Breaking up a monopoly that isn’t natural is clearly a good idea: the gains to consumers outweigh the loss to the producer. But it’s not so clear whether a natural monopoly, one in which large producers have lower average total costs than small producers, should be broken up, because this would raise average total cost. For example, a town government that tried to prevent a single company from dominating local gas supply—which, as we’ve discussed, is almost surely a natural monopoly—would raise the cost of providing gas to its residents.

Yet even in the case of a natural monopoly, a profit-maximizing monopolist acts in a way that causes inefficiency—it charges consumers a price that is higher than marginal cost and, by doing so, prevents some potentially beneficial transactions. Also, it can seem unfair that a firm that has managed to establish a monopoly position earns a large profit at the expense of consumers.

What can public policy do about this? There are two common answers.

In many countries, the preferred answer to the problem of natural monopoly has been public ownership. Instead of allowing a private monopolist to control an industry, the government establishes a public agency to provide the good and protect consumers’ interests.

The advantage of public ownership, in principle, is that a publicly owned natural monopoly can set prices based on the criterion of efficiency rather than profit maximization. In a perfectly competitive industry, profit-maximizing behavior is efficient because producers set price equal to marginal cost; that is why there is no economic argument for public ownership of, say, wheat farms.

Experience suggests, however, that public ownership as a solution to the problem of natural monopoly often works badly in practice. One reason is that publicly owned firms are often less eager than private companies to keep costs down or offer high-quality products. Another is that publicly owned companies all too often end up serving political interests—providing contracts or jobs to people with the right connections.

In the United States, the more common answer has been to leave the industry in private hands but subject it to regulation. In particular, most local utilities, like electricity, telephone service, natural gas, and so on, are covered by price regulation that limits the prices they can charge.

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Figure 62.2 shows an example of price regulation of a natural monopoly—a highly simplified version of a local gas company. The company faces a demand curve, D, with an associated marginal revenue curve, MR. For simplicity, we assume that the firm’s total cost consists of two parts: a fixed cost and a variable cost that is the same for every unit. So marginal cost is constant in this case, and the marginal cost curve (which here is also the average variable cost curve) is the horizontal line MC. The average total cost curve is the downward-sloping curve ATC; it slopes downward because the higher the output, the lower the average fixed cost (the fixed cost per unit of output). Because average total cost slopes downward over the range of output relevant for market demand, this is a natural monopoly.

Panel (a) illustrates a case of natural monopoly without regulation. The unregulated natural monopolist chooses the monopoly output Q_M and charges the price P_M. Since the monopolist receives a price greater than average total cost, she or he earns a profit, represented by the green-shaded rectangle in panel (a). Consumer surplus is given by the blue-shaded triangle.

Now suppose that regulators impose a price ceiling on local gas deliveries—one that falls below the monopoly price P_M but above average total cost, say, at P_R in panel (a). At that price the quantity demanded is Q_R.

Does the company have an incentive to produce that quantity? Yes. If the price the monopolist can charge is fixed at P_R by regulators, the firm can sell any quantity between zero and Q_R for the same price, P_R. Because it doesn’t have to lower its price to sell more (up to Q_R), there is no price effect to bring marginal revenue below price, so the regulated price becomes the marginal revenue for the monopoly just like the market price is the marginal revenue for a perfectly competitive firm. With marginal revenue being above marginal cost and price exceeding average cost, the firm expands output to meet the quantity demanded, Q_R. This policy has appeal because at the regulated price, the monopolist produces more at a lower price.

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If regulators pursued allocative efficiency by setting a price ceiling equal to marginal cost, the monopolist would not be willing to produce at all in the long run, because it would be producing at a loss. That is, the price ceiling has to be set high enough to allow the firm to cover its average total cost. Panel (b) shows a situation in which regulators have pushed the price down as far as possible, at the level where the average total cost curve crosses the demand curve. At any lower price the firm loses money. The price here, P*_R, is the best regulated price: the monopolist is just willing to operate and produces Q*_R, the quantity demanded at that price. Consumers and society gain as a result.

The welfare effects of this regulation can be seen by comparing the shaded areas in the two panels of Figure 62.2. Consumer surplus is increased by the regulation, with the gains coming from two sources. First, profit is eliminated and added instead to consumer surplus. Second, the larger output and lower price leads to an overall welfare gain—an increase in total surplus. In fact, panel (b) illustrates the largest total surplus possible.

Sometimes the cure is worse than the disease. Some economists have argued that the best solution, even in the case of a natural monopoly, may be to live with it. The case for doing nothing is that attempts to control monopoly, one way or another, will do more harm than good.

The following FYI describes the case of cable television, a natural monopoly that has been alternately regulated and deregulated as politicians change their minds about the appropriate policy.