[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

PRICE (p)
p m
Average
cost curve
Demand curve
Negative profits
p c
Marginal
cost curve
Marginal
revenue
curve
Q m Q C
FIGURE 13.3
QUANTITY (Q )
A PROBLEM WITH REGULATING A NATURAL
MONOPOLY
A natural monopoly will set marginal revenue equal to
marginal cost, and produce at quantity Q m and price p m .
In perfect competition, price would be equal to marginal
cost, at Q c and p c . However, the perfectly competitive
outcome is not possible in this case, since it would force
the natural monopoly to produce at below its average
cost, and thus to be making losses.
marginal cost, as would be true under perfect competition (the output
level Q c and the price p c in the figure).
However, a decreasing average cost curve necessarily precludes
perfect competition. To understand why, recall that under perfect
competition, price equals marginal cost. Now look again at Figure 13.3
and consider what would happen if price were driven down to marginal
cost. In the figure, marginal cost is equal to p c . At a price equal
to p c , the quantity demanded is equal to Q c . But at that quantity, the
firm’s average costs are greater than p c . When average costs are declining,
marginal costs are less than average costs. Hence, a price equal
to marginal cost would be less than average costs. But if the firm sells
its output at a price that fails to cover its average costs, it will lose
money. So when average costs are declining, profits will be negative
when price equals marginal cost, as shown by the shaded area in the
figure. No firm will be able to stay in business if it always loses money.
There is old joke about a firm that loses money on every sale but
makes it up in volume. Of course, selling more when there is a loss on
each sale just makes the firm even worse off. And that would be exactly
the condition of a firm with declining average costs that set price equal
to marginal cost.
If the government wanted a natural monopoly to produce at the
point where marginal cost equaled price, it would have to subsidize
the firm to offset its losses. But the taxes that would have to be raised
to provide the subsidy impose other economic costs; thus the severity
of the two distortions—caused either by a firm charging a price above
marginal cost or by the taxes required to fund the subsidy to eliminate
the first distortion—would have to be compared. Moreover, the
government would likely have a difficult time ascertaining the magnitude
of the subsidy needed. Managers and workers in the firm would have an incentive
to exaggerate the wage and other costs necessary to produce the required output,
because exaggeration would win them a bigger subsidy from the government.
Governments have found three different solutions to the problem of natural
monopolies.
PUBLIC OWNERSHIP
In some countries, government simply owns natural monopolies, such as electric
power, gas, and water. There are problems with public ownership, however.
Governments often are not particularly efficient as producers.
Managers of such monopolies commonly lack adequate incentives to cut costs and
modernize vigorously, particularly since government is frequently willing to subsidize
the industry when it loses money. In addition, public ownership tends to politicize
business decisions. Political influence may affect where public utilities, for
example, locate their plants—politicians like to see jobs created in their home
districts—and whether they prune their labor force to increase efficiency. Publicly
run firms may also be under pressure to provide some services at prices below
294 ∂ CHAPTER 13 GOVERNMENT POLICIES TOWARD COMPETITION