Economic Analysis System

Question: Discuss About the Economics? Answer: Introduction: For the last thirty years, the network industry in Australia has undergone evolution through vertical integration. Industries that have undergone this kind of evolution are electricity, telecommunication and railroads. These industries enjoy natural monopoly. Huge infrastructural cost act as the main barrier to entry and exit in this industry. This is the fixed cost remains constant for each extra unit produced (Allison, 2014). When the firm supplies to a large market, they get a good return on their initial investment. To set up the network for transportation in the electricity is huge. The In case of a monopoly, a single firm operates in the market have the tendency to charge high process to earn supernormal profits. The monopoly market is an imperfect form of market structure where the society incurs loss in form of deadweight loss. To reduce this cost the government regulates the price level so that the welfare of the society is maximized (Beckman, DeAngelo Smith, 2014). In Aust ralia, the electricity sector enjoys natural monopoly. The federal government regulates the price level in this sector. The purpose of this essay is to evaluate the cause and the effect of natural monopoly on the society. This essay also gives a brief overview about the regulations the government imposes on the firm to regulate the price and output level of the firm. Analysis: A natural monopoly exists in an industry when high cost of infrastructure and other barriers to entry inhibits other potential entrants. The only supplier is large enough to supply the whole market. This is predominant in industries with high capital cost. Natural monopolies are found in public utilities like electricity and water supply. John Stuart Mill conceptualized the notion of natural monopoly (Beckman, DeAngelo Smith, 2014). In micro economic theory two different types cost are marginal cost and fixed cost. Marginal cost is cost incurred by the company while serving one extra consumer. Fixed cost is the cost incurred by the company irrespective of the quantity produced. A natural monopoly is characterized high fixed cost and the marginal cost for production for producing one extra unit remains approximately constant. Entering in to public utility sector requires huge amount of investment. This often acts as a barrier to entry, which reduces the number of potential entrants r egardless of the level of profit. Natural monopolies emerge when a single supplier enjoys the immense cost advantage over the other potential competitors. This in predominantly seen in industries with high fixed cost and they create economies of scale (Bs, 2014). The firm investing high amount of fixed cost requires large number consumers in order to have return on their initial investment. With economies of scale, the average total cost decreases with the increase in output (Bs, 2014). After the establishment of natural monopoly, the firm will enjoy huge profits due to economies of scale. External and internal economies of scale are defined as the benefits associated with the expansion of a firm as well as the industries as a result of positive externalities. The monopolistic market is characterized by inefficiency over time. They are not innovative because they are not required to compete with other firms. The main objective of the monopolist is to maximize the level of profits (Ekelund Hbert, 2013). The absence of competition gives the firm the advantage of the situation. The monopolist being the sole seller in the market can control the supply of the entire market. The firm takes the market demand curve as its demand curve, which is also the average revenue curve. The firm operating under the condition of the Law of Diminishing Returns will observe that cost of production for each extra unit produced (marginal cost) decreases with the increase in the output level (Foster, 2014). In the early stage of production, the marginal cost is less compared to the marginal revenue curve. This enables the monopolist to earn huge amount of profits. Thus, the monopolist will stop producing any additional unit at this point (Heen, 2013). The monopol ist fixes the price level where the marginal revenue equals marginal cost. In case of monopoly, marginal cost is less than marginal revenue and price level. However, marginal revenue is not equal to the marginal cost and is much less than the marginal cost and the price level. The monopolist sometimes misuses their power to regulate the market, which leads to market failure. A monopoly is an imperfect market structure that has a tendency to restrict production level. Consumer surplus is the difference between the consumers is actually paying and the price they are willing to pay. Consumer surplus declines with the increase in the price level following the law of Diminishing returns (Hua, 2012). In imperfect market situation that is in case of monopoly the single firm supplying the market tries to capture the whole consumer surplus by charging the highest price they are willing to pay. Producer surplus is the benefit derived by the firm when they get more price than the minimum price level they are willing to supply the market. This is expressed in terms of profit. Deadweight loss occurs within an economy when the total welfare of the society is not maximized. The welfare of the society is ensured when the total of producer and the consumer surplus is maximized (Joskow, 2014). Economic welfare is defined as the benefit derived by the whole society because of some economic transaction . Figure 1: Producer and Consumer Surplus (Source: Author) In monopoly, the firm takes as a single supplier in the market takes the market demand curve as its own demand curve. The monopolist has the market power to raise the price level above the marginal cost without losing supernormal profits (Leveque, 2013). The monopolist optimizes its profit by setting it price where the marginal cost equals the marginal revenue curve that is at Pm as shown in the diagram. The monopolist operates at a price, which is greater than marginal cost. The consumers are worse off in monopoly compared to the competitive structure, as the price charged is higher than in competitive market structure. Thus, as a single supplier the firm is better off in monopolistic structure as they can increase their profit level. Hence, monopoly market structure is not optimum. The price charged in competitive structure is Pc which is PcMC implying that some of the consumers are willing to pay more for each extra unit of output. Thus, it can be said that an extra unit of output will be sold at a price higher than the marginal cost; the consumer utility would increase along with the profits of the firm. To measure the inefficiency in the monopoly, the difference between loss of the utility of the consumers and the gain in the profit level of the producers are compared (Nepal Jamasb, 2015). By measuring the total deadweight loss, that is the total of producer surplus and the consumer surplus, the total loss incurred by the society is measured. Figure2: Deadweight Loss (Source: Author) The consumer surplus increases for two reasons as given below: Under competitive structure, the consumers pay less for the quantity consumed than under monopoly. It is represented by the area A. The utility increases as they are consuming extra unit of the quantity produced in competitive structure. It is represented by the area B. The producer surplus gets affected, as the quantity sold is less (shown by the area A). Under monopolistic structure, the area A is a shift of the surplus from the monopolistic firm to the consumers. Hence, it is neutralized from the perspective of the society. The area (B+C) is the gain the society enjoys when the price is set at Pc with quantity produced is Yc (Varian, 2014). This is because the values that both the consumers and the producers add to the number of units transacted under monopolistic market structure. Hence, the area (B+C) is the deadweight loss under monopoly. Deadweight loss is the cost the society pays due to monopoly (Vikharev, 2013). In case of natural monopoly, the demand curve intersects the marginal cost curve under the average cost curve. The governments sometimes force the monopolist to set price equal to the marginal cost curve, which leads to negative profit. Figure3: Natural Monopoly (Source: Author) When the government compels the monopolist to charge price p=MC the monopolist leaves the business. This situation is more inefficient compared to the situation where the monopolist is allowed to charge price where marginal revenue is equal to marginal cost. When the government compels the monopolist to charge price p=MC then it gives the provision to for lump sum subsidy to the firm (Vining, Boardman Moore, 2014). To control pricing policy in case of natural monopoly government imposes price ceiling where the demand curve or the average revenue curve (AR) cuts the average cost curve. The average cost is less, when the firm serves the entire market. The monopolist tends to set their price at the level where marginal revenue equals marginal cost that is MR = MC (Yan Chao, 2012). Here before regulation the monopolist is making profits as shown by the figure PF*OM by selling OM output at price MP. After regulation the monopolist is now sells output OQ at QK price level. When the price regulatory authority sets the price level at WS, where the average cost AC cuts the demand curve or average revenue curve (AR) and sells output OW, the monopoly is only able to earn normal profit. Operating at this level will eliminate the deadweight loss and hence the welfare of the society is maximized (Vikharev, 2013). In Australia, the electricity industry is an example of natural monopoly. In this industry, a large infrastructural cost is required to enter the industry. This cost is referred to as the sunk cost. Huge amount of sunk cost is incurred to build cable, grids and pipelines for supply and transmission of electricity. New entrants will result in the loss of efficiency and the cost will be borne by the whole society. Thus, it is better that a single firm is allowed t o serve the whole market. In case of natural monopoly, economies of scale play a significant role and the minimum scale of efficiency is not reached until the size of the market is not large enough. Minimum efficient scale is the minimum level of output at which all the scales of economies are exploited (Beckman, DeAngelo Smith, 2014). The public utility sectors, like water supply and electricity, have high possibility that the society is exploited without any government intervention. The federal government with the objective of minimizing the cost of the society set the price equal to the average revenue equals the average cost curve. In electricity industries mainly dominated by the huge fixed cost and legal barriers the government often responds to the market power by taking control over that firm. The form of control can be different forms like imposing tax or levying subsidy. The public authorities take charge of the market condition. Technological advancement in sectors with natural monopoly can turn this sector to a competitive market structure (Ekelund Hbert, 2013). Conclusion: Natural monopoly is a market structure where a single firm supplies the whole market. Usually the product or the service supplied does not have any close substitutes. The purpose of the essay is to analyze the problems and the cause associated with the natural monopoly. The electricity, natural gas and railroads are the industries that enjoy natural monopoly. The average cost is lowest if a single firm serves the entire market. The huge infrastructure cost at the initial level discourages new entrants to enter the industry. Without any competition, the monopolist charges the price where marginal price equals marginal revenue (Beckman, DeAngelo Smith, 2014). Government intervention is required to minimize the inefficiencies in a monopolistic market structure. 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