A NATURAL MONOPOLY is a firm that  has economies of scale throughout the production range due to extremely high start- up costs, meaning that the AC curve is declining throughout the production range and MC is insignificant for each additional unit of production.

A Natural Monopoly can supply the market more efficiently and at a lower cost than two or more firms.

A Natural Monopoly may be more efficient than a perfect competitor because of the very high start up costs it may be inefficient for more than one firm to supply the market.

The Social Desirability of Natural Monopolies

A rational producer will not incur unsustainable losses  - it will not operate below the AC curve in the long run nor the AVC curve in the short run.
Consider the following situation, where Price (P) is below AC.

P<AC

No rational, privately owned business could stay in business under these conditions.

But what if it was considered socially desirable for the economy to have this product or service? Suppose it was a nationwide energy grid that would boost economic growth?

Then the government may provide the good / service, especially where very high startup costs are involved.

Once demand increases and economies of scale start to appear the government may then sell off the natural monopolies.

Examples of this include:

- Telecom

- Electricorp

The government can also separate the natural monopoly area of the firm to ensure it can't take advantage of its market position.
The government separated the lines / transmission part of electricorp from the electricity generator part to help ensure one electrcity company couldn't take advantage of being the only transmitor of electrcity.

Chorus was separated from Telecom to stop Telecom over charging other firms from using its telephone lines.

The government is the provider of the fibre roll out for broadband to ensure no one provider can monopolise the fibre network

Socially Desirable Monopoly Equilibrium and Government Intervention

The socially desirable equilibrium quantity occurs when MC= AR. Firms will maximise profit where     MC = MR, and, with a downward sloping demand curve, MR is always below AR. This would imply that only perfect competition is socially desirable, yet the majority of New Zealand industries sell in an imperfect market. A monopolist operates in the most imperfect market that can exist.

Should the government choose to intervene, it has a number of measures available with which to force the privately owned monopoly away from private profit maximisation towards the socially desirable equilibrium.

Price is regulated to the point where P = AC, the monopoly would make a normal profit or a ‘fair rate of return’.

By ensuring the firm only gets a normal rate of return, price should be lower and so the consumer surplus is increased and the market is moved to a more allocatively efficient level of output.

The main benefit of average cost pricing is that it reduces the price but there
is no need for a subsidy by the government as the firm is making a normal profit.

It is however; difficult to know what a fair rate of return would be. The government can look at the private sector and see what a fair rate of return could be for a firm in a similar industry.

Marginal Cost Pricing – The government can regulate to a fair rate of return and force a monopoly to price its product where P = MC or MC = AR, just like in perfect competition.  This would help the market to achieve allocative efficiency.
However; this may not result in a normal profit for the firm or even average cost being minimized.
If it results in a sub normal profit the industry may need to be subsidized.

Where the private market cannot provide a socially desirable good or service.                                                                                                     
i) A government set-up monopoly, theoretically, would be controlled by government to ensure that its activities were socially desirable, and to meet any market-generated losses with taxation receipts.

(ii)      Breaking a socially undesirable monopoly.                                                  
If a monopoly already existed and the government wished to break the socially undesirable power of this privately owned natural monopoly, without resorting to price control or subsidy, it could enter the market and compete directly with the firm, thus breaking the monopoly by creating effective competition.
Kiwi bank is a recent example of this.

Nationalisation
This is the ultimate tool of government — to take over a monopoly, with or without compensation for the previous owners. In a democracy a government needs to use this tool carefully, as threats of nationalisation could stifle investment, particularly overseas investment

GOVERNMENT POLICIES TO INCREASE COMPETITION.
Encouraging competition by removing barriers to entry. This was done in the telecommunications industry, opening up the market to increased competition. Before 1984, the Post Office controlled phone lines in NZ, but this was then privatised and competitors such as Clear Communications (now Telstra – Clear) entered the market.
Recently Telecom has been made a separate company to its lines provider – Chorus and it has been forced to share its phone lines with competitors, giving them equal access.

Deregulation and isolating the natural monopoly components of a firm.  Deregulaion that occurred in the 80’s and 90’s was intended to make the monopoly behave in a competitive way.
One way of doing this was to separate the natural monopoly and the firm from it natural monopoly components. As discussed before – recently Telecom has had to separate it line (the high setup cost part) of its business and now all firms have access to its line and fibre network.
The electricity industry is another example where the lines company was separated from the providers and generation part of the firm. So Transpower maintains and provides the electricity lines while firms such as Contact, Genesis e.t.c. produce and provide the electricity.