9.10

• A natural monopoly arises when a single firm can produce the entire market output at a lower cost than multiple firms due to significant economies of scale. This means the firm's long-run average costs (LAC) keep falling as it increases output, making it more efficient for one firm to dominate the market rather than having many smaller competitors.
• Features of a Natural Monopoly:

  • falling average costs
  • cost structure
  • high fixed costs
• Falling Average Costs: As output increases, average costs fall due to large economies of scale. This happens because the firm can spread its fixed costs (such as infrastructure) over a larger output.
• Cost Structure: A natural monopoly’s cost structure discourages entry of new competitors because new entrants would face much higher average costs.
• • High Fixed Costs: Industries like utilities (e.g., electricity or telephone networks) have high infrastructure costs, making it inefficient for multiple firms to duplicate these costs.
• • At the socially optimal point E, the price PC is lower than the firm’s average costs. The firm would make losses if forced to sell at this price because the total revenue (based on PC and Q') wouldn’t cover the high fixed and average costs.
  • To make the firm break even while producing at the efficient output level, governments may need to provide subsidies or allow the firm to charge higher fixed fees, which is referred to as two-part tariffs.
• Solutions for Dealing with Natural Monopolies:

  • regulation
  • Two part tariff
  • public ownership
• Regulation: Natural monopolies are often regulated to prevent abuse of market power. The government can set prices or limit the profits a natural monopoly can make to reduce inefficiency.
• Two-Part Tariff: One regulatory solution is to use a two-part tariff. The monopolist can charge a fixed fee (to cover fixed costs) and then charge a lower price per unit based on marginal costs. For example, telephone companies often charge a fixed line rental fee and a per-minute charge for calls.
• 1. Public Ownership: In some cases, natural monopolies are publicly owned to ensure prices reflect the true cost of production without profit maximization, aiming for social efficiency.
• • A natural monopoly has significant cost advantages because of economies of scale, which leads to a single firm dominating the market.
• The monopolist produces where MR = MC to maximize profits, but this leads to lower output and higher prices compared to the socially efficient output.
• The deadweight loss occurs because the monopolist restricts output, leading to a loss of potential social surplus.
• • Regulatory approaches like two-part tariffs can help improve efficiency without driving the firm into losses.