Microeconomics: Natural Monopoly

Notes on natural monopolies:

Recall that natural monopolies arise because they have economies of scale so large, their size prevents competition from smaller firms.

You can see the large area of the dead-weight loss that typically occurs in a natural monopoly. However, unlike other monopolies which can be broken up into smaller parts (see trust-busting), breaking up a natural monopoly would be less productively efficient as the ATC and MC curves would be higher.

Government regulation of the firm's prices for its goods.

The government allows the monopoly to exist, since its economies of scale is so large, it produces at a much lower average total cost (ATC) than multiple smaller firms producing the same amount of goods.
The government's goal is to reduce the DWL.

The graphs below show the differences between a productively and allocatively efficient prices, using the graph of an unregulated natural monopoly used at the beginning of this lesson.

Productively efficient price (P(Q)=ATC):

You can see that by setting the price equal to the intersection of the demand curve to the ATC curve, the DWL is now smaller and the consumer surplus higher. Furthermore, the market is productively efficient.

Allocatively efficent price (P(Q)=MC):

By setting the price equal to the intersection of the MC curve and demand curve, we see that the consumer surplus is now equal to what it would have been under perfect competition (thus the DWL is completely eliminated). It is represented by the right triangle area formed by the demand and the bottom horizontal dotted line. However, the firm is now facing a large negative profit, equal to the area of the rectangle given by the three dotted lines. The firm will be forced to close if the government does not intervene.

Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 107-110.

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