28.1 Natural Monopoly

• Natural monopolies occur when the economies of scale for producing a product are so large that only a single firm can survive.

• The long-run average curve for water service in a particular city is negatively sloped and steep, reflecting the large economies of scale that occur because water service requires a costly system of pipes, and the cost is the same whether the firm pipes 70 or 70 million cubic meters of water.

  • For each additional unit, a water company incurs a cost for the energy required to pump the unit from the water source to a customer.

  • To simplify matters, we’ll assume that the marginal cost is constant at $0.80 per cubic meter.

• If a single firm-a monopolist-provides water, the firm-specific demand curve is the same as the market demand: The market demand curve shows, for each price, the number of units sold by the monopolist.

  • From the firm’s perspective, the marginal benefit of a cubic meter of water is the increase in revenue-the marginal revenue.

  • The marginal principle is satisfied at point a, with 70 million cubic meters. The price associated with the quantity is $2.70 per unit (shown by point b), and the average cost is $2.10 per unit (shown by point c), so the profit per unit is $0.60.

  • The price exceeds the average cost, so the water company will earn a profit.

• If there are no artificial barriers to entry, a second firm could enter the water market.

  • At each price, the first firm will sell less water because it now shares the market with another firm.

  • The larger the number of firms, the lower the demand curve for the typical firm.

• Will a second firm enter the market?

  • The demand curve of the typical firm in a two-firm market lies entirely below the long-run average-cost curve, so there is no quantity at which the price exceeds the average cost of production.

  • No matter what price the typical firm charges, it will lose money.

  • The firm’s demand curve lies below the average-cost curve because the average-cost curve is steep, reflecting the large economies of scale for water provision.

  • The second firm-with half the market-would have a very high average cost and wouldn’t be able to charge a price high enough to cover the cost of building the pipe system in the first place.

  • Therefore, the second form will not enter the market, so there will be a single firm, a natural monopoly.

• When a natural monopoly is inevitable, the government often sets a maximum price that the monopolist can charge consumers.

• How will this regulatory policy affect the monopolist’s production costs?

  • Under average-cost pricing, a change in the monopolist’s production cost will have little effect on its profit because the government will soon adjust the regulated price to keep the price equal to the average cost.

  • The government will increase the regulated price when the monopolist’s cost increases and decreases the price when the monopolist’s cost decreases.

  • Since the monopolist has no incentive to cut costs and faces no penalty for higher costs, its costs are likely to creep upward.

  • As the average cost increases, the regulated price will too.

28.2 Antitrust Policy

• A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees.

• The purpose of antitrust policy is to promote competition among firms, which leads to lower prices for consumers.

• The government organizations that are responsible for initiating actions against individuals or firms that may be violating antitrust laws are the Antitrust Division of the Department of Justice and the Federal Trade Commission.

• There are three types of antitrust policies:

  • One form of an antitrust policy is to break up a monopoly into several smaller firms.

  • The second form of an antitrust policy is blocking mergers.

    • A merger is a process in which two or more firms combine their operations.

    • A horizontal merger involves two firms producing a similar product.

    • A vertical merger involves two firms at different stages of the production process.

    • The second type of antitrust policy is to block corporate mergers that would reduce competition and lead to higher prices.

    • One possible benefit from a merger is that the new firm could combine production, marketing, and administrative operations, producing products. Lower average cost.

    • Consumers might reap the rewards in the form of lower prices.

  • The third form of an antitrust policy in regulating business practices.

  • A tie-in sale occurs when a business under which a business requires a consumer of one product to purchase another product.

  • Predatory pricing occurs when a firm sells a product at a price below its production cost to drive a rival out of business and then increases the price.