
Temporary Natural Monopoly
Economies and Diseconomies of
Scale
Subadditivity and Multiproduct Mo
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A multiproduct monopoly
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Electricity during and off-peak hours
Intercity or international phone calls
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Economies of scale exist until output level Q’
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Subadditivity refers to whether it is cheaper to have one firm
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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
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For least cost production firms must:
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Produce the same level of output
Produce at the same marginal cost (why?)
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The intersection of AD and AC2 defines the range of
subadditivity (i.e. it is cheaper to have only one firm
producing the output)
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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
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For demand DD, the natural monopoly is not
sustainable since positive profits will induce
entry
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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
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Doing nothing
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Ideal pricing solutions
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Linear marginal cost pricing
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Nonlinear pricing
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Ramsey pricing
Marginal Cost Pricing
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Marginal cost pricing can be efficient and at
the same time result in a loss for the
monopolistic firm
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Subsidizing the firm would be one possible
solution
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Where do subsidies come from? Taxes that
result in DWL
Marginal Cost Pricing Causing
Losses
Problems with Lump Sum Taxes
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Sometimes the good should not be produced
at all: in the graph total costs (AOQB) are
greater than total consumer benefits (DOQB)
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Soft budget constraints (subsidies) result in
lack of incentives to produce efficiently
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Distributional grounds: why should nonbuyers of monopolistic products pay for the
subsidy?
Natural Monopoly with Costs
Exceeding Benefits
Pricing So As To Cover Costs
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Linear pricing means a buyer pays single price per
unit (alternatively, a buyer’s expenditure is
proportional to the consumption volume)
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Linear pricing implies that prices must be equal to
average costs if total revenues are to be equal to
total costs
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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
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A two-part tariff consists of a fixed fee (regardless of
consumption) and the price per unit
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If price per unit is equal to marginal cost, it is
possible to have efficient prices and cover costs with
revenues
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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
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However, efficiency losses can occur if some consumers get excluded from the
market
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If the subsidy exceeds consumer surplus due to the nonlinear tariff, some consumers
get “kicked out” of the market
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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
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Ideally, for each consumer type we should have an individual two-part tariff
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The design of this type of tariff structure has to be such as to make consumers to
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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
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Marginal cost pricing, although efficient,
can generate welfare losses in the case
of a multiproduct monopolist as well
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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
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Consider the case of two goods the
demands for which are independent
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Marginal costs are each equal to $20
and fixed costs are $1800
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Prices must exceed marginal costs for
revenues to cover costs
Ramsey Pricing and Demand
Elasticities
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Prices must exceed marginal costs for revenues to cover costs
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Solution 1: raise prices above marginal costs so as to cover all costs
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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:
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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
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Welfare losses are minimized by charging $40
for good X and $30 for good Y
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DWL for good X is MTV
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DWL for good Y is NTV
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Combined DWL is smaller compared to the
DWL given by the “proportional” pricing
method