Put simply, a natural monopoly can keep producing more and more cheaply as it gets bigger and doesn't have to worry about eventual cost increases due to size inefficiency. Mathematically, a natural monopoly sees its average cost decrease over all quantities of output because its marginal cost doesn't increase as the firm produces more output. Therefore, if marginal cost is always less than average cost, then average cost will always be decreasing.
A simple analogy to consider here is that of grade averages. If your first exam score is a 95 and each marginal score after that is lower, say 90, then your grade average is going to continue to decrease as you take more and more exams. Specifically, your grade average will get closer and closer to 90 but never quite get there.
Similarly, a natural monopoly's average cost will approach its marginal cost as quantity gets very large but will never quite equal marginal cost.
Economic natural Monopoly | Compliance and Regulation Law bilingual Dictionnary mafr
Unregulated natural monopolies suffer from the same efficiency problems as other monopolies due to the fact that they have an incentive to produce less than would a competitive market would supply and charge a higher price than would exist in a competitive market. Unlike regular monopolies, however, it doesn't make sense to break up a natural monopoly into smaller companies since the cost structure of a natural monopoly makes it so that one large company can produce at lower cost than multiple small companies can.
Therefore, regulators have to think differently about appropriate ways to regulate natural monopolies. One option is for regulators to force a natural monopoly to charge a price no higher than the average cost of production.
This rule would force the natural monopoly to lower its price and would also give the monopoly an incentive to increase output. While this rule would get the market closer to the socially optimal outcome where the socially optimal outcome is to charge a price equal to marginal cost , it still has some deadweight loss since the price charged still exceeds marginal cost.
Under this rule, however, the monopolist is making an economic profit of zero since price is equal to average cost. Another option is for regulators to force the natural monopoly to charge a price equal to its marginal cost. Currently, though, the antiquated transmission system and continuing retail and distribution regulation at the state level hamper growth and efficiency in the electricity industry.
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Backward-looking, static regulatory thinking about how benefits are generated through competition hampers the unleashing of possible benefits of competition in the electricity industry. Both federal and state policymakers continue to treat transmission and distribution as natural monopolies, meaning they believe one firm could supply the entire demand at lower cost than multiple firms serving the relevant market. From this premise they conclude that transmission and distribution must continue to be regulated, because in the absence of regulation, transmission and distribution owners would not face sufficient competition to keep prices low to consumers and to achieve economic efficiency in transmitting and distributing electricity.
Thus even under current Federal Energy Regulatory Commission proposals to revise the regulation of electricity, both transmission and distribution would continue to be regulated.
Regulating Natural Monopolies
Although regulators are considering ways to incorporate more performance-based rates to move away from rate-of-return regulation, the natural monopoly paradigm locks them into a regulatory framework that is becoming outmoded as a result of technological change. Overcoming the traditional regulatory mindsets is a crucial step in delivering a variety of benefits to consumers, the economy and the environment from competition in electricity.
Through such a process we could actually get closer to achieving economic efficiency in transmission, without running the risk of the regulatory mandate to build more grid that could lead to expensive overconstruction.
Many technological and market innovations have reduced the natural monopoly rationale for traditional electric industry regulation. For example, consider distributed generation. Distributed generation DG is the use of an energy source gas turbines, gas engines, fuel cells, for example to generate electricity close to where it will be used.
Technological change in the past decade and deregulation in the natural gas industry have made DG an economically viable alternative to buying electricity from a monopoly utility and receiving it over the utility—s transmission and distribution grid. The potential for this competition to discipline a transmission owner—s prices for transmission services is immense, but it still faces some obstacles. Some utilities are offering DG, particularly to large industrial consumers who require higher reliability than the standard offering.