So just what the heck is ever natural about Monopoly?

Well, do you remember what you learned in lesson four about

production theory and the shape of the long run average total cost curve?

Let's refresh that memory as you take a look at

these four graphs and shapes of the average total cost curve.

Do you remember which one characterizes natural monopoly and why this is so?

Please pause the presentation now to figure that out and jot down your answer.

Well, it is this graph in the lower right hand corner,

that illustrates natural monopoly.

In the downward slope of the average total cost curve, ATC,

you can see that this industry is characterized by

increasing returns to scale over the relevant range in output.

In fact, this is an important graph in

every industrial society because it depicts in varying degrees a number of industries,

critical not just for meeting social needs,

but also for providing the kind of infrastructure

any successful business is going to have to rely on.

I'm talking of course about things like electricity,

gas and water distribution.

There's no business or home in a modern society that can do without.

Of course, here's the problem this natural monopoly situation creates.

Because of increasing returns to scale,

over time one firm will inevitably

emerge as the low-cost producer and capture the entire market.

Question is, what should society do about natural monopoly?

And the knee jerk response is often to use tools like

antitrust regulation to order the breakup of the monopoly.

But is that the best idea?

Can you think of another way to go about this?

Please pause the presentation now and just jot down

a few possible alternatives.

Okay, let's figure this out and let's start by

observing that if you simply break up a natural monopoly,

you will have a number of smaller firms producing at

a significantly higher unit cost than the monopolist.

So consumers will still have to pay higher prices

and there will be a possibly even bigger efficiency loss.

Scratch that idea, at least for most natural monopolies.

So what should we do?

Well, was one of your ideas to simply allow

the natural monopoly to exist but regulate its prices?

Well, that certainly has potential.

But what exactly would you set the price to?

That's our next puzzle to figure out.

So knowing what you know so far about pricing rules,

take a look at this graph and tell me where would you

set the regulated price for this regulated natural monopoly?

Please pause the presentation now to figure out what is

actually a really interesting puzzle.

Now, just how did you answer this question?

I suspect you may have been tempted to regulate the monopolist in a way which

simply forces the monopolists to set price equal to the natural monopolist marginal cost.

After all, at this point,

price regulation would effectively simulate

the outcome in a perfectly competitive market and therefore,

that should yield the allocatively efficient outcome, shouldn't it?

True that. But, setting price at point A,

where price equals marginal cost,

may not be the most feasible answer in the real world of politics.

Just why is this so? Well, simply because this pricing rule would

force the monopolist to lose money equal to the shaded triangle.

Just simply price times average cost minus revenue.

Therefore at this point,

the only way the monopolist could really stay in business over time,

would be to receive a subsidy from the government equal to the lose.

While economically this may make sense,

will likely be a tough sell politically as

subsidizing a big monopoly may not appeal to the taxpayers and voters.

So, what is our next best or what we call in economics,

our second best option?

Well, the more politically feasible option is point

C. This is where price equals average cost.

Under this scenario, the monopolist earns zero economic profit.

As we have learned, that's enough to stay in business.

At the same time, this price equals average cost,

P equals AC rule,

reduces, if not eliminates,

monopoly price gouging consumers and as should be apparent from our figure,

the deadweight loss is considerably smaller than the natural monopoly.

And because of these many virtues,

this price equals average cost rule has in fact been used in industrial countries

around the world to regulate prices in

natural monopoly industries ranging from electricity,

gas and water distribution to the railroads

and even cable TV.

One of the favorite cliches of economics is that,

there is no free lunch and it is briefly worth pointing out how a reliance on the price

equals average cost rule in

regulated industries may not be as cool a solution as it is made out to be.

Problem is what the Harvard economist Harvey Leibenstein dubbed long ago,

X efficiency as illustrated in this figure. Here's the deal.

Suppose you were the chief executive officer of

a regulated electric utility and your price is set by the P equals AC rule.

This is due to your incentive to maximize profit.

Well think about this,

under the P equals AC rule,

you're basically guaranteed to recovery of any costs that you incur.

In fact, that's why this type of regulation is known as cost plus pricing.

So do you see the problem?

Pause the presentation now just to think about that for

just a minute and jot down some ideas.

Well, under cost plus pricing,

regulated industries no longer have the incentive to

minimize cost and therefore maximize profits.

Instead, there is what economists call a perverse incentive.

That's another key term,

to increase cost for the benefit of the executives operating the firm.

For example the X in efficiency theory predicts that

executives in regulated industries will tend to hire more staff,

buy thicker carpets, build larger offices and engage in

more business travel than they otherwise would under strict profit maximization.

In such a case,

what do you think such behavior would do to

the observed average total cost curve and the regulated price in this figure?

And here's the tough question.

How would you actually measure x inefficiency?

Please pause the presentation now to draw and jot down your answer.

That's right. The perverse incentives of price regulation would raise

the average total cost curve and lead to

a higher regulated price and you can see in the figure,

that the shaded rectangle is precisely the measure of X in efficiency.

It just means that firms will tend to operate well above their potential ATC

if X in efficiency is indeed present. Now here's the punchline.

In some cases, it may well be that any increase in

allocative efficiency achieved by regulating

a monopolist may be more than offset by

an increase in X in efficiency due to cost plus pricing.

That's a fine example of irony in Webster's Dictionary.

The point here is that

the appropriate public policy response to

monopoly is not as straightforward as it may seem.

And here's just one more reason why this may be

so offered up by yet another Harvard economist,

renowned Joseph Schumpeter.

If you want to create controversy as an economist,

just raise a toast to the benefits of monopoly,

tell the government to back off.

That's essentially what Harvard's Joseph Schumpeter

did when he introduced the idea that the gains from

dynamic efficiency due to monopoly would

more than offset any losses from allocative inefficiency.

So, just what is dynamic efficiency?

In this key definition,

dynamic efficiency measures the rate

of technological change in Innovation in an industry.

And obviously, the faster this rate,

the better the industry will perform and the faster the economy will grow.

Schumpeter argued that monopolies will lead to higher rates of dynamic efficiency

precisely because monopolists are likely to earn

a much higher level of economic profit than competitive industry.

These profits will in turn give the monopolists much deeper pockets

to engage in long term strategic activities such as research and development.

At the same time, the monopolists will also have

a much bigger cash fund with which to make

investments to speed the diffusion of technology.

Of course the counter argument to Schumpeter is equally interesting.

For example, while the monopolist may have

deep pockets to spend on developing new technology,

that very same monopolist has little incentive in

the absence of other competitors to introduce the technology.

So technological progress is actually slow.

Now the poster child for this particular problem is

the old telephone monopoly in America called AT&T.

The classic example is the touch tone phone.

In fact AT&T actually invented

the touch tone phone in its research facilities known as Bell Laboratories.

But, this particular monopolist would wait years and

years before ever bothering to introduce the touch tone phone to the market.

Precisely because it faced no competition.

At any rate, suffices to say that we can't settle

this debate over the benefits and costs of monopoly here,

but the debate does provide us with yet an additional layer of

complexity to help us think through

the public policy and business implications of economic theory.

That said, let's turn in our next module to an even more complex beast,

that of monopolistic competition.

Regulating Natural Monopoly; The P=AC Rule; X-efficiency Under Cost-Plus Pricing; Schumpeter’s Argument for Monopoly

Strategic Business Management - Microeconomics

Meet the Instructors