Question

A natural monopoly is an example of market failure in the sense that competition will result in higher price. Why does such a market failure occur and what is the second-best solution?

Answer 1

A natural monopoly is a type of monopoly market which face the strong economies of scale over the entire demand curve and a single producer will supply the entire market at a lower cost.

Consider the following fig.

So, here “D” be the demand curve and “MR” be the marginal revenue curve and the monopolist is face the downward sloping AC and MC curves. So, at “E1” the intersection of “MR” and “LRMC” the corresponding “Q” and “P” are “Qm” and “Pm”. So, here the monopolist is getting positive economic profit.

So, a policy make may set price which is socially efficient which is given by the “Qc” the intersection of “D” and “LRMC” but this output the monopolist is make losses in the LR. So, the 2^nd best alternative the “AC” pricing, => the intersection of “D” and “LRATC”. So, at “E2” the “Q=Qe” and “P=Pe”. So, the monopolist will get normal profit.

So, here the natural monopoly market is an example of market failure, because the output supply by the monopolist is less than the socially efficient level of “Q” and the “P” is also more than the socially efficient level. So, here the reason for such market failure is that the strong economies of scale, => MC is lower than ATC, => the zero profit level of “Q” lower than the socially efficient level of “Q”.

So, here the 2^nd best solution is average cost pricing because at the socially efficient level of “Q” the monopolist make losses.