Explain the scenario of regulating monopoly and natural monopoly by the government with help of

suitable diagram.

Monopoly firm has the highest market power and imposes higher price reduces the output. Thus, a
monopoly firm leads to ineffective allocation of resources. Monopoly is regarded as unwanted and
illogical so the government uses various methods and policies for preventing the monopoly. Antitrust
policy is effective method for monopoly regulation. Generally, government enacts the competition
promotion policy to prevent the formation of monopoly power on a firm or uses such policies to break
the existing monopoly power of a firm. However, government allows some firms to be monopoly firm
legally in forms of natural monopoly or patent right.

Natural monopoly

Natural monopoly is a direct result of the superior efficiency of a single large producer. Some firm need
to invest large amount in fixed assets initially but their operating cost is low. As a result, their average
costs decline continuously as output expands, and a single large firm has the potential to produce
output more efficiently than any group of smaller producers. In case of the firms of public utilities such
situation happens. The firm supplying goods and services like electricity, drinking water,
telecommunication, transportation etc are public utilities. Such public utility firms create natural
monopoly.

Government need to regulate natural monopoly firms of public utilities or the firms having patent right
because if not regulated they can get excess economic profit with high price and less quantity. In the
following figure, AR and MR are average revenue and marginal revenue curve of monopoly firm. Both
AR and MR slope downward and MR curve lies half-way below AR curve. LAC and LMC are long run
average cost and long run marginal
cost curves of a natural monopoly
firm. Both the LAC and LMC slope
downward continuously and MC
curve lies below the AC curve. A
monopolist attains equilibrium at Q3
quantity where MR is equals to MC
and charges the price P3 and the
firm gets high profit AB per unit.

(Following figure shows the pricing

and regulation of natural monopoly.
Other legal monopoly having U
shaped AC and MC curve also have
same process of pricing and Fig: Pricing and regulation of natural monopoly
regulation)

Regulating monopoly by Government

To control the high price, high profit and low output, the natural monopoly may be regulated through
price, profit or incentive regulation.

1. Price Regulation

Regulating body of government wants the monopoly to produce the effective output level and
competitive price level. Marginal cost pricing (P=LMC) is the methods in which the price is fixed at
competitive price level (socially optimal price). In figure, this price is P1 where LMC equals to price. But,
at this price, the natural monopoly takes a loss. At Q1, average cost is greater than price (AR) by JH, thus
total cost is greater than total revenue. Obviously, the natural monopoly would rather go out of
business than be subject to this type of regulation unless it receives a subsidy for tis operation.

Another way of regulating the monopoly is average is average cost pricing. Government does not want
to shut down the natural monopoly it allows fixing price equation to average cost. In this situation the
firm gets only normal profit (i.e. zero economic profits). in figure, regulatory body of government will
require the natural monopoly to charge a price of P2 (because P2 = LAC) and to supply the quantity
demand at that price (Q3).

2. Profit regulation

Government can regulate the natural monopoly through profit regulation by fixing fair return price. This
done by fixing annual rate of return. Regulatory body can fix a certain percentage of annual rate of
return based on level of risk and condition of market. The monopoly form fixes the output abd price to
achieve that rate of return.

Theoretically, both average cost pricing and fixing annual rate of return may seem like a good way to
proceed, but in practice it is often difficult. The problem is that if the natural monopoly is always held to
zero economic profits or a certain profit-and is not allowed to fall below or rise above this level-then it
has an incentive to let costs rise. Higher costs-in the form of higher salaries or more luxurious offices-
simply mean higher prices to cover the higher costs. In this case, average cost pricing is not likely to be
an efficient way to proceed.

3. Incentive Regulation

Regulatory body of government can change the attitude to increase cost by proving positive incentive to
the firm to reduce the cost of production. The regulatory body fixes the price based on its cost and that
price will not be changed for a certain time period. During this time if the firm reduces the cost of
production, it gets more profit. Thus, the firm gets incentive to reduce the cost of production.

A government regulated natural monopoly may not have as much autonomy in the market as compared
to a non-regulated natural monopoly. It seemed on the surface that consumers’ welfare is more
protected under a regulated monopoly, however this is under the assumptions of the regulators being
knowledgeable, benevolent and would act in the interest of the consumers.