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.