9.4: Regulating Natural Monopolies

Learning Objectives

By the end of this section, you will be able to:

• Evaluate the appropriate pricing policy for a natural monopoly
• Interpret a graph of regulatory choices
• Contrast cost-plus and price cap regulation

Most true monopolies today in the U.S. are regulated, natural monopolies. A natural monopoly poses a difficult challenge for competition policy, because the structure of costs and demand makes competition unlikely or costly. A natural monopoly arises when average costs are declining over the range of production that satisfies market demand. This typically happens when fixed costs are large relative to variable costs. As a result, one firm is able to supply the total quantity demanded in the market at lower cost than two or more firms—so splitting up the natural monopoly would raise the average cost of production and force customers to pay more.

Public utilities, the companies that have traditionally provided water and electrical service across much of the United States, are leading examples of natural monopoly. It would make little sense to argue that a local water company should be divided into several competing companies, each with its own separate set of pipes and water supplies. Installing four or five identical sets of pipes under a city, one for each water company, so that each household could choose its own water provider, would be terribly costly. The same argument applies to the idea of having many competing companies for delivering electricity to homes, each with its own set of wires. Before the advent of wireless phones, the argument also applied to the idea of many different phone companies, each with its own set of phone wires running through the neighborhood.

The Choices in Regulating a Natural Monopoly

Figure \(\PageIndex{1}\): Natural Monopoly Pricing outcomes. (CC BY-NC 4.0; via Ravjeet Singh)
 

In order to understand how the natural monopoly is different from a regular monopoly, we can look at Figure \(\PageIndex{1}\). Here, we have R (Revenue) and C ( Cost) on the y-axis plotted against Q (Output) on the x-axis. The shape of the demand curve and the corresponding marginal Revenue curve are downward sloping which is the same as a regular monopoly.  What about the Cost Curves though?  The shape of the Average Cost Curves and Marginal Cost curves are not the usual U-shaped curves as in other market structures including a regular monopoly but they are different. As seen in Figure \(\PageIndex{1}\), the Average Cost and Marginal Cost curves are no longer U-shaped but instead are declining continuously over much larger range of output due to high initial infrastructure costs.

This takes us to the next obvious question: What then is the appropriate pricing policy for a natural monopoly?

Let's examine all the alternative pricing policies one by one. The first possibility is the competition one and why not? The competitive equilibrium point will be at point E_C where Price = Marginal Cost.  This rule is appealing because it requires price to be set equal to marginal cost, which is what would occur in a perfectly competitive market, and it would assure consumers a higher quantity and lower price than at the monopoly choice. The only potential problem is that the price, P_C  is lower than the continuously declining Average Total Cost curve. In other words, at such a pricing level, the firm is always experiencing a loss. And because such a scenario is likely to be a true for a public utility, then this competitive outcome may not be sustainable. Unless the regulators or the government offer the firm an ongoing public subsidy (and there are numerous political problems with that option), the firm will lose money and go out of business.

The second possibility is to leave the natural monopoly alone. In this case, the monopoly will follow its normal approach to maximizing profits. It determines the quantity where MR = MC, which happens at point E_M.  The firm will produce at point Qm.  Since the price, P_M is above the average cost curve, the natural monopoly would earn economic profits. This is definitely better than the loss making scenario but what about the consumers?

Perhaps the most plausible option for the regulator is point E_F ; that is, to set the price where Average Total Cost is equal to Price. This plan makes some sense at an intuitive level: let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit, so that it can continue operating, but prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Determining this level of output and price with the political pressures, time constraints, and limited information of the real world is much harder than identifying the point on a graph. 

Cost-Plus versus Price Cap Regulation

Regulators of public utilities for many decades followed the general approach of attempting to choose a point like E_F in Figure \(\PageIndex{1}\). They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation.

Cost-plus regulation raises difficulties of its own. If producers receive reimbursement for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing many staff, because what they can charge is linked to the costs they incur.

Thus, in the 1980s and 1990s, some public utility regulators began to use price cap regulation, where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.

Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. However, if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.

With natural monopoly, market competition is unlikely to take root, so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task.