Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Natural monopoly
Explain natural monopoly using economies of scale and falling average costs. Identify unregulated output, price and the limits of competition.
The economic idea
A natural monopoly exists when economies of scale are so extensive across the relevant range of market demand that one firm can supply total market output at a lower average cost than two or more firms. The cost function is subadditive over that range.
It commonly arises in networks with very high fixed infrastructure costs and relatively low marginal costs, such as water pipes or electricity distribution. Dividing the market may duplicate networks and raise total cost.
Falling average cost creates a policy tension. An unregulated natural monopolist can restrict output where MR = MC and charge the price on demand, producing a price above marginal cost and deadweight loss.
Allocative efficiency would require P = MC, but when AC remains above MC the firm would not cover total economic cost. Average-cost pricing permits normal profit but leaves P above MC and output below the allocatively efficient quantity.
Natural monopoly does not mean that every activity in an industry must be monopolised. Competitive production can sometimes coexist with a regulated natural-monopoly network.
Reading the unregulated natural monopoly outcome
“Price, costs, revenue” is measured vertically and “Output” horizontally. Revenue and cost values are expressed per unit.
“D = AR” is the firm or cartel’s average-revenue curve: each point shows the price buyers will pay for a particular output.
“MR” lies below “D = AR” because selling another unit requires a price reduction that affects revenue from earlier units.
“MC” shows the extra cost of producing the next unit, while “AC” is total economic cost per unit.
Choose output at E
“E” is the profit-maximising outcome where “MR” equals “MC”. The firm produces “Q” and then charges “P” on “D = AR”. Price exceeds marginal cost, showing allocative inefficiency and market power at the displayed outcome.
Compare Q with Q*
“Q” lies below “Q*”, the output where “D = AR” meets “MC”. Mutually beneficial units are forgone and the resulting triangle is deadweight welfare loss.
Identify the current profit position
“P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Keep profit, surplus and welfare loss separate
Consumer surplus is below “D = AR” and above “P”, up to “Q”. Producer surplus is above “MC” and below the price over the units sold; it covers fixed cost as well as economic profit. The profit rectangle instead compares price with “AC” at that output.
The welfare-loss triangle lies between “D = AR” and “MC”, from “Q” to “Q*”. Buyers would value those missing units more than they cost to produce. A transfer from consumers to the seller is not itself deadweight loss.
The natural-monopoly argument concerns cost savings from one network. To evaluate it, weigh those economies of scale against restricted output, the price charged and the costs of regulating service quality.
Why MR = MC comes before the price decision
For outputs below “Q”, “MR” exceeds “MC”, so another unit adds more to revenue than to cost.
At “E”, “MR” equals “MC”, fixing the profit-maximising quantity “Q”.
Move vertically from “Q” to “D = AR” to find the price “P” consumers are willing to pay.
Compare “P” with “AC” to identify profit. “P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Common mistakes to avoid
- Do not read price from “MR”. It is found on “D = AR” after output has been chosen.
- MR = MC identifies profit maximisation, not allocative efficiency. Allocative efficiency requires price, or marginal benefit, to equal marginal cost.
- Market power does not guarantee abnormal profit; high average cost can leave the firm earning normal profit or making a loss.
- A single seller is not automatically a natural monopoly. Natural monopoly requires declining average cost across the relevant market demand.
How to draw this diagram
- Title the diagram “Natural monopoly”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw D = AR first and label it clearly.
- Draw MR next and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram treats the relevant demand and cost curves as known, while regulators often rely on information supplied by the firm.
- Technology can change the natural-monopoly boundary by lowering fixed costs or enabling network access by competing suppliers.
- Falling AC does not prove that private unregulated ownership is desirable; ownership and pricing are separate questions.
- Marginal production cost may exclude congestion, environmental damage, reliability and long-run replacement cost.
- A single static demand curve does not capture peak-load pricing or capacity investment over time.