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Specifically, your grade average will get closer and closer to 90 but never quite get there.


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Similarly, a natural monopoly's average cost will approach its marginal cost as quantity gets very large but will never quite equal marginal cost. Unregulated natural monopolies suffer from the same efficiency problems as other monopolies due to the fact that they have an incentive to produce less than would a competitive market would supply and charge a higher price than would exist in a competitive market. Unlike regular monopolies, however, it doesn't make sense to break up a natural monopoly into smaller companies since the cost structure of a natural monopoly makes it so that one large company can produce at lower cost than multiple small companies can.

Therefore, regulators have to think differently about appropriate ways to regulate natural monopolies. One option is for regulators to force a natural monopoly to charge a price no higher than the average cost of production. This rule would force the natural monopoly to lower its price and would also give the monopoly an incentive to increase output. While this rule would get the market closer to the socially optimal outcome where the socially optimal outcome is to charge a price equal to marginal cost , it still has some deadweight loss since the price charged still exceeds marginal cost.

Under this rule, however, the monopolist is making an economic profit of zero since price is equal to average cost.

Natural Monopoly

Another option is for regulators to force the natural monopoly to charge a price equal to its marginal cost. Of these three solutions, the first one is the most efficient i. But from the point of view of society, the owner of a natural monopoly cannot be allowed to enjoy this solution. That is why natural monopolies are regulated or operated by the government.

Privatization of natural monopoly public enterprises : the regulation issue

However, a natural monopoly by definition suffers from insufficiency of demand relative to its productive capacity. It is assumed that the demand curve of the firm under such a monopoly passes through its AC curve to the left of the minimum point of the latter. Because, here the firm would supply too little at too high a price although it is in a position to produce more under diminishing average cost of production.


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We have to examine, therefore, the remaining option, i. While regulating a natural monopoly, if the authorities do not consider to pay any subsidy to the business, then they must see that the monopoly operates on its average cost curve so that all its costs are recovered, and also on its demand curve so that demand for the product is fully satisfied.

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.

Regulating Monopolies (Socially Optimal and Fair Return)- Micro Topic 6.4

If producers are reimbursed 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 lots of staff, because what they can charge is linked to the costs they incur. Thus, in the s and s, some regulators of public utilities 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.

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. But 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 being 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.

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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. While it is important to consider the efficiency implications and outcomes of those goods and services markets that are not perfectly competitive, it is also fair to consider those input markets that are also not perfectly competitive.

This generally occurs in labor markets, where wages, or more broadly labor compensation, is above the perfectly competitive equilibrium. This may occur for multiple reasons, but is often attributed to minimum wage laws or union activity. Minimum wage laws may act like price floors, pushing the legal minimum wage above its equilibrium. While this may be beneficial for those workers who can still find work at the minimum wage, it may also serve to reduce the quantity demanded of labor while simultaneously increasing the quantity supplied of labor.

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In other words, just like a price floor in a market for a good or service, a minimum wage law can create a surplus. In this case, it is a surplus of labor, causing higher unemployment. Through its ability to negotiate and collectively bargain with firms, a labor union may have the same impact.

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As it successfully increases wages for its members, if this increase pushes wages above equilibrium, it will act like a price floor, again creating a surplus of labor. Union activity can also be regulated by individual states through so-called right to work regulations. There are 26 states that are right to work states. There is also the rare case of the monopsony , when there is only one buyer of a good. A monopoly refers to only one seller of a good. Perhaps the best example here is that of the one factory town , where the major or even sole employer is a single buyer of labor.