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Natural Monopolies
PERFECT COMPETITION AND MONOPOLIES (3.2)
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PERFECT COMPETITION AND MONOPOLIES (3.2)
case studies
Microsoft
In 1975 a small unknown computer programmer, Bill Gates and his firm Microsoft began. In
1981 Gates negotiated to produce the operating system for IBM personal computers. At the
time, IBM was a dominant seller of personal computers.
Today it is estimated that over 90% of all computers use Microsoft Windows as their operating
system. Between 1975 and today, Microsoft grew from a small and unknown firm to, at one
stage, the largest and most dominant computer firm in the world. In the process it made Bill
Gates one of the richest men in the world.
With such huge sales globally, Microsoft’s average costs of production were very low. Other firms struggled to
compete and found it very difficult to match Microsoft’s low costs, thus creating a barrier to other firms competing
with it.
A second barrier to competition was that other software developers primarily wrote their software to work on Windows
- and not other operating systems, because most computers had it installed on them when they were sold. This creates
barriers to entry for competing firms.
A third barrier to competition occured because Microsoft chose to include software as part of Windows free of charge.
In the 1990’s Windows did not have Internet Explorer for people to surf the web. An competing firm - Netscape created a web browser and grew in popularity (and sales) as the internet took off. This started to cost Microsoft sales
until it developed its own web browser, Internet Explorer, which it then in Windows for free. Given that they could
be a free web browser, sales of Netscape plummeted until the firm went out of business.
Similarly the decision to include Windows Media Player in Windows for free, hurt firms who sold similar software.
By the turn of the century many feared that Microsoft was a natural monopoly with too big an advantage over any
possible competitors. Microsoft was accused and prosecuted for its monopolistic behaviour. In Europe it paid nearly
€1.4 billion in fines for its anti-competitive behavioura, and still faces further lawsuits in USA and Europe.
However, today Microsoft has been overtaken by other technology firms - Google, Apple and Facebook. Changes in
technology have allowed these firms to overtake and compete Microsoft. Is it still a natural monopoly?
Telecom
At the turn of this century, Telecom was the dominant telecommunications firm in New Zealand.
It owned all telephone lines, was the largest cellphone and internet provider, as well as other
telecommunication services.
Ownership of the telephone network meant that Telecom had a huge advantage over competitors such as Vodafone.
Even with mobile phones, Vodafone (or other firms’) customers needed to access the landlines to contact business and
homes. Because it owned the network, Telecom could charge wholesale prices to other firms that put them at a cost
disadvantage to Telecom Mobile.
Telecome was effectively a natural monopoly. Significantly it was also accused of using its market dominance against
other firms and the interests of consumers. It was repeatedly investigated by the Commerce Commission under the
1986 Commerce Act.
4
After several attempts to regulate the price Telecom charged other firms for using its network and various other aspects
of its business, the Commerce Commission eventually broke Telecom into two separate firms - Telecom and Chorus.
Chorus owned the telephone lines and associated network, while Telecom provided retail services.
The new Telecom now has to compete with the same costs as other firms.
PERFECT COMPETITION AND MONOPOLIES (3.2)
89
unit over
view
au naturelle...
A natural monopoly is a specific type of monopoly that can occur, especially in
industries that involve large infrastructures or networks.
This unit looks at what can lead to a natural monopoly occurring, the advantages
and disadvantages of a natural monopoly, and how the government can intervene
in natural monopoly to protect the interests of consumers.
by the end of this unit, you should be able to answer these questions...
1
what is a natural monopoly ?
natural monopolies &
government intervention
2
how can the
government intervent
in a natural monopoly?
4
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PERFECT COMPETITION AND MONOPOLIES (3.2)
4
mind-map
Mind-maps are very good revision tools. Our minds learn by
making patterns. Mind-maps help you to make these patterns
and so makes the content easier to learn and remember.
BEFORE you start this unit (in pencil) ...
•write the key idea of this unit in the centre of the page
•write what you know about this idea around it and draw lines to them.
•try and group the ideas together
AFTER you finish this unit (in pencil) ...
•remove anything that doesn’t belong to this unit
•ensure that things are grouped together appropriately. Move stuff around if needed
•add any extra ideas that you think are missing
PERFECT COMPETITION AND MONOPOLIES (3.2)
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this place ain’t big enough for the both of us!
Monopolies that control large networks, e.g. power or telephone networks, or natural
resources can gain such an advantage over potential competitors that other firms have no
chance of being able to compete against them.
In some situations it can be advantageous to allow natural monopolies to exist, but as we saw in unit 3 - monopolies can work against consumers and reduce allocative
efficiency.
This topic looks at what a natural monopoly is, how they can occur, and the pro’s/con’s
of natural monopolies.
by the end of this topic, you should be able to...
o describe a natural monopoly and show it on a graph
o explain how a natural monopoly occurs
o desribe the advantanges and disadvantages of a natural monopoly
4
remember - try the exercises and then read the notes to learn what you don’t know ...
92
PERFECT COMPETITION AND MONOPOLIES (3.2)
The graph below shows a natural monopoly.
Study the graph and answer the questions below.
Revenue & Costs
($/unit)
150
140
130
120
110
100
90
AC
80
70
MC
60
50
40
30
Natural Monopoly
20
10
0
AR
MR
2
4
6
8
10
12
14
16
18
20
Q (millions)
1. Explain how the graph above shows this industry is a natural monopoly.
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
Exercise 4.1
2. Identify the level of profit-maximising (loss-minimising) output (QPM) and price (PPM).
3. What is the firm’s economic profit (loss) at this level of output? $ ____________________
4. Add an average variable cost (AVC) curve that would result in the monopoly NOT shutting down in the long-run.:
5. Show an increase in demand that will result in the firm earning a supernormal profit in the long-run.
6. Use marginal analysis to explain how the firm will respond to the long-run increase in demand.
4
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
PERFECT COMPETITION AND MONOPOLIES (3.2)
93
Identify whether the following markets are examples of natural monopolies or not:
Ports of Auckland
YES
NO
Auckland Airport
YES
NO
NZ Rail
YES
NO
Air New Zealand (International Trave)
YES
NO
Fonterra
YES
NO
2. The following graph shows a natural monopoly.
a) Add an average cost (AC) curve that identifies the graph as one for a natural monopoly.
Revenue & Costs
($/unit)
b) Show the profit-maximising (loss-minimising) level of output (QNAT) and price (PNAT).
c) Shade and label any economic profit that occurs at QNAT.
Q
3. On the graph below, add an appropriate average revenue (AR) and marginal revenue (MR) curve that shows a
natural monopoly earning a supernormal profit.
($/unit)
MC
AC
Exercise 4.2
AR
MR
Natural Monopoly
MC
4
Q
94
PERFECT COMPETITION AND MONOPOLIES (3.2)
Natural Monopolies
notes
Define and Illustrate Natural Monopolies
In unit 3 we looked at monopolies and how they act in markets, i.e. set the market price or quantity. This
unit looks at one special type of monopoly - a natural monopoly.
A natural monopoly is a market in which one firm can supply the entire market more cheaply than if
two or more firms supply that market. For a variety of reasons (see ‘Identify and Explain the Causes of a
Natural Monopoly’ below) a natural monopoly has a enormous cost advantage over any other firm that
may want to enter the market.
Figure 4.1 shows a natural monopoly. The first thing you should notice is that the lowest point of the
average cost curve is to the right of the average revenue curve. This second (related) thing you should
notice is that the average cost curve falls through the ‘relevant range of demand’.
The relevant range of demand refers to that part of the demand curve where the firm is prepared to
supply the good or service. In Figure 4.1 the firm will not supply below QPM because it would not be
profit maximising. As we will see the government may intervene and require the firm to increase output.
However, it will not produce more than QE because this is where S=D in a competitive market. So the
stretch of the demand curve between QPM and QE is called the relevant range of demand.
Figure 4.1 ... Natural Monopoly
($/unit)
Relevant Range
of Demand
MC
AC
NOTE: In a natural monopoly, the
lowest point on the AC curve is always
to the right of the Demand (AR) curve.
MR
QPM
(MC = MR)
AR=D
QE
(S = D)
Q
The ‘relevant range of demand’ is all levels of output between the profit-maximising level of output (QPM) which the monopolist will
not supply less than . . . and the market equilibrium level of output (QE) which consumers will not demand more than. Through
this range of demand, the firm’s average cost curve is falling.
4
Ideally for the firm, it will produce at its profit-maximising level of output - QPM. However if other firms
tried to enter the market, the firm could increase production. This would lower its average cost of
production and allow it to undercut the prices of the competition. Remember - it can do this because
(by definition) a natural monopoly can supply goods or services to the market than if there were two or
more firms in the market.
As we will see, natural monopolies tend to happen in two situations - markets that involve large
infrastructure or networks, and statutory monopolies.
Current examples of natural monopolies:
•
Auckland Airport - the only commercial airport in Auckland
•
Transpower
- the only provider of electricity transmission lines around New Zealand
•
Airways Corporation - the only provider of navigation services to air traffic
Natural Monopoly: A market where one firm can supply the entire market more
cheaply than two or more firms.
PERFECT COMPETITION AND MONOPOLIES (3.2)
95
Identify and Explain the Causes of Natural Monopolies
A natural monopoly can arise for various reasons:
Economies of Scale
From time to time, one firm in a market will succeed more than its competitors and start to gain a
dominant market share. As it grows it is able to dominate the market and enjoy greater economies of
scale. Eventually, a firm may grow so big that it can supply the entire market more cheaply than were
there other firms in the market, i.e. a natural monopoly exists.
Google would be a possible current example of this, as it has grown to dominate the market for internet
search engines.
Control Over Resources
When a firm controls a resource that is essential to producing a good or service, it creates a barrier
to other firms entering the market and gives the monopolist such an advantage over other possible
competitors that it becomes a natural monopoly.
In some markets, the key resource may be an infrastructure or network. These markets involve very large
assets such as telephone transmission lines, postal delivery routes, large power plants, or railway lines.
The start-up cost in these markets is so immense that it acts as a huge barrier to new firms entering the
market.
Statutory Monopolies
Occasionally a government may pass a law (statute) that grants one firm a legal or ‘statutory monopoly’.
This means that no other firm may produce the same or similar product.
Typically this has been done in markets that require significant up-front investment, such as the building
of hydro-electricity dams and electricity transmission lines. In these situations, firms are wary of investing
large amounts of money without the guarantee of future income to cover their investment.
By granting a statutory monopoly, the government can guarantee revenue to the firm and so give it the
necessary incentive to invest in a product. This has been done in the past to ensure necessary infrastructure
was built in New Zealand, e.g. electricity, telecommunications, airports. Typically statutory monopolies
that were set up were also government owned (e.g. Electricorp, Air New Zealand, New Zealand Post
Office).
Explain Output and Pricing Decisions for a Natural Monopoly
A natural monopoly acts the same as a normal monopoly., a monopolist will produce at its profitmaximising level of output. In a natural monopoly this output level will always be below the market
equilibrium level of output, as shown in Figure 4.2.
Figure 4.2 ... Output and Pricing Decisions for a Natural Monopoly
($/unit)
An unregulated natural monopolist will
produce at QPM and price at PPM. This is
where it maximises its profit, i.e. MR = MC.
MC
Deadweight Loss
PPM
AC
PE
Consumers however would prefer an output
level of QE and a price of PE. This is the
level of output when in a competitive market
supply supply (MC) would equal demand
(AR).
Unregulated, the market will operate below
market equilibrium, resulting in deadweight
loss.
Market
Equilibrium
Profit
Maximisation
MR
QPM
AR=D
QE
Q
4
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PERFECT COMPETITION AND MONOPOLIES (3.2)
Describe the Advantages and Disadvantages of a Natural
Monopoly
Natural monopolies can be good and offer the following advantages to consumers and the economy:
1. Lower Costs of Production
By definition, a natural monopoly can supply goods or services more cheaply than if there
were two or more firms in the market. This is good, as long as these low costs are passed
on to consumers through lower prices.
2. Incentive to Provide Expensive or Important Products
As discussed above, the cost of setting up to provide some products is very expensive. A
natural monopoly can create the incentive needed for private firms to invest in large-scale
projects, rather than government.
Alternative, natural monopolies can have be negative for consumers and the economy:
1. High Price, Low Output
Unregulated, a monopolist will produce at the profit-maximising level of output. For a
natural monopolist this level of output is always below the market equilibrium level of
output. This means that less goods are produced, at a higher price than would occur
were there a competitive market.
2. Deadweight Loss
Because it is a monopoly and faces a downward sloping average revenue curve, a
natural monopoly will produce at an output level below a perfectly competitive market
equilibrium. This will reduce consumer and producer surplus and result in deadweight
loss.
3. Stifling Innovation
Because a natural monopoly controls the entire market, there is less need to spend
money on research and development in order to develop new products or lower costs
of production.
4
PERFECT COMPETITION AND MONOPOLIES (3.2)
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this place ain’t big enough for the both of us!
Monopolies that control large networks, e.g. power or telephone networks, or natural
resources can gain such an advantage over potential competitors that other firms have
no chance of being able to compete against them.
In some situations it can be advantageous to allow natural monopolies to exist, but as we saw in unit 3 - monopolies can work against consumers and reduce allocative
efficiency.
This topic looks at what a natural monopoly is, how they can occur, and the pro’s/
con’s of natural monopolies.
by the end of this topic, you should be able to...
o describe anti-trust laws and deregulation can avoid natural
monopolies from occurring
o explain the three types of price regulation (average, marginal, differential tariff) and show these on a graph
o desribe how government ownership can be used to control natural monopolies
4
remember - try the exercises and then read the notes to learn what you don’t know ...
98
PERFECT COMPETITION AND MONOPOLIES (3.2)
Exercise 4.3
Natural Monopoly & Government Intervention
Answer the multiple choice questions below:
4
1.
A natural monopoly is one that . . .
a. is required by regulators to earn zero profit.
b. gets its market power from the ownership of patents.
c. has economies of scale over the entire market.
d. is unable to cover its costs, no matter what price is charged.
2.
Natural monopolies are different to other monopolies in that they . . .
a. are imperfect competitors.
b. are sole producers of organic products.
c. can determine price and output but not both at the same time.
d. have downward sloping average cost curves in the relevant output range.
3.
Which of the following is most likely to be a cause of a natural monopoly?
a. Government regulation or ownership.
b. Supernormal profits.
c. High start-up costs.
d. Climate.
4.
Which is the typical feature of a natural monopoly?
a. Higher prices occur compared with perfect competition.
b. Diminishing returns does not apply in this industry.
c. The profit maximising level of output is allocatively efficient.
d. Economies of scale occur over the entire market size.
5.
Which is the closest to a natural monopoly in New Zealand?
a. Auckland Airport.
b. Vodafone.
c. Air New Zealand.
d. The Starship Hospital in Auckland.
6.
A key feature of a natural monopoly is that . . .
a. one firm can supply the entire market at lower prices than any two or more firms.
b. it will be state-owned.
c. it must always earn supernormal profits.
d. it will always produce at a level of output where P = MC.
7.
The Government may allow a natural monopoly to occur because . . .
a. as the majority shareholder, it will earn a supernormal profit.
b. without statutory protection, private firms may refuse to invest in important infrastructure.
c. the monopoly will have lower costs than a competitive market and so produce more goods.
d. it is not the role of government to punish firms who are successful.
8. Identify and describe the three ways that a government can regulate a natural monopoly:
a) ______________________________________________________________________________________________
______________________________________________________________________________________________
______________________________________________________________________________________________
b) ______________________________________________________________________________________________
______________________________________________________________________________________________
______________________________________________________________________________________________
c) ______________________________________________________________________________________________
______________________________________________________________________________________________
______________________________________________________________________________________________
PERFECT COMPETITION AND MONOPOLIES (3.2)
99
Revenue & Costs
($/unit)
24
22
20
18
16
14
MC
AC
12
10
8
6
4
2
0
AR
MR
2
4
6
8
10
12
14
16
18
20
Q (millions)
1. Show the natural monopoly’s profit-maximising price (P1) and quantity (Q1).
2. Shade and label the natural monopoly’s economic profit.
3. Explain why the government may choose to intervene in this market by regulating the price.
Natural Monopoly & Government Intervention
The following graph shows a natural monopoly.
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
4. Show the price (P2) be charged to consumers, and the resulting market quantity (Q2) if the government implemented
an average-cost pricing regime.
5. Show the price (P3) be charged to consumers, and the resulting market quantity (Q3) if the government implemented
an marginal-cost pricing regime.
6. Describe what the government would need to do to support the firm, to keep the marginal-cost pricing regime in
place.
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
Exercise 4.4
_________________________________________________________________________________________________
4
Exercise 4.5
Natural Monopoly & Government Intervention
100
PERFECT COMPETITION AND MONOPOLIES (3.2)
Use
the following graph to compare and contrast the different types of government
intervention in a natural monopoly.
($/unit)
MC
AC
AR
MR
Q
1. Show the natural monopoly’s profit-maximising price (P1) and quantity (Q1).
2. Shade and label the natural monopoly’s economic profit.
3. Show the price (P2) be charged to consumers, and the resulting market quantity (Q2) if the government implemented
an average-cost pricing regime.
4. Show the price (P3) be charged to consumers, and the resulting market quantity (Q3) if the government implemented
a differential taff, or two-part pricing regime.
5. Shade in the following on the graph above:
variable charge
fixed charge
6. Explain how the average-cost pricing regime improves allocative efficiency in the market. Your answer should
clearly identify the changes to consumer and/or producer surplus.
_________________________________________________________________________________________________
4
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
PERFECT COMPETITION AND MONOPOLIES (3.2)
Natural Monopolies and Government
101
notes
The government has a number of tools at its disposal to prevent natural monopolies occurring or to
control them when they do exist in order to protect consumers. In New Zealand this is done through the
Commerce Commission.
Describe Anti-Trust Laws, Deregulation and Market Reforms
Many governments have laws that can stop firms from becoming monopolies . . . or laws that stop
monopolies from abusing their dominant market position. In New Zealand, the Commerce Commission
is responsible for overseeing these laws. It can stop takeovers or take other measures to stop monopolies
occurring or negatively affecting consumers.
Where statutory monopolies exist, the government can deregulate, i.e. remove all legal protection the
firm has from competition. This allows other firms to enter the market and compete.
Describe and Illustrate Price Regulation
Alternatively the government can allow natural monopolies to exist and regulate their prices. The three
types of price regulations are:
• Average Cost Pricing
• Marginal Cost Pricing
• Differential Tariff
Average Cost Pricing
This price regulation requires the monopolist to set
its price at a break-even point, i.e. where the price
covers its costs.
Because these are economic costs of production,
they cover the minimum profit necessary to keep
the firm in the industry.
Figure 4.3 ... Average Cost Pricing
The government forces the firm to produce at an output
level where the price (PR) covers the average cost.
($/unit)
On a graph, this point occurs where AC = AR, as
shown in Figure 4.3. Price is at PR and output at QR.
While this system seems fair to all because it brings
the price down for consumers while still allowing
the monopolist to make a reasonable return on its
investment, there are problems.
1. Defining a Reasonable Return
The definition of economic costs includes
earning a profit that is as good or better than
the next best alternative, i.e. the opportunity
cost. However, it can be very difficult to define
exactly what this is.
MC
AC
PR 18
AR
MR
QR
Q
A common approach is to state a percentage return on investment. For example the monopolist may
be allowed to earn 8% return on investment. So if the net value of its assets are $1 billion, it would
be allowed to earn $80 million profit. Any profits above this would be taken by the government.
2.
Accurate Measurement of Financial Data
Under the Average Cost approach of defining a reasonable level of return, the monopolist may be
tempted to change its accounting records to maximise its return. For example, it may overstate the
value of its assets to justify a higher profit.
3.
Less Investment and Innovation
Normally if a firm can improve its productivity and lower its operating costs, it earns a better profit.
But if its profit is regulated, e.g. it can only earn an 8% return then there is little incentive to develop
new products or production techniques that will lower costs. In the long-run this is bad for
consumers.
4
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PERFECT COMPETITION AND MONOPOLIES (3.2)
Marginal Cost Pricing
Marginal cost pricing regulations require the firm to produce at a level of output where supply (MC)
equals demand (AR), i.e. the level of output that a competitive market would produce at.
The major problem with this intervention is that the monopolist is making subnormal profits at this output
level. The government must subsidise the firm to ensure it stays in the industry. In Figure 4.4 the subsidy
must equal the subnormal profits shown by the shaded area. PR shows the price that consumers would
pay, while PS is the price the monopolist would earn.
Figure 4.4 ... Marginal Cost Pricing
($/unit)
MC
The government forces the firm to produce at an
output level where supply (MC) equals demand
(AR).
Subnormal Profits
(economic loss)
AC
PS
16
PR
14
This results in the firm making an economic
loss (shaded area), which the government must
compensate the firm for by subsidising them the
same amount as the loss.
AR
MR
Q
QR
Differential (2-Part) Tariff
This situation is the same as the previous one (marginal cost pricing), except that the government allows
the firm to charge customers to cover the subnormal profit.
To do this, the firm imposes two charges on consumers – a fixed charge and a variable charge. The fixed
charge ($2 per unit in Figure 4.5) covers the economic loss, i.e. the gap between AR and AC at QR.
The variable charge ($14 in Figure 4.5) is set at the price that consumers are willing to pay, i.e. the
average revenue (or demand) at the regulated output level (QR).
Figure 4.5 ... Differential Tariff
($/unit)
MC
The government forces the firm to produce
at an output level where supply (MC) equals
demand (AR).
Fixed Charge
AC
To cover the economic loss made by the
firm, the government allows the firm to
charge customers a second fixed charge
($2 per unit).
16
14
Variable (User-pays) Charge
AR
MR
4
QR
Q
Describe Government Ownership
A final solution to natural monopolies is for the government to own it. The benefits of this are that the
government can choose to maximise its profits and then feed its profits back into the country or it can
direct the monopoly to earn low profits (or even a loss) and benefit consumers through low prices.
The disadvantage of this policy is that the government has a mixed record of trying to run a business,
sometimes doing it well and sometimes doing it poorly. It also means that the government must use
scarce public funds.
PERFECT COMPETITION AND MONOPOLIES (3.2)
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104
PERFECT COMPETITION AND MONOPOLIES (3.2)
This question checks that you can:
 describe the characteristics of a natural monopoly
 identify the pricing and output decisions of a natural monopoly
 compare the different government policies to regulate a natural monopoly
Up until the 1980’s Electricorp was a state-owned natural monopoly in the New Zealand wholesale electricity
market.
Electricorp owned all electricity power stations, including all of the hydro-electric dams, as well as the
electricity transmission lines through the country. It then sold the electricity to regional power boards, who
had a similar natural monopoly within their own regions.
1. Using Electricorp as an example, define what is meant by the term ‘natural monopoly’.
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
Natural Monopoly
_________________________________________________________________________________________________
Graph 1: The New Zealand Wholesale Electricity Market
Prices / Costs
Revision 4.1
MC
D=AR
Quantity
MR
2. On Graph 1, draw an appropriate average cost curve (AC) to show Electricorp as a natural monopoly
4
3. Show the profit maximising quantity QELECTRICORP and profit maximising price PELECTRICORP
4. Because Electricorp was government-owned, the government was able to regulate the price that Electricorp charged
its customers. The government did this by requiring Electricorp to set the price at a level that would occur if the
wholesale market was perfectly competitive.
Show this price (PREG) and the resulting quantity (QREG) on the graph above.
5. Shade the subnormal profit that Electricorp suffered as a result of charging at PREG.
PERFECT COMPETITION AND MONOPOLIES (3.2)
105
6. Explain how requiring Electricorp to produce at a price where it earns a subnormal profit is effectively the same as
applying a differential tariff to a natural monopoly.
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
7. An alternative government policy would be to require the firm to set its price at a level that matches its average cost
of production, i.e. at its break-even point. Show this price (PAC) and quantity (QAC) on Graph 1.
• the impact on producers and consumers
• the impact on the government and taxpayers
• any impact on allocative efficiency in the market
• any flow-on effects to the rest of the New Zealand economy
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
Natural Monopolies
8. Compare the two different government policies to regulate the wholesale electricity market in New Zealand. Your
answer should clearly refer to:
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
Revision 4.1
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
_________________________________________________________________________________________________
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106
PERFECT COMPETITION AND MONOPOLIES (3.2)
This question checks that you can:
 describe the characteristics of a natural monopoly
 identify the pricing and output decisions of a natural monopoly
 compare the different government policies to regulate a natural monopoly
Graph 2: Natural Monopoly
Costs / Revenue
MC
revision 4.2
Market Reforms
MR
D = AR
Output
1. On Graph 2 above, draw an appropriately positioned average cost curve (AC) for a firm that is a natural monopoly.
2. On Graph 2, identify:
a. the natural monopoly’s profit maximising level of output as Q1.
b. the natural monopoly’s profit maximising price as P1.
c.
the deadweight loss that would result if the natural monopoly produces at P1.
3. Use marginal analysis to explain why the natural monopoly will not produce more than Q1.
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4. On Graph 2, identify:
a. the socially desirable level of output as Q2.
b. the socially desirable price as P2.
PERFECT COMPETITION AND MONOPOLIES (3.2)
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5. Explain why the profit maximising level of output is less socially desirable than producing at QS.
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6. To get the market closer to the socially desirable level of output, the government could impose average-price
controls, i.e. set the price at a level where average revenue (AR) equals average cost (AC), i.e. the natural monopoly’s
break-even point.
Show the price (P2) and quantity (Q2) that would result from this government policy.
7. Show the change to consumer surplus as a result of the government requiring the firm to charge P2 to consumers.
8. Evaluate the effectiveness of average-cost price controls as a government policy to improve resource allocation in
markets controlled by natural monopolies. Your answer should clearly compare the average-cost price controls to
either no regulation or other regulations.
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Revision 4.3
Natural Monopolies
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108
PERFECT COMPETITION AND MONOPOLIES (3.2)
UNIT 4
Natural Monopolies
Unit Content:
Understanding
1
(poor)
4.1
2
Perfectly Competitive Firms’ Costs and Revenue
• Identify and Classify Resources Used by Firms
• Describe Accounting and Economic Costs
• Describe Fixed and Variable Costs
• Derive a Firm’s Costs of Production
• Describe and Show a Firm’s Revenue
4.2
Profit Maximisation and Marginal Analysis
• identify a Firm’s Profit Maximising Output
• Identify and Describe Economic Profit
• Describe Loss Minimisation
• Compare Short-Run to Long-Run
• Identify a Firm’s Shut-Down Point (Short-Run Decision)
checklist:
I have ...
 done a mind-map of the main ideas (before and after I did the work)
 tried (and marked) all of the exercises
 watched the online videos of this work
 read the notes and summarised the key ideas in the margins of the pages
 made (or downloaded from quizlet) flashcards of the key ideas and definitions
relevant current events and examples:
relevant events and examples for this unit are:
I didn’t really get the following parts of this unit ...
4
... and I’m going to ask ___________________ to help me with this
3
(good)
PERFECT COMPETITION AND MONOPOLIES (3.2)
tips
4
109
revision
YouTube
To help you with the material in this workbook, you can access video resources on YouTube. There is a wide
variety of economic resources that you can search for. There are specific videos that have been created to go along
with this workbook. Many of these videos relate to the notes. However there are also videos that show you how
to do the exercises in this workbook. To find these, go online to www.youtube.com and search the following
keywords - dykesnz, economics.
quizlet
To help you revise, make revision resources through the year. At the start of the year, create your own Quizlet
(www.quizlet.com) account. As you finish each topic, create a set of flash cards for the definitions and concepts you
must learn. Some sets have been created on Quizlet for you (keywords - dykesnz, economics).
how to study
Too many students do bucket study, i.e. they think their mind is a bucket and if they just
read their notes again ... and again ... and again ... etc, they will fill their mind up with
lots of facts, which they can then download during a test of exam.
YOUR MIND IS NOT A BUCKET.
Revision does include some memorising or rote learning. But remember that you mind
learns new stuff by forming patterns, so study in a way that supports this. There are three
main types of revising:
• memorise
In economics, and all of your courses, there will be some stuff that you do need to memorise.
Definitions, key concepts, rules, formulae. The key to this is repetition. It’s better to spend 2 minutes
every hour doing some memorising, that one half-hour block per day. To help you make some
flashcards, or download some digital flashcards (e.g. from Quizlet) on to your phone. And then look
at them between periods, or during ad breaks while watching tv.
• understand
Most importantly you must understand the course and demonstrate this in a test or exam. Mindmaps are useful for this as they get you to work out how the different pieces of the course relate to
each other, and help your brain form patterns. Mind-maps are also very good if you are a visual
learner, as you will find it easier to remember a picture than lots of facts or definitions.
• practise
The most effective way to revise is do past tests or exams. Use the exercises and revision
activities in this book, or go to www.nzqa.govt.nz and download past exam questions and
model answers. Check with your teacher about which ones to use as the standards changed
in 2013. As you do the tests or exams, identify what you don’t know and go back to the notes
to find the answers. Then redo the test and check your answers. Make sure you understand
it correctly.
4
110
PERFECT COMPETITION AND MONOPOLIES (3.2)
tips
4
exam technique
scan ... plan ... do
When you sit the exam or test, there’s a good strategy to use ... scan, plan and do
• scan
Quickly read through the exam or test and identify what the
exam is asking you about.
• plan
take two minutes to write down on a blank piece of
paper ideas that come into your mind. Focus on what
you do know and don’t worry about what you don’t.
Once you’re under way, you’ll be surprised what comes back to
you. As you do the test and ideas about questions pop into your
mind - write them down on the piece of paper for you to use later.
• do
Get started. If you don’t know the answers to something,
make a note on your planning piece of paper and come
back to it. Don’t waste time trying to remember. When
you’ve finished the exam or test, go to your planning
sheet and go back to the questions you left unanswered.
Finally ... go through actual test paper and make sure you’ve left
nothing blank.
no white space
In NCEA it is important that you answer every question even if just part of it. Under the marking schedule,
markers can find evidence of you meeting the standard ... including with merit and excellence ... anywhere in the
exam.
a
e
no white spac
p
s
e
t
i
h
w
Don’t leave any question unanswered.
no whit
e
no
no white space
pace
ite s
h
no w
wh
Ac
NO WHITE SPACE !!
e
ac
e sp
4
space
e
e
no white spac
o hit
n
o
n w
no w
So try to answer every question.
ce
ace
sp
hite
no white space
no white space
ite
ce
H
nO
no whi
nO
spa
ite
no wh
ite spa
ce
sp
w
te spac
W
hi
Te
SP
e
ace
e sp
hit
w
no
aC
Ee
no white space
no white space
no white space no white spac
e
PERFECT COMPETITION AND MONOPOLIES (3.2)
tips
4
111
writing
To do well in economics - this year, at university and as a professional economist, you must be able to write well.
As an economist, you write to persuade. You must write an argument, that through a series of ideas or evidence, leads the
reader to understand your conclusion and why it is the correct or best conclusion.
Structure
Your writing should have the following basic structure:
Introduction
... what is the question or issue that I am considering?
... what options / arguments / evidence will I consider?
... what is the conclusion I will make?
Analysis
... what are the key parts to my conclusion?
... what what are the arguments or evidence, for and against my conclusion?
Conclusion
... what is the question or issue?
... what options have you considered?
... evaluate the arguments or evidence - which do you think are the best?
... what is your preferred conclusion?
Paragraphs / S.E.X.
Paragraphs are the building block of any writing. They help you to organise your work and the reader to follow your logic.
If you can write good paragraphs, you will write good essays.
Every paragraph should have one point. Use the mnemonic S.E.X. when writing each essay
Statement
Explain
eXample (evidence)
... state the key idea of this paragrah?
... unpack your key idea with more detail
... back up your key idea with an example or evidence (data)
- provide data, anecdotes or economic theory to support the key idea
A paragraph does not need to be long. It is far better to have more smaller paragraphs, than one large paragraph with lots
of points. KEEP IT SIMPLE.
Plan
Always plan your writing. Start with a very high level plan and gradually build it up.
Your first plan may only state the topic, you main points and you conclusion.
Your second plan may add the arguments for and against within your main points, and/or some of the evidence
(data) you will use.
Your third plan may include the ideas (paragraphs) within your main points.
Use your plan to check that you have answered the question ... that you have a definite conclusion ... that you have a range
of ideas and/or evidence .... and that you have a logical structure for the reader to follow.
4
112
PERFECT COMPETITION AND MONOPOLIES (3.2)
tips
4
teachers
calculating firms’ costs of production
This standard does not require students to calculate firms’ costs of production.
Exercises getting students to do this are included in this workbook to help students understand how the different
types of costs and revenue relate to each other and affect firms’ short-run and long-run output decisions.
supply in a monopoly market
Unlike a perfectly competitive market, the marginal cost curve in a monopoly does not equal the firm’s supply curve.
Any analysis, e.g. with natural monopolies, that gets students to identify the market equilibrium should refer to
where demand would equal supply - if the market was competitive.
• achieve
Students can identify simply (on a graph) and explain
how firms decide how much to produce (or set a price for
monopolies), the allocative efficiency (or deadweight loss)
in a market, how firms will change their output (or price)
in the long-run, a government policy to regulate a natural
monopoly.
• achieve with merit
Students can do the same as for achieve but for more complex
ideas, e.g. two changes, and can provide more detailed
explanations about the allocative efficiency of perfect competition
versus a monopoly.
• achieve with excellence
Students must compare / contrast one of the following three items:
- the allocative efficiency of monopoly vs perfect competition
- the changes to a market in the short-run and the long-run
4
- the effeciveness of different government policies
•
The second item requires students to use marginal analysis to explain
how firms decide to change their quantity or price (for monopolies)
in the long-run
•
The third item refers to the government policies for a natural
monopoly
monopoly - price vs output
A monopolist can not set both price and quantity sold. It must set either price and allow consumers decide how
much they will demand ... or determine the quantity it wants to sell and accept the price that consumers are willing
to pay for this output level.
private goods
Achievement Standard 3.2 assumes all goods and services are private.
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PERFECT COMPETITION AND MONOPOLIES (3.2)