Natural Monopolies

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The natural monopolies have been subject to price controls by the government. The general aim of price regulation has been to protect consumers and ensure adequate output. For instance, in the case of a monopoly supplier of natural gas, once the pipes have been laid in an area, the marginal cost of adding an additional user is very low. With no regulation, the monopolist would produce where marginal revenue equals marginal cost. This is very inefficient, as the marginal cost will be less than price at the profit maximizing level of output. This implies that not enough service will be supplied and the price will be too high for some consumers to afford. Moreover, due to high economies of scale, it is hard to encourage competition.
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If the Regulator sets price equals to marginal costs, then the price and output is Pmc, Qmc. This gives the socially optimum quantity of the product with low price. Unfortunately, as you can see in the graph, since the average total cost is the average of all costs including the large fixed costs while the marginal cost is only the extra cost of producing an additional unit, the average total cost of a natural monopoly continually declines and the marginal cost will always be less than the average total cost. This implies a loss for the firm if the price is limited to its marginal cost. Hence, the monopolist will only operate under this regulated price if this loss is subsidized by the government like this figure…show more content…
Broadly speaking, incentive regulation refers to the use of regulatory regimes that rely on rewarding firms for improvements in efficiency. It includes price cap, rate of return regulation and two part tariffs.
A rate of return regulation is quite similar to average cost pricing, but deviates via allowing a model that can create consistent returns for the company involved. The percentage net profit brought in by company must be below a government specified percentage to insure compliance with this regulatory approach, which is normally between three to five percent.
Price or revenue capping are now the most commonly adopted approached in Australia, being used in the regulation of electricity and airport
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