Session 5 – Theory of natural

monopoly

Dr. B. Sundar

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 Flow

1. Introduction
2. Policies to correct natural monopoly
• Pricing schemes
• Linear marginal cost pricing
• Non linear pricing
• Ramsey pricing
• Franchise bidding
• Actual solutions
3. Regularization, liberalization, and competition research paper (2006; sec. 1, 2)

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1. Introduction
• Market failures are the cause for economic regulation; ex. nm (water, electricity,
and gas distribution, telephones)
• An industry is a nm, if the production of a good by one firm minimizes costs
• Long run average cost curve (lrac) decreases for all outputs, which means that
• Long run marginal cost curve is lower than lrac for all outputs
• This single firm expands output, wins the market, and society suffers monopoly pricing
• Characteristics of nm- A. Permanent and temporary nm
• Permanent nm – lrac falls continuously for all outputs
• Temporary nm – lrac falls till a certain output (q*, say), and then stays constant
• An example is cable tv during the 1990s which offered all regional and english channels at
~rs. 150, reflecting falling average costs. With more demand fueling the advent of dish tv
from sun, videocon, airtel, in the 2000s, and more quality enhancements, the lrac is
constant, and the services getting pricier
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1. Introduction …

• At DD, the industry is a monopoly; As demand jumps to D1D1, the industry

becomes competitive
• Another example is railroads which had cost advantages for transporting freight; as
demand for transporting freight increased, truck industry appeared which eroded the cost
advantages of rail roads 4
1. Introduction …
B. Subadditivity – When two firms produce q1 and q2, and costs are such that
c(q1+q2) < c(q1) + c(q2)
• Most nm are multi-product; ex. electric utilities supply high and low voltage, and
peak, and off peak power; here, interdependence of products become important
• Production of all combinations of output is cheaper by a single firm and depends
on economies of scale (esca) and economies of scope (esco)
• For single product: esca implies nm
• For multiple product: esca and esco both must be present, as interdependence among
outputs become important

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1. Introduction …

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2. Policies to correct nm
Options to correct the nm inefficiencies include,
1. Doing nothing: if monopoly power is not strong; ex. cable tv started as a nm,
but with close substitutes, chances of earning above normal profits are small
2. Linear mc pricing
• Expenditure is a linear function of price (p) and quantity (q), pq for this nm
• The mc is p0, quantity is q0, which is efficient, but results in loss of Rp0ST
• This firm will need a subsidy to operate at q0, which theoretically may be raised by the
government through taxing, but seldom done
• It is possible that consumer benefits (area under the demand curve) is less than total costs (area under
mc curve), implying that goods must not be produced at all
• If losses are met by assured subsidies, there is no incentive to cut costs – x –inefficiency
• Why must non-buyers of nm good subsidize those who buy the nm good at mc?
• Linear mc pricing thus implies that p = ac (not mc) if revenues should cover costs, which
results in welfare loss (shaded triangle in figure 11.8)
• This argument, that the buyer pays a single price per unit of the nm good, is linear pricing
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2. Policies to correct nm …
Linear mc pricing

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2. Policies to correct nm …

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2. Policies to correct nm …
3. Non linear pricing (np)
• Np consists of a fixed fee (ff), regardless of consumption, plus a price per unit (p)
• If p = mc, and the loss under linear mc pricing is k (shaded rectangle, fig. 11.6),
the ff could be k/n, where n = number of consumers
• This above nondiscriminatory two-part tariff might have these issues
• Drives away consumers whose wtp < price plus k/n (users vary in their demand for a good)
• Cannot enforce a ff for the “right to buy” at p per unit
• So, we charge different ff to different consumer classes such that total ff = k
• We need to balance efficiency losses (high ff may exclude consumers) and
consumption losses (p > mc)
• In reality, p is slightly greater than mc, and ff does exclude some consumers

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2. Policies to correct nm …
4. Ramsey pricing for multiproduct nm

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2. Policies to correct nm …
• Ramsey pricing provides a theoretical justification for the “value of service”
pricing as in the rail roads industry; freights for transporting low value items
(potato, gravel) are lower as compared to high value items (electronic goods)
• Elasticities of demand for shipping potato are higher as compared to those for electronics
• Thus, each pricing policy has issues; the problem is how to induce managers to
implement these pricing schemes?
• Managers of private firms maximize profits, not total surplus
• Managers of public firms worry about personal perks besides efficiency
• How can ra incentivize nm to price efficiently? Loeb – magat proposal shows how

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2. Policies to correct nm …

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2. Policies to correct nm …
5. Franchise bidding
• Call for bids for rights to supply the entire demand
• There would be competition to serve this market among potential suppliers
• Eventually, the firm with the lowest bid would actually produce at p = ac (not mc); ie. P0 and q0
(fig. 11.8) which is not efficient
• At p0, the bidder would just about cover costs, and p<ac would be unviable for the bidder
• Note that p0 is an improvement over the monopolist price
Actual solutions: (a) Regulation - Ra do not seek to implement ideal pricing schemes nor
maximize efficiency; price discrimination is employed across- and within- customer
groups
• The goal is to set prices that are not unduly discriminatory and tr = tc
• Recent trend is to promote pricing that improves efficiency; ex. peak pricing
(b)The other solution is for the government to operate the nm as a public enterprise; ex.
electricity and rail roads in india
• Public managers can be asked to maximize total surplus and no need for ra 14
Regulation, competition, and liberalization paper (2006)
(Armstrong and Sappington, JEL, sections 1 and 2)

• The paper begins with the following premise; we imperfectly know

• where regulated nm supply is preferable to unregulated competition
• about liberalization, the process that governs the transition to competitive markets
• These issues are important in telecom, cable, natural gas where nm is preferred
• Liberalization has garnered world’s attention in these industries; the paper
describes liberalization experiences of 3 countries
• Chile’s telecom (substantial success)
• UK’s natural gas (again a success)
• California’s electricity (substantial failure)
• There are a variety of liberalization policies to choose from; no one size fits all
• Those policies that remove entry barriers and empower users to discipline
industries are more successful
• Liberalization can facilitate a transition from “tightly regulated” to less obtrusive
antitrust 15
End of session

Thanks

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