Electricity and Natural Gas Markets †Free Samples to Students

Question: Discuss about the Electricity and Natural Gas Markets. Answer: Introduction Monopoly is a market where single seller captures the entire market share. Because of maximum market power the monopolist always, exploit resources. In a monopoly market resource allocation and distribution is not done in an efficient manner. There is always a deadweight loss in the resulting market. However, there are situation where presence of a single business firm leads to economies of scale and hence, is best in terms of efficiency in allocation. Such a market is called natural monopoly. It might happen that one firm is able to operate at the decreasing part of average total cost and still satisfies market demand. This is the situation where the production process entails a high fixed cost compared to the variable cost. This is described as the situation of natural monopoly. Dividing natural monopoly market results in rising average cost and hence a higher price in the market. Mostly public utilities such as water service, electricity service are examples of natural monopoly. Natural monopoly possesses a dilemma in public policy designing. Because of presence of economies of scale, natural monopoly entails productive efficiency. If entry is allowed in the market then consumers suffers with a high price. Being a sole supplier in the market the monopoly might be tempted to exploit its monopoly power and earn a higher profit. Therefore, such an unregulated monopoly causes concern. Comparison between monopoly and perfect competition In a perfectly competitive market, there are several sellers and buyers participating in the exchange process. The equilibrium of a single firm occurs at a point where price equals marginal cost in the short run and in the long run price is set at the minimum point of average total cost leaving only normal profit for the firms presents in the industry (Lim Yurukoglu, 2015). The equilibrium in the industry is obtained at the point of intersection between the industry demand and supply curve. The situation is different in a monopoly market. There are no difference between firm and industry in a monopoly market. The industry supply curve becomes marginal cost curve for the monopolist. The monopolist set it price where marginal revenue equals marginal cost. The resulted price and quantity in the monopoly market is inefficient in comparison to the competitive market. It is seen that the monopolist sells a lower quantity at a high price as compared to competitive firm (Stiglitz Rosengard, 2015). This results in loss of welfare to the society known as deadweight loss. This is explained in the following figure. As discussed above existence of monopoly in a pure form is a inefficient form of market. The situation in natural monopoly is quite different. There are markets where allowing competition is not an optimal decision. Public utilities are examples of natural monopoly. Natural monopoly operates at the falling part of average total cost. Because of operating at the left of minimum point of average cost natural monopolists reap the benefit of economies of scales (Lim Yurukoglu, 2014). However, the pricing strategy here leads to ambiguity. Three types of pricing strategy can be observed in a natural monopoly market. Unregulated natural monopoly In a natural monopoly market, the single supplier can behave like a pure monopolist if the market left unregulated. Here, the monopolist set its price by following standard profit maximization condition. The profit maximizing condition indicates price and quantity where marginal revenue and marginal cost curve cut each other. In an unregulated situation profit maximizing monopolist would chose this point at an optimum equilibrium point (Kirzner, 2015). A denotes the point where the natural monopolist operate in the absence of regulation. The profit maximizing price is shown in the above figure is shown as PM. It is obtained corresponding to the point where marginal revenue cuts marginal cost curve. Condition of a competitive form of market is most efficient for the society. The competitive firm set its price at a point where is equalizes with marginal cost. It is called the efficient pricing (Foster, 2014). Point C shows the socially optimum point. PE is the socially efficient price. Corresponding to this the optimum quantity is QE. Price in the efficient condition is less than that that under profit maximization condition. The situation is different from the competitive market. In the competitive market firms operates at the minimum point of average cost. In the natural monopoly, firm operates at the falling part of average cost curve. Hence, natural monopolist fails to recover average cost of production. It the monopolist set its price at his level then a loss will be realized. The loss is indicated by the area of the rectangle PRBCPE. Natural monopolist output when leave unregulated is QM and corresponding price is PM. Socially optimum price is PC and optimum quantity is Qc. Clearly PM is much grater than PC and QM is much less than QC. As the society gets a lower quantity, good at a high price there are huge amount of dead weight loss as shown by the triangle AEC. To make the monopolist operate at the efficient point government has to subsidize for the loss incurred by the monopolist at this point. The additional burden of subsidy may exceed the deadweight loss (Brown, 2017). Hence, the regulators should make some alternatives of price. Price regulation As an alternative, the regulators can set price following average pricing rule. The price here is set at a point where price equals average cost (Makholm, 2015). In the above figure, B denotes this point. Corresponding to this point optimal market quantity is OQR and price is OPR. At this point total revenue earned by the monopolist equals total cost. Hence, if the monopolist operates at this point then only normal profit will be earned. Debate remains whether government should go for a regulatory policy or not (Yurukoglu Lim, 2014). If the policy of regulation fails to give desired return then it might lead to inefficiency in the allocation of resources and results in loss to the entire society. The regulator has two options whether to go for a marginal cost pricing strategy or choose an average pricing strategy. The monopolist will never choose an output level beyond OQR. With a natural monopoly, the monopolist enjoys economies of scale. This means the long run marginal cost curve is below the long run average cost curve. Therefore, pricing strategy based on marginal cost results always incurred loss for the monopolist. The best option for regulator is then to use average cost pricing strategy and set the price equal to its average cost. In this situation, there will be no excess profit (Carvalho Marques, 2014). Here, only profit is realized that is a part of cost. Price cap regulation versus Cost plus regulation Regulators attempt to choose a regulation point like by equalizing price with marginal cost. In order to implement the strategy the regulators use a simple and general approach. They first compute the average production cost of natural monopoly companies like electricity or water companies. In the cost calculation, they include the normal profit rate (Simshauser, 2017). The normal profit is included in order to ensure the fact that the monopolists able to earn a normal profit after the regulation. After calculation of cost, price is determined accordingly. The process of regulating price in this method is called cost plus regulation. Though the method is simple but is has its own shortcoming. The monopoly seller can reimburse for the cost accounted in the production process. The producer gives less care to the issue of high cost. Because the monopolist knows that, the burden of high cost can be pass to the consumers by charging a high price. The regulation through cost plus technique lacks efficiency. It cannot efficiently choose the minimum price for the society (Basso, Figueroa Vsquez, 2017). Once price regulation is undertaken through cost plus method then the monopolist has a tendency to overstate its cost. If the right cost figures are not disclosed then it is not possible to efficiently set the price. There is another factor to be considered here. When price is set equal to its average total cost then the producer lose all initiatives for reducing its production cost. In an unregulated market monopolists tries to minimize cost at least as possible to maximize profit. In fact, in the regulated market monopo list can engage in practice that unnecessarily increase total cost and hence average cost (Puller, 2013). Here, the monopolist can employ a large number of staff even when their marginal productivity is zero. The monopolist can consider expanding its business by undertaking capital projects. Building additional factory or raising its fixed capital cost the monopolist always attempt to maintain a high price in the market (Li et al., 2015). As an alternative to cost plus regulation, the regulators can undertake price cap regulation for a natural monopoly market. The policy began in 1980s and 1990s when policy makers were searching for an alternative to cost pricing technique and implemented price cap regulation. In this technique, the regulators set a fixed price that is independent of the production cost. The monopolist has to this price for a specific period. The price is usually revised with the passes of time (Varian, 2014). Considering the fact that the monopolist enjoys economies of scale, a general downward trend is observed in price revision. As the price is fixed, the monopolist attempts to reduce its profit retain a higher profit margin. If the monopolist able to find some cost efficient production technology then is its profit shares goes up until next revision of price s made. In case the monopolists fail to do so, the profit margin goes down. As a upper cap is fixed on the price this is known as price cap r egulation. If the monopolist fails to offer services at the set price then it suffers loss. In this situation, the monopolist has to wait for the next price revision. The next price revision is made based on firms performance (Dahl, 2015). However, execution of such a policy needs good care. The set price should be a realistic one. If the regulators set an unexpectedly low price then the monopolist cannot sustain with such a low price. Again, the policy fails to work if market condition changes overtime. In times f unexpected shock in the market, cost might be increased and hence the monopolist is unable to offer goods or services at the set cap (Leveque, 2013). However, price cap regulation is superior to cost plus regulation in terms encouraging the monopolist to make greater investment on innovation and thus increasing efficiency. Conclusion The essay discusses price regulation in a natural monopoly market. A competitive market is preferable over a monopoly market. In the monopoly market a lower quantity is sold at high price. As a result, the society suffers from welfare loss. A natural monopoly on the other hand, is a market where a single seller than allowing competition in the industry best serves the market. The natural monopolist always faces a falling average total cost and hence enjoys the benefits of economies of scale. The problem occurs when the natural monopolist behaves like a pure monopolist and charges abnormally high price. In this situation, the government considers regulating price in the monopoly market. The pricing policy used by the regulator is average pricing policy. The regulators cannot choose marginal pricing policy because at this point the monopolist incurs lose. Implementation of such a pricing strategy needs subsidy from the government to recover loss. It is unlikely for the government to in crease unnecessary burden on its budget. Average or marginal pricing policy is considered under the cost plus regulation. However, here the monopolist can still maintain a high price by overstating its cost. Another regulatory practice is in terms of implementing price cap regulation. It is superior in the sense that here the monopolist has a tendency to reduce cost for increasing profit and thus entails greater efficiency. References Basso, L. J., Figueroa, N., Vsquez, J. (2017). Monopoly regulation under asymmetric information: prices versus quantities.The RAND Journal of Economics,48(3), 557-578. 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