Explore unregulated profit maximisation, average cost pricing, and marginal cost pricing for a natural monopoly. See how economies of scale create the case for regulation. Built for AQA, Edexcel and OCR.
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Steeper slope = more inelastic demand
A natural monopoly exists when one firm can supply the whole market at a lower average cost than two or more firms could. This is common where fixed costs are very high, as with water pipes, rail track or electricity networks. This tool shows the falling long-run average cost curve and compares three ways of pricing: unregulated profit maximisation, average cost pricing and marginal cost pricing.
Draw a downward-sloping LRAC with LRMC below it, and AR and MR starting from the same point on the price axis. Mark the three key outputs: where MR = MC (profit maximisation), where AR = AC (average cost pricing) and where AR = MC (marginal cost pricing), and shade the profit or loss. Your chain should explain why competition is inefficient here: duplicating the network would raise average costs, so one firm is efficient, but left alone it would use its monopoly power to raise prices. Conclude with the regulator’s trade-off between allocative efficiency and allowing the firm to cover its costs.
Evaluate: Regulation solves one problem but can create others. The regulator has less information about costs than the firm, so a price cap may be set too high, allowing excess profit, or too low, discouraging investment in the network. Firms may cut quality to meet a cap, and over time regulators risk regulatory capture. Nationalisation or subsidised marginal cost pricing bring their own problems of funding and weak incentives to control costs, so no option is clearly best.
Revise the theory behind this tool in our Edexcel revision notes:
Practise drawing the static versions you will need in the exam:
A natural monopoly is an industry where one firm can supply the whole market at a lower average cost than two or more firms could. It usually arises where fixed costs are very large and marginal costs are low, so long-run average cost keeps falling over the full range of market demand. Examples include water supply, rail track and national electricity and gas networks.
When average cost is falling, marginal cost must be below average cost. If the regulator sets price equal to marginal cost to achieve allocative efficiency, the price is also below average cost, so each unit sells for less than it costs on average. The firm makes a loss and would need a subsidy to stay in the market.
Most are privately owned and overseen by industry regulators, such as Ofwat for water and Ofgem for gas and electricity networks. Regulators limit prices or revenues, historically using formulas such as RPI − X for energy networks, which allows prices to rise by inflation minus an efficiency factor (water used RPI + K, adding an allowance for investment). They also set quality standards and require firms to invest in their networks.