Natural Monopoly and the need for Government Regulation

In most cases, it can be argued that increased competition in a market will lead to an increase in efficiency, benefiting society and consumers. More competition, it can be argued, puts downward pressure on prices and forces firms to use their resources in a more efficient manner, encouraging firms to reduce their average total costs.

But what if the total demand for a good in a particular market is not high enough to necessitate more than one firm producing the good in question? In other words, what if having more than one firm means that each individual producer will have higher average total costs than a single firm would have? Such a scenario exists if the market demand curve intersects a monopolist’s average total cost curve in the range in which economies of scale are experienced, in other words where ATC it still decreasing. This is known as a natural monopoly.

Such industries exist, particularly in the case of large utilities such as water, electricity, natural gas, sewage and garbage collection. Think about the town you live in: how many firms can you choose to buy your electricity from? The answer is most likely ONE. Would you be better off if the answer were 100? Probably not. Here’s why: If 100 firms competed to provide electricity to your city, no single firm would achieve the economies of scale needed to lower its average total cost to a level that would allow it to provide electricity at the low, desirable rates that you currently pay. With 100 firms providing electricity, each firm would have much higher average costs and therefore would have to charge higher prices to their consumers! Competition would drive the price UP, instead of DOWN, like it is supposed to do, due to the significant economies of scale, namely the huge fixed costs of capital and infrastructure, needed to provide a utility such as electricity.

The problem with natural monopolies is that if they are left unregulated, they will produce much less and charge a price much higher than what is socially optimal (where marginal benefit equals marginal cost). Thus arises the need for regulation. This lesson will explain the theory of natural monopolies and examine the use of subsidies and price controls to promote a more socially optimal outcome in such industries.

After watching this lesson, read and respond to the discussion questions for the following blog post:  Monopoly prices – to regulate or not to regulate, that is the question!


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