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Chapter 29: Theory of the firm – natural monopoly (1.5) Economies of scale Definition of a natural monopoly Different possible pricing and output decisions Natural monopoly • With reference to economies of scale, and using examples, explain the meaning of the term “natural monopoly” • Draw a diagram illustrating a natural monopoly Economies of scale When there are very large fixed/initial costs and a very large potential for economies of scale based on technological gains, a monopoly might well have a profitmax point which renders a lower price and higher output than a perfectly competitive market. We now relax our earlier two assumptions added-on in comparing a monopoly with a perfectly competitive market. The sum of the MC curves for PCM firms are not the MC curve for the monopoly; and there are indeed economies of scale to be had. Fig. 2.3.40 Economies of scale in a monopoly P, costs ($) P, costs ($) SPCM = ΣMCPCM MC SRAC PPCM MCSRAC Pmon MCmon LRAC QPCM MR QPCM Qmon D, AR Q/t Qmon A monopoly firm which can attain economies of scale results in a lower price and higher output than is possible when competing firms have too small a portion each to benefit from scale economies. Q/t Figure 2.3.40 illustrates the outcome when a monopoly can enjoy economies of scale. The supply curve for the perfectly competitive market (left diagram) is the sum of the MC curves shown in the LRAC diagram to the right. Scale economies allow the monopoly to move along the LRAC (diagram on the right), allowing the monopoly to decrease MC and AC. The monopoly can produce a higher quantity and lower price – Qmon and Pmon – than the perfectly competitive market. Simply put, a large quantity of (smaller) competing firms could not attain large enough scale to be able to compete with a single monopoly firm. Definition of a natural monopoly A natural monopoly has nothing to do with ‘organic ’, in case any of you neo-hippies were wondering. A natural monopoly is when the barriers to other firms entering the market are in some way built-in to the environment, infrastructure or the nature of the good itself. In this, the single firm will have very large benefits of scale which competing firms could never acquire – this enables the incumbent (= “sitting”, “current”) monopoly firm to continuously undercut potential rivals and (intentionally or unintentionally) prohibit them from entering the market. The concept of a natural monopoly is an extension of the scale benefit model done above. However, a natural monopoly will have such large scale benefits, that no single firm can fully exploit them. “Natural” in usage here means that the economies of scale make it more efficient for one firm to produce the good than for any other constellation in the industry. 1 Easily understandable examples of natural monopolies are gas networks for households, water lines, electricity, telecommunications and cable TV – imagine the costs in having each individual gas or electricity company having their own lines into each house! My favourite example is railways; imagine having two competing companies with their own tracks – side by side – running between two cities. How about two bridges…side by side?! There are of course very high barriers to entry in industries characterised by natural monopolies. This is due to two common characteristics of natural monopolies: 1) Extremely high fixed costs and low variable costs 2) High initial (start-up) costs – often infrastructural Definition: “Natural monopoly” A natural monopoly is a situation (not a firm!) where the market is most efficiently served by a single firm since the benefits of scale are so large that not even a single firm can fully exploit the potential economies of scale. Gas, water and electricity lines to homes are examples of natural monopolies. On one of my trips through Ireland in the mid-eighties, I visited a far-northern town called Glencolombcille. It soon became apparent that getting there involved taking a series of buses – which were mostly provided by non-competing bus companies which had local monopolies for a number of town-totown routes. It also became apparent that there was no cooperation between the companies since arriving 1 It is noteworthy that the term natural monopoly does not in fact refer to the dominant firm but rather to the industry itself. There can be many competing firms in a natural monopoly situation and in using the term natural monopoly we are claiming that one firm would increase efficiency in the industry. This is a common political argument put forward in favour of nationalising water works, electricity and train services. buses invariably arrived ten minutes after connecting buses had departed!2 Bus services have high fixed costs since it basically costs the same to drive an empty bus from point A to point B as a bus full of inebriated Irish fiddle-players and confused tourists. The route I was travelling simply could not have supported competing bus lines, and it would be ludicrous to think that competitive forces could have lowered the market price while firms still covered their costs. Part of the network of gas pipelines in the Australian ‘outback’. Natural monopolies do tend to occur where fixed costs are very high, giving potential economies of scale only to firms which can exploit sheer size to some extent and spread the fixed costs over large output; one firm can satisfy market demand at a lower cost than competing firms. The markets for cable TV, water/ gas/ electrical utilities, railroad tracks and local bus services all have strong elements of natural monopoly. Just imagine how inefficient it would be to have several hundred competing gas pipes to each household or fifteen firms each laying down competing railroad tracks! The Öresund Bridge connecting Sweden to Denmark is also a natural disaster monopoly3 …and two bridges would basically be a monument to financial stupidity – and that might explain why politicians at this very moment are planning yet another connection via a tunnel4. Different possible pricing and output decisions The issue of is illustrated by the continuously falling LRAC curve in figure 2.3.41; as average costs fall throughout the entire boundary of market demand, LRMC too continues to fall. This renders three possible pricing outcomes – all of which are lower than for a PCM: 1) Profitmax pricing; where the monopoly sets price according to the MC = MR condition. This creates an output of QΠ-max and a price of PΠ-max. The firm makes an abnormal profit of the blue area. Examples include private telecoms companies and gas companies. 2) Average cost pricing; is when the monopoly sets the price at the break-even point of AC = AR. 2 I strongly suspect collusion between the bus companies and local pubs – which were always right next to the bus stations. It was all very Irish and very fun; we’d all get off one bus, tumble into the pub for a few pints, singing, joke-telling and fiddle-playing, and off we’d go on the next bus. I spent more in the pubs than on the bus tickets. 3 The bridge was initially a monumental failure in terms of recouping the immense initial costs of building it. It ran at a loss for almost seven years since its inauguration in July 2000 – in part because of the high price for those in the vehicles that use it. 4 I am not making this up! 3) Marginal cost pricing; at an output of QMC, the monopolist would incur a loss of the purple shaded area. Marginal cost pricing is commonly done in order to achieve social benefits – for example, providing water – and often involve public ownership or government funding via subsidies. Fig. 2.3.41 Natural monopoly P, costs ($) If the industry is forcibly turned into a duopoly, each firm would have ACduo and losses (grey area). Profitmax: the monopoly enjoys an abnormal profit (blue area) at P π-max and Q π-max. Pduo PΠ-max AC pricing: The firm sets output at break-even point, earning a normal profit. PAC PMC MR Qduo QΠ-max QAC AC MC D, AR Q/t QMC MC pricing: Setting price at MC means a loss (purple area) for the firm, which is only tenable in SR. (Or via subsidies and price discrimination in LR) What would happen if the natural monopoly was broken up in order to establish a competitive market? Assume an existing monopoly at the profitmax price of PΠ-max. If government forced the firm to break up into two parts – a duopoly – each firm would have a far higher AC than the monopoly; the two firms would have an average cost of ACduo and an output of Qduo. This is clearly economically impractical. (Note the suboptimal productive efficiency in all three pricing scenarios, and the suboptimal allocative efficiency in all cases but MC pricing.) (Type 4 Smaller heading) Public and merit goods Goods provided and/or produced by government monies, i.e. public and merit goods such as roads and health care are often priced at AC or MC. Societal welfare is deemed to benefit so much by the provision of such goods that the profitmax condition is not considered applicable. Instead, the good is priced at cost or – via subsidies – at below marginal cost. Whether public/merit goods warrant government support or provision or not is subject to very heated debate. The trend over the past 20 years has been increasingly in favour of market openness and privatization, where a number of traditionally government-controlled markets have been sold off or otherwise subjected to open market competition. State-owned telecom companies, electricity and railroads are notable examples. In certain cases the results have been rather dismaying, for example England ’s privatisation of British Rail, completed in 1997, was called a ‘Disaster ’ by Time Magazine5 ; over 100 5 Time, July 14 2003, pages 54 – 57. different competing rail-service providers saw how costs spiralled upwards continuously leading to fewer departures and lower levels of service. There are increasingly loud cries for re-nationalisation. A very similar debate raged in California during 2002, as overloaded private electricity companies led to daily blackouts. You can just imagine how popular sudden power interruptions were to the programmers in Silicon Valley. Summary and revision 1. A large monopoly might enjoy significant economies of scale and therefore be able to produce at a lower price and higher quantity than competitive market firms. 2. A natural monopoly is a market situation (rather than a specific firm) where there are considerable entry barriers (very high fixed and start-up costs) and no single firm would be able to fully exploit these scale benefits. Common examples are electricity and gas lines. 3. The economies of scale result in falling or constant average and marginal costs throughout the realm of demand. 4. A natural monopoly can set price and output at different levels: 1) At profitmax price and output (MC = MR); 2) At breakeven price and output (AR = AC); 3) At a level considered approaching the societally optimal – where a loss can be made up for via subsidies or price discrimination (AR = MC). 5. Natural monopolies are frequently controlled/operated by government. Price and output is commonly set at breakeven or marginal cost price to maximise social benefits. Good examples of government run natural monopolies include railroads and electricity networks.