Worked example 5 — Natural monopoly: the cost arithmetic, and why the remedy is regulation

Competition law's usual instinct is that more sellers are better than fewer. Natural monopoly is the case where that instinct is wrong, and the reason it is wrong is arithmetical rather than political. This example does the arithmetic, then draws the legal conclusion: the remedy for a natural monopoly is not dissolution but price and access regulation.

Natural monopolies have economies of scale for very large quantities of production, so the demand curve intersects the long run average cost curve in the downward-sloping portion. It therefore makes sense to have only one firm provide the good, because that one firm can produce a very large quantity, taking full advantage of the economies of scale.

Read that definition carefully, because two conditions are packed into it and both must hold:

1. Economies of scale over the whole relevant range — average cost is still falling at the output the market actually wants.
2. Demand cuts long-run average cost while it is still falling — that is, the market is not large enough for a single efficient-scale firm to be exhausted, let alone several.

If average cost turned upward before the market was satisfied, several firms could each operate at minimum efficient scale and the case for a single supplier would disappear.

A single comparison makes it concrete. Five firms each producing 100,000 units give an average cost of $5.00, while with one large firm producing 500,000 units, the average cost is only $1.00.

Set it out:

| Structure | Firms | Output per firm | Total output | Average cost per unit | Total cost | |---|---|---|---|---|---| | Fragmented | 5 | 100,000 | 500,000 | $5.00 | $2,500,000 | | Single supplier | 1 | 500,000 | 500,000 | $1.00 | $500,000 |

The same 500,000 units cost $2.5 million to make in five firms and $0.5 million in one. Five-sixths of the cost is eliminated by consolidation. That is why this is called the typical argument in favour of a natural monopoly.

Note the shape of the saving. It is not that the single firm is better managed; it is that the fixed costs are spread over five times the output. Over the years public utility firms, such as electric and gas companies, have been considered examples of natural monopolies, largely due to the large fixed costs for delivering their products. A second set of wires down the same street duplicates the whole fixed cost and serves the same houses.

Efficiency in production does not buy efficiency in pricing. Everything the previous chapter established about monopoly still holds for this firm.

Price is a fourth decision variable. Firms with market power must decide not only how much to produce, how to produce it and how much to demand in each input market, but also what price to charge for their output.

The equilibrium condition is MR = MC, with the marginal cost curve cutting the marginal revenue curve from below.

The comparison with competition: because the monopolist's marginal revenue is below its price, price and quantity will not be the same as under competition — the monopolist's equilibrium output is less than, and its price is higher than, for a firm in a competitive market. Less output, higher price.

And the inefficiency, which is the examinable chain: monopoly leads to an inefficient mix of output. The monopolist produces a quantity at which MR = MC, but since MR is less than P, at that level of output P is greater than MC. Since the price is greater than the marginal cost, demanders are willing to pay more for one more unit than the marginal cost of making one more unit — and the monopolist will not sell them that unit. So the monopolist cannot be making the allocatively efficient quantity.

Follow the chain and see what the loss actually is. Buyers value an extra unit more than it costs to make, and it is still not made. The loss is not merely that consumers pay more — that is a transfer from buyer to seller — but that mutually beneficial trades do not happen at all.

There is also no supply curve to appeal to. A monopolist cannot trace out a short run supply curve because for a given price there is not a unique quantity supplied; the key obstacle is market control and the negatively sloped demand curve facing the monopoly, and for a monopoly it is the marginal revenue curve that determines the profit-maximising quantity. The qualification is general: any firm with market control, which includes all market structures except perfect competition, has the same qualification about supply.

Put steps 2 and 3 together and the policy problem is exact:

• Break the firm up and unit cost rises from $1.00 to $5.00. Consumers lose more than they gain.
• Leave it alone and it prices where P is greater than MC, restricting output and destroying trades that both sides wanted.

Neither prohibition nor laissez-faire is right. Hence the third answer: one of the primary tools of antitrust policy has been the regulation of natural monopolies. Not prohibition, not dissolution — price and access regulation, which in India is the work of sectoral regulators for electricity, telecommunications and the rest, rather than of the Competition Commission.

Barriers to entry are what make the assumption of blocked entry realistic. A barrier is something that prevents new firms from entering and competing in imperfectly competitive industries, and there are four: government franchises — a monopoly by virtue of government directive; patents, a barrier to entry that grants exclusive use of the patented product or process to the inventor; economies of scale and other cost advantages; and ownership of a scarce factor of production.

Two of those four are created by law. A patent is a statutory monopoly, deliberately granted; a franchise is a monopoly conferred by the State. The legal system manufactures some monopolies on purpose, which is why competition law could not coherently treat monopoly as such as the mischief. Natural monopoly is the third item on the list — a barrier created by technology — and it is the one that most clearly cannot be legislated away.

That is the deeper reason the Competition Act's operative concept is abuse, not size. Section 4(1) provides that no enterprise shall abuse its dominant position; dominance is lawful.

The arithmetic dictates the regulatory agenda, and an answer that spells this out shows understanding rather than recall.

1. Price. Left alone the firm charges where P is greater than MC. A regulator wanting allocative efficiency would push price towards marginal cost — but at an output where average cost is still falling, marginal cost is below average cost, so pricing at marginal cost makes the firm lose money on every unit. That tension is the central problem of utility regulation, and it is why regulated tariffs are typically set by reference to average cost plus a permitted return rather than to marginal cost.
2. Access. Because duplication is wasteful, the network must be shared. Access regulation obliges the owner of the single efficient network to carry rivals' traffic on stated terms — which is the regulatory analogue of the section 4(2) prohibition on practices resulting in denial of market access.
3. Entry where duplication is not wasteful. The natural-monopoly argument covers the network, not everything sold over it. Separating the parts that must be single from the parts that can be competitive is the standing question in every network industry.

The cost figures are illustrative figures, expressed in dollars, and they describe no Indian utility.

1. Natural monopoly = economies of scale over the whole relevant range, so demand cuts long-run average cost while it is still falling; one firm is cheapest.
2. The arithmetic: five firms at 100,000 units → $5.00 average cost; one firm at 500,000 units → $1.00.
3. It still prices as a monopolist: MR = MC, MR less than P, therefore P greater than MC — output restricted and mutually beneficial trades lost, which is a real loss and not merely a transfer.
4. Hence the remedy is regulation of price and access, not dissolution — historically the public utilities.
5. Four barriers to entry: government franchises, patents, economies of scale and cost advantages, ownership of a scarce factor. Two of the four are created by law, which is why the Act forbids abuse and not size.