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Natural
Monopoly
A
"natural
monopoly"
is
a
monopoly
where
the
average
total
cost
curve
is
always
downward
sloping
as
illustrated
below.
So
far
we
have
studied
monopolies
with
small
fixed
costs
and
rising
marginal
costs.
In
contrast,
natural
monopolies
typically
have
large
fixed
costs
but
negligible
marginal
costs
associated
with
producing
succeeding
units
of
output.
The
average
total
cost
declines
as
the
large
initial
cost
is
spread
out
over
a
larger
quantity
of
output.
Most
utilities
tend
to
fit
into
this
pattern
such
as
sewage,
Internet,
or
phone
service.
Once
the
telephone
lines
in
a
city
are
installed
and
the
switching
equipment
is
ready
to
go,
the
marginal
cost
associated
with
one
more
customer
or
call
is
negligible.
When
a
natural
monopoly
exists,
we
can
minimize
costs
by
letting
one
large
firm
produce
everything.
But
with
just
one
firm
we
cant
rely
on
competition
to
ensure
low
prices
and
an
efficient
quantity
of
output.
Thus,
the
social
problem
of
natural
monopolies
is
trying
to
get
the
low
cost
production
while
avoiding
the
high
prices
and
deadweight
loss.
There
are
several
traditional
approaches:
1. The
government
could
produce
the
product.
The
government
could
own
the
telephone
system,
for
example,
or
the
post
office.
This
has
upsides
and
downsides
that
are
beyond
the
scope
of
Ec10.
2. The
government
could
contract
with
a
private
firm
to
provide
the
product.
Here,
competition
among
firms
occurs
during
the
bidding
process,
but
once
a
particular
firm
has
been
awarded
the
contract,
it's
the
only
one
doing
the
1.
Average
Cost
Pricing
(often
abbreviated
P
=
ATC)
Here,
the
commission
sets
the
price
at
the
point
where
the
ATC
curve
cuts
the
demand
curve
(P*)
and
the
firm
must
sell
output
to
any
consumer
who
is
willing
to
pay
that
price
(Q*).
Since
P*
=
ATC*
the
firm
is
not
losing
money
so
this
pricing
scheme
is
sustainable.
Unfortunately,
Q
<
QEFF
so
this
pricing
scheme
is
inefficient.
The
DWL
associated
with
average
cost
pricing
is
shaded
in
the
diagram
below.
Average
Cost
Pricing
for
a
Natural
Monopoly
In
summary,
average
cost
pricing
is
sustainable
but
inefficient
while
marginal
cost
pricing
is
efficient
but
unsustainable.
As
you
can
guess,
it
is
(basically)
impossible
for
a
natural
monopoly
pricing
scheme
to
be
both
efficient
and
sustainable.