Professorship in Faculty 07

Federal and Regional Financial Relations Prof. Dr. André W. Heinemann Business Studies & Economics

Public Sector Economics

Chapter 5
Network Infrastructures, Natural Monopolies, and
Regulation
5.1 Monopoly
What Is a Monopoly?

 A market controlled by only one supplier (monopolist) is known as a monopoly.

 A monopolist is a firm that is the only producer of a good that has no close
substitutes.

 A monopolist has market power, and market power is the ability to raise prices.

 A monopolist reduces the quantity supplied and moves up the demand curve,
raising the price.

1
5.1 Monopoly
Why Do Monopolies Exist?

 For a profitable monopoly to persist, something must keep others from going
into the same business, that „something“ is known as a barrier to entry.

 Principal types of barriers to entry:

 Control of a Scare Resource or Input

 Technological Superiority

 Government-Created Barrier

 Network Externality

 Increasing Returns to Scale

2
5.2 Natural Monopoly
What Is a Natural Monopoly?

 Public good → Provision by the public sector

 In some cases, the public sector produces some private goods and services
• Examples:
Rail-based urban mass transportation, public water supply, urban electricity grids etc.
• Main argument for public sector production:
Efficiency enhancement

 Background for natural monopoly: decreasing average cost

 Caused by
- High fixed costs related to low variable costs
- Economies of scale (increasing returns to scale), subadditivity

3
5.2 Natural Monopoly
Reasons for Natural Monopolies

Subadditivity

Decreasing
Average Cost

Economies of Scale

Source: Fritsch, Michael (2014), Marktversagen und Wirtschaftspolitik. 9., vollständig überarbeitete Aufl., Vahlen, München, p. 167.

4
5.2 Natural Monopoly
Marginal Cost, Average Cost and Natural Monopoly

𝑃
𝐴𝐶: Average Cost
𝑀𝐶: Marginal Cost
𝑀𝑅: Marginal Revenue
𝑃: Price
𝑋: Output
𝐷𝑋

𝐵
𝑃 𝐴𝐶 𝐴𝐶
𝑃∗ 𝑀𝐶
𝐴

𝑋∗ 𝑋

5
5.2 Natural Monopoly
Natural Monopoly and Deadweight Loss

𝑃
𝐴𝐶: Average Cost
𝑀𝐶: Marginal Cost
𝑀𝑅: Marginal Revenue
𝑃: Price
𝑋: Output
𝐷𝑋

𝐶
𝑃𝐶

𝐹 𝐵
𝐴𝐶
𝑃∗ 𝑀𝐶
𝐸 𝐴

𝑋𝐶 𝑋𝐹 𝑋∗ 𝑋
𝑀𝑅
6
5.2 Natural Monopoly
Unregulated Monopolist

 A monopolist seeking to maximize profits produces up to the point that marginal

 Output level 𝑋 𝑐 , with associated price 𝑃𝑐 .

 Monopoly profit are equal to the product of number of units sold times the profit per
unit.

 Inefficiency!

7
5.3 Public Sector Production
Goals of Public Sector Production

 Public sector produces 𝑋 and provide to the point where price equals marginal cost 𝑀𝐶.
 Losses can be financed by taxes.

 Attention: Taxation (excluding lump-sum taxes) lead to allocative distortions!

 Public sector produces 𝑋 and provide to the point where price equals average cost 𝐴𝐶.
 Neither profits nor losses

 Average cost pricing leads to more output than at the profit-maximizing level, it still falls
short of the efficient amount.

 Ramsey solution

8
5.3 Public Sector Production
Average Cost Pricing

𝑃
𝐴𝐶: Average Cost
𝑀𝐶: Marginal Cost
𝑀𝑅: Marginal Revenue
𝑃: Price
𝑋: Output
𝐷𝑋

𝐹 𝐵
𝑃 𝐴𝐶
𝐴𝐶
𝑃∗ 𝑀𝐶
𝐴

𝑋𝐹 𝑋∗ 𝑋

9
5.3 Public Sector Production
Problems of Public Production

 Public ownership means the government establishes a public agency to provide the good
and protect consumers´ interests.

 Beside economic objectives, public enterprises can have political or social

 Sometimes publicly owned companies are less eager than private companies to keep
costs down or offer high-quality products.

10
5.4 Limits of Natural Monopolies

𝑃 𝐷2

𝐷1
𝐴𝐶

𝐵
𝐵
𝑃

𝐴
𝑃𝐴

𝑋𝐴 𝑋𝐵 𝑋

11