A Problem with Natural Monopoly

Natural monopoly happens when, at the socially optimal quantity output (q), a single firm is able to produce total output at a lower total cost than multiple firms do. It means that only single firm serves the market and it is called as subadditivity. One obvious example is electricity industry due to its peculiar behavior e.g. large fixed-cost and non-storability. In other words, Natural monopoly occurs when in the long run, average cost (AC) is declining as demand (output) increases because the total cost is dispersed over output level for long period and thus declining AC will push down MC below it.

Given only one firm is operating in the market, firm will act to maximize its profit and it will choose to produce output (q) where its marginal revenue (MR) is equal to marginal cost (MC). We know that it creates allocative and productive inefficiencies (deadweight losses/DWL). See figure 1. 




Therefore, government steps in when natural monopoly exists. But, the problem is not over. Regulator is in onerous position because the two available choices are not economic efficient. First, when the efficient price is imposed (P=MC), firm will make a loss (see figure 2). So this is not an option.

The second option is set price equal to average cost (P=MC). This condition  also creates inefficiency (DWL) and firm makes profit. It seems that this is not suitable solution. See figure 3.

Thus, how to set appropriate price in natural monopoly is not trivial problem.