Governments Regulate Natural Monopolies †Myassignmenthelp.Com

Question: Why And How Governments Regulate Natural Monopolies? Answer: Introducation Today, natural monopolies are one of the oldest varieties of the free market economy throughout the world. In Australia, natural monopolies play a significant role in the economy. Mainly, this form of market structure arises due to high fixed and initial costs of setting up and operating in a particular industry (Welker, n.d.). Also, they may arise due to constraints brought about by control over raw materials and technological factors in a given industry. Thus, companies explore the high barriers to entry to create a defensive wall that keeps off competition (Arkani, 2010). Consequently, it blocks potential competition in the market, and acts as the sole seller of a given product. Thus, firms have the power to determine the quantity of a product that is produced and the prices charged for that product (Monopoly, n.d.). In most cases, monopolies limit their production to raise the prices of their goods and services. In this regard, governments regulate natural monopolies in order to protect consumers from exorbitant monopoly prices. Reasons for Regulation Maintain low prices One of the major reasons why governments regulate natural monopolies is to ensure that they maintain low prices. As noted earlier, the monopoly market structure permits firms to set the quantity and price for the goods they produce. As a result, producers have the power to raise their prices higher than they could of they were operating under competitive market structures (Pettinger, 2012). In a perfect competitive structure, prices are determined by forces of supply and demand in the market. Thus, the prices are always at equilibrium. However, in a monopoly market structure, firms manufacture goods at the point where the MR equals their MC, but charge the price determined by the demand curve. In turn, they make supernormal profits at the expense of consumers welfare. Monopoly pricing Source: (Pettinger, 2012) From the graph above, one notes that the prices charged by a natural monopoly is higher than the average total cost incurred in the production of the product. In turn, this results in deadweight loss, thereby leading to a reduction in consumers welfare (Pettinger, n.d.). For this reason, the government steps in and initiates measures that aim at reducing the price level that such firms charge their consumers. Improve efficiency The government also instills measures to regulate monopolies with the aim of improving their level of efficiency. More precisely, the lack of competition in this market may cause firms to be unproductive and wasteful as they are the only firms that can produce a particular product. Often, they have little incentive to improve the quality of the goods and services that they produce. Therefore, the government steps in by creating minimum standards of service and quality of products that the firm must meet. How Governments Regulate Natural Monopolies The government instigates regulatory measures on natural monopolies in various forms. In most cases, the regulation takes the form of price capping, regulation of the quality of service, rate of return policies, and average cost pricing systems, among others. Price Ceiling Notably, price capping is one of the most efficient methods used by the government to regulate the price charged by monopolies for their goods and services. Fundamentally, a price ceiling is where the government sets a maximum price that firms can charge for a particular product. In this case, firms cannot charge a price higher than the designated price. In turn, this helps in regulating the amount that monopolies can charge for their products. Indeed, this way, monopolies are unable to raise their prices, thereby leading to the protection of the welfare of consumers of that product. According to the figure below, the firm would charge consumers a price of Pm if its prices are not regulated. However, when the government sets the price ceiling at the point Pr, the firm is forced to reduce the price it charges to the one set by the government. In this case, the government spares the consumer Pm-Pr that they would have used on buying one unit of the commodity at the monopoly price. It also reduces the deadweight loss associated with monopolies, thereby increasing welfare of consumers. Regulation through creation of a Price Ceiling Source: (Osborne, 1997). Average Cost Pricing The government may also set a policy that requires a monopoly to set its prices equal to the overall costs incurred in producing a particular product. In this case, the price set by the firm is limited to the average costs incurred during the production of the good. Consequently, this reduces the pricing flexibility of a company by ensuring that it cannot obtain supernormal profit margins. Rate of Return Regulation In the same way, the government may use the rate of return on capital invested to regulate monopolies. In this policy, the rate of return on investment is capped and, thus, forces firms to reduce the prices they charge for their commodities. Primarily, the percentage net profit that a firm obtains must be below the amount specified by the government to ensure compliance with the regulation. Primarily, the government considers the size of the monopoly and determines a reasonable level of profit from the capital base. Thus, if the firm is making supernormal profits when compared to its size, it is forced to enforce price reductions on its services and goods. As a result, this protects consumers welfare by ensuring the firm sets optimal prices. Regulatory Bodies Another way for regulating monopolies may involve the creation of regulatory bodies that monitor and control the conduct of natural monopolies. Fundamentally, the regulatory bodies are formed to examine the quality of services and products that are produced by the monopolies and compare them with the predetermined standards (Pettinger, n.d.). They also monitor the prices charged by monopolies for their commodities to ensure that they do not exploit their clients. Furthermore, regulatory bodies investigate claims when it is suspected that monopolies are practicing market segmentation, price fixations, and predatory pricing, and take action against offenders. Consequently, it is worth noting that the setting up of regulatory bodies significantly reduces the incidence of exorbitant pricing by monopolies as well as ensures the production of high quality goods by natural monopolies. Indeed, this mechanism guarantees consumer protection and efficiency of firms. Example In Australia, the government has put in place various regulatory bodies (The Conversation, 2012). For instance, the energy regulatory body is charged with the responsibility of regulating the prices of electricity in the country. In the same way, Office of Rail Regulation, in Australia is the economic and independent safety regulator of the railway monopoly in Britain while OFGEM is charged with the responsibility of overseeing and regulating the gas and electricity market. All in all, all factors taken into consideration, it is important for the government to regulate monopolies in the country. Usually, natural monopolies take advantage of the fact that there is limited competition in their market structure. As a result, they charge high prices for their goods and services. On other occasions, monopolies offer poor quality commodities since they do face any form of competition. What is more, the lack of competition in the market reduces the incentives of monopolies to produce efficiently. For this reason, governments initiate regulatory policies to ensure the capping of prices charged by monopolies, ensure production of high quality products and improve their efficiency. Mainly, this is achieved through the setting of price caps in the form of price ceiling, average cost pricing policies, and rate of return regulations. In addition, the government may establish regulatory bodies to monitor the operations of natural monopolies. In turn, the implementati on of these measures ensures the safeguarding of consumer welfare through reasonable prices and high quality products. References Arkani, G. (2010). Monopoly marketing structure- meaning, features and types. Kaylan City Life. Retrieved on 28 Aug 2017, from https://kalyan-city.blogspot.co.ke/2010/11/monopoly-market-structure-meaning.html Deregulation is crucial for lowering Australias electricity costs (2012). The Conversation. Retrieved on 28 Aug 2017, from https://theconversation.com/deregulation-is-crucial-for-lowering-australias-electricity-costs-10625 Monopoly (2012). Economics Online. Retrieved on 28 Aug 2017, from https://www.economicsonline.co.uk/Business_economics/Monopoly.html Orsborne, J. M. (1997). Policies to control a monopoly. University of Toronto. Retrieved on 28 Aug 2017, from https://www.economics.utoronto.ca/osborne/2x3/tutorial/MONCON.HTM Pettinger, T. (2012). Natural Monopoly. Economics Help. Retrieved on 28 Aug 2017, from https://www.economicshelp.org/blog/glossary/natural-monopoly/ Pettinger, T. Regulation of monopoly.Economics Help. Retrieved on 28 Aug 2017, from https://www.economicshelp.org/microessays/markets/regulation-monopoly/ Welker, J. Natural Monopoly and the need for Government Regulation. Economics Classroom. Retrieved on 28 Aug 2017, from https://econclassroom.com/?p=3115