Role of Government in a Natural Monopoly Economy | Economies of Scale

The goal of antitrust is to increase competition and improve the efficiency of markets. However, breaking up a monopoly is not necessarily in the interest of economic efficiency. In the provision of certain utilities such as water, it is efficient for more than one company to deliver the product to households. To provide its services, a water company must dig up the stretchy lay by water pipes, and maintain them. It would be inefficient to such companies to supply the water because that would require two sets of pipes and would be a duplication of reserves.

The natural monopoly is a single firm in an industry in which average total cost (ATC) is declining over the entire range of production and the minimum efficient scale is larger than the size of the market.

Economies of Scale and Natural Monopolies

A natural monopoly is a declining average total cost curve. ATC declines as more is produced because fixed costs are very large compared to variable costs. A large initial expenditure is necessary to lay the main water pipes at main electrical lines but therefore the cost is relatively low. The more houses that are hooked up, the less the ATC is relatively low. When the long-run average total cost curve declines, there are economies of scale. It can be shown in the figure as:

The figure shows that why one firm can always produce more cheaply than more firm which ATC curve is downward sloping. If two firms divide up the market then the ATC is higher than if one firm produces for the entire market. It is more costly for more firms to produce a given quantity in case of a declining ATC curve than for one firm.

Alternative Methods of Regulation

The question arises what may be the best government policy toward a natural monopoly. Having one firm in an industry lowers the cost of production, but there will be inefficiencies associated with a monopoly, price will be higher than marginal cost and there will be dead weight loss. To get both the advantages of one firm producing and competition like behavior, the government can either run the firm or regulate the firm.

The monopoly price and quantity of a natural monopoly with declining ATC are shown in the figure below. The monopoly quantity occurs where MR equals MC, the profit maximizing point for the monopolist. The monopoly price is above MC. If the firm’s price was regulated, then the government could require the firm to set a lower price, thereby raising output and eliminating some of the dead-weight loss associated with the monopoly. There are three ways for the government to regulate the price as below.

a) Marginal Cost Pricing

The process of setting monopoly price equals to marginal cost is said to be marginal cost pricing. The declining ATC, the MC is lower than ATC. It is shown in the figure as below:

MC is constant in the above figure. Thus, if price were equal to MC, the price would be less than ATC and the monopoly’s profits would be negative. Therefore, there would be no incentive for any firm to come into the market.

As shown in figure, two alternatives marginal cost pricing and average total cost pricing are compared with the monopoly price. Marginal cost pricing gives the greatest quantity supplied, but because price is less than ATC, the firm comes to negative profits. ATC pricing results in a larger growth supplied and the firm earns zero economic profits.

b) Average Total Cost Pricing (ATC)

This is the method of regulation in which the firm set the price equal to ATC. It is also represented in the above figure. When price is equal to ATC, the economic profits will be equal to zero; there will be enough to pay the managers and the investors in the firm according to their opportunity costs. Although price is still above MC, it is less than the monopoly price and dead weight loss will be smaller.

But there are some serious problems with ATC pricing. Suppose the firm knows that whatever its ATC is, it will be allowed to change a price equal to ATC. In that situation, there is no incentive to reduce costs. With the regulatory scheme which the price equals ATC, the price would rise by any increase in cost. Inefficiencies could occur with no penalty whatever. This approach provides neither an incentive to reduce costs nor a penalty to avoid increasing costs on the part of the management and the workers of the regulated firm.

c) Incentive Regulations

There is third regulation method endeavors to deal with the problem that ATC pricing provides to little incentive to keep cost low. It is a relatively new idea but it is quickly spreading and most predicted in the way of the future. The method project a regulated price out over a number of years. The price can be based on an estimates of ATC. The regulated firm is said that the projected price will not be revised upward or downward for a number of years. If the regulated firm achieves ATC lower than the price, it will be able to keep the profits, on perhaps pass on some of profits to a worker who came up with the idea for the innovation. Similarly, if supply management causes ATC to rise, then profits will fall because the regulatory agency will not revise the price.

Thus, under incentive regulation, the regulated price is only imperfectly related to ATC. The firm has a profit incentive to reduce costs if a firm does poorly pays the penalty in terms of lower profits or losses. Under incentive regulation, the incentives can be adjusted. Incentive regulation is sometimes made difficult by asymmetric information problems. The regulated firm knows more than the regulator about its equipment, technology and workers. Thus, the firm can mislead the regulator and say its ATC is higher than it actually in order to get a higher price as shown in the following figure.

d) Price Discrimination

Many natural monopolies are allowed to price discriminate. Monopolists can increase their TR and profits for a given level of output by practicing price discrimination. One form of price discrimination occurs when the monopolist charges different prices for the same commodity in different markets in such a way that the last unit of the commodity sold in each market gives the same MR.

Sometimes, the government can run natural monopoly itself rather than regulate a private firm. Nepal Government has natural monopoly in utilities sectors.

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Role of the government in different economic systems | Role of government in a capitalist / market economy | Government role in a socialist economy | Government role in mixed economy

We have noted that the interference of the government with the market mechanism is indispensable because of the failure of the system. Now, the question arises as what should be the government role for the appropriate economic management of the country or what should be the form, nature and extent of the government’s interference with the market mechanism.

These questions remain controversial. The reason is that all is not well with government that can be established by a priori reasoning. In fact, the issue of appropriate economic role of the government is an ideological question and a matter of collective social choice. However, the economic roles of the government can be broadly categorized on the basis of three economic systems presently prevailing in the world, viz., capitalist or free enterprise economies, socialist economies and the mixed-economies.

1) Role of the Government in a Capitalist / Market Economy

A market economy is known as a capitalist economy. There is no central authority to guide production and solve central problems. The individual buyers and sellers decide the nature and amount of goods and services to be produced. Every worker is free to offer his services to anyone who promises highest reward. Thus, there is freedom of contract. Similarly, every person has the right to own property and use it in any way he thinks most profitable. Under the conditions, price system tries to solve the central problems of an economy. What the central authority does in a socialist economy is done by price mechanism in capitalist economy. The price system operates in completely impersonal way through which all central problems get solved.

In a market economy, each person is guided by self-interest. The producer tries to get maximum profit. The employees prefer to work where they get maximum salary. Likewise, consumers want to get maximum satisfaction from their limited income. The place where this drama is interacted is called a market. It is the price mechanism through which such aims are achieved. There are markets for every commodity and factor service known as commodity market wherein firms are sellers and the households are buyers.

Generally, the sellers sell more at higher prices and the buyers buy more at lower prices. As a result of competition among buyers and sellers, a price gets determined where demand for the commodity is equal to the supply of the commodity. This is called the equilibrium price of that commodity.

In the capitalist system, the primary roles of the government are essentially:

• To restore and develop the free market mechanism wherever it is possible to ensure workable competitive conditions.
• To remove all unnecessary restrictions on the operation of free competitive market, and
• To provide a background through necessary government interventions, and controls in which free competition can work effectively. Besides, government intervention and its economic activities should deliver what the free market mechanism cannot.

Meade has recommended the following eight kinds of activities for the state to perform: 

1. Control of inflation and deflation mainly through indirect measures, like fiscal and monetary regulations;
2. Control and regulation of monopolistic powers to large corporate undertakings with a view to avoiding inefficiency, unemployment and wastage of resources;
3. Ownership and state monopoly of essential goods and services. E.g., railway transport and generation and distribution of electricity and such other services on the ground of efficiency and economies of scale;
4. Promoting equality of opportunity by providing equal access of education opportunities and restricting the restrictive trade practice and activities of trade unions, etc.;
5. Administration of justice and maintenance of law and order, and ensuring freedom of activities;
6. Aiding private planning in view of the uncertainties of the future by some measure of government indicative planning;
7. Making central planning for large structural changes in the economy; and
8. Tackling the problems of environmental controls, of the use of exhaustible resources, and of population growth.

It may be inferred from these propositions that the government’s role in a capitalist society is supposed to be limited to (a) restoration and promotion of necessary conditions for efficient working of the free market mechanism; and (b) to enter those areas of production and distribution in which private entrepreneurship is lacking or is inefficient. Any planning by the government is indicative and should supplements the private plans for safeguard against future uncertainties.

2) Government Role in a Socialist Economy

The role of the government in a socialist economy is all pervasive. While in the former, the government is supposed to play a corrective and complementary role in the economic sphere, in the latter, it exercises comprehensive control on almost all economic activities. In the socialist system, not only is there a complete disregard for private ownership of property beyond the permissible limit, free enterprises and market mechanism, but also these institutions are abolished by law. The private ownership of factors of production is replaced by state ownership. All economic activities are centrally planned, controlled and regulated by the state. All decisions regarding production, allocation of resources, employment, pricing etc., are centralized in the hands of the government or its Central Planning Authority. The individual freedom of choice and decision-making in regard to economic activities is drastically curtailed. Individuals are provided freedom of choice, but within the policy framework of the socialist economy. Prior to the disintegration of the Soviet Union in 1989, the Soviet economy was the most prominent example of the socialist economic system. The other countries with socialist economic system are China, Poland, Czechoslovakia and Yugoslavia.

The social aim of the socialist economic system is the same as in the free enterprise system, viz., efficiency growth, social justice and maximization of social welfare. But, their methods of achieving these goals are totally different. The motivating force in a capitalist economy is private profit, whereas in the socialist economy, it is maximization of social welfare. Socialist way of management of the economy eliminates many evils of the capitalist system. E.g., exploitation of labor by capitalists, forces generating economic fluctuations, unemployment and social and economic inequality. The socialist economic system in its classical form in, however, disappearing from the economic scene.

3) Government Role in Mixed Economy

A mixed economy is one which combines the features of both free enterprise and socialist (centrally planned) economic systems. A mixed economy is essentially an admixture of private and public undertaking. In this system, the major part of the economy, the private sector, is allowed to function on the principle of free enterprise system or free market mechanism within a broad political and economic policy framework of the government. The other part of the economy, the public sector is constituted of industries and utilities promoted, owned and managed by the government largely on the principles of a socialist economy. The public sector is created by reserving certain industries, trade, services and activities for government ownership, management and operation. The government prevents by the law to enter private capital into the industries reserved for the public sector in the nationalization of private sector industries. The nationalization of private commercial banks and insurance companies are prominent examples of the public sector extension in India. The promotion, control and management of the public sector industries is the sole responsibility of the state.

Apart from controlling and managing the public sector industries, the government controls and regulates the private sector through its industrial, monetary and fiscal policies. If necessary, direct control is also imposed.

The mixed economies of free enterprises system can, however, be distinguished from the mixed economies of ‘socialist pattern’ on the basis of the rationale of public sector in the two systems. The public sector in a free-enterprise system is a matter of pure economic necessarily and is complementary to the free market mechanism. It functions with the objectives of aiding, supplementing and strengthening the free enterprises system. On the other hand, creation of the public sector is a mixed economy like India, is a matter of ideological and social choice. Its creation and functioning are aimed at creating a ‘socialist pattern of society’ through the market mechanism. It is another thing that India has failed to achieve any of these social goals. Another point of destruction is that the public sector of the socialist pattern of society has comprehensive economic planning whereas in a free enterprise system such plans are mostly indicative.

In the mixed economy or a socialist pattern of society, the role and responsibilities of the government are much wider than in the free enterprise system, and much less than in the socialist society. The government in this system undertakes to perform all the functions that the state performs in a free enterprise economy. In addition, it assumed the responsibility of making and implementing the plans for economic development of the country. The government has also to perform the task of coordinating private sector activities with the public sector, and controlling and regulating the former to bring it in true with public sector policies.

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Role of the government in the market economy

The market economy is also said to be a free-enterprises economy because the government restrictions on production and distribution are the least possible in such an economy. A capitalist economy is also called a free-market economy because supply and demand forces are allowed a free pay in the markets for factors as well as for products. This type of economy is also known as laissez faire economy because the government in this economy is supposed to intervene into the functioning of an economy only where it is must.

The economic problem is solved by the freely functioning price mechanism. The rise and the fall in the prices of products and factors of production in the markets give signals to the producers and consumers who respond to correct the disequilibria wherever they exist. If there is problem of unemployment that would be solve by reducing wage rate. If a particular commodity is in short supply, then its price will rise in induce producers to increase its output. On the other side, a surplus of a commodity will lead to a fall in its price thereby inducing its producers to contract its production. Thus, it was believed for a long time that a freely functioning price mechanism automatically solves the economic problem in the capitalist economy.

The functioning of capitalist economies for the last three hundred years has proved that a capitalist economy is unable to solve all the economic problems automatically. There are some instances of market failure where the price mechanism is unable to take the correct decisions from the society’s viewpoint. These instances of market failure are popularly known as ‘those goods’, ‘external effects’, ‘market imperfections’ and ‘distribution justice’. The government in a capitalist economy has to intervene in the markets to cover these points of market failure. Thus, the role of the government in a modern capitalist economy can be summed up in the following:

1) Supply of public goods

Those goods and services such as roads, telephone, telegraph, defense, police and justice are called public goods and services. This is because these goods and services are supplied and consumed publicly. No private party will be prepared to build and supply these public goods at which people in general need it. In the capitalist economy, the government at reasonable cost provides these public goods.

2) Management of the external effects

The government is required to tax those people who are in their private production or consumption inflict losses on the other people. Factory-owners, whose production spoils the air and water in the locality are taxed heavily. Similarly, those rich people who tend to make a vulgar show of their wealth are taxed and the proceeds of these taxes are given to the poor people. Further, the government builds health resorts and national parks for which the visitors are charged a toll tax. All these examples are those of external effects.

3) Corrective polity for market imperfections

The price mechanism can work properly only when the markets are competitive and work normally. But there are many imperfections in the market, which tend to go against the national interest.

Firstly, some firms try to build a monopoly to influence in the market through cartels and mergers or through secret understanding. In such cases, the government enforces its anti-monopoly laws to protect the consumers against exploitation.

Secondly, sometimes the speculators in the stocks markets or commodity markets tend to create panic in these markets, which disturbs their normal functioning. The government then partially or wholly bans the functions of these speculators to restore normalcy in these markets.

Thirdly, the association and unions in some markets are deliberately encouraged legally, protected to enhance the bargaining power of the working sections so that they are not exploited by their employers.

4) Public policies against unemployment

In a capitalist economy, there are serious problems of booms and depressions, unemployment and wastage of resources. Governments in capitalist countries are committed to following anti-inflation policies. These policies are of public works, fiscal measures and monetary management. Whenever the capitalist economy shows signs of slackness or stringency, the government comes forward to use the appropriate policies.

5) Redistribute policies

Governments in capitalist economies are also committed to the reduction of income inequalities to a socially tolerable level. The rich people are taxed heavily through tax on income, wealth or expenditure with a view to building large funds to be used for the welfare of the weaker sections. These payments to the poor made from funds obtained through taxation of the rich are called compensatory payments.

In short, the role of the government in a capitalist economy is of a regulatory and protective nature. The effort is to give the maximum of economic freedom allowable to producers and consumers.

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Public Choice Theory | Reasons for Government not being efficient in distributing public goods and services

Public Choice Theory is a very important and popular principle. According to this principle, people's rationality should be promoted. The incentives or benefits that a person receives are based on his or her discretionary choices. The basic premise of public choice theory is the belief that people should be active in activities that benefit them and stay away from activities that are unfavorable.

The behavior of politicians and administrators can be explained and predicted. Politicians and employees are a class that puts more importance on their own interests. Therefore, the best return is obtained only by increasing the role of the market and reducing the role of the government. The bureaucracy is not accountable to anyone, only when the market is contracted does accountability succeed in practice.

Based on these points, the public choice theory is to give the people the right to choose. The NPM has also adopted this principle in line with the principle that the client or citizen should be able to choose public service even in the public sector.

Public choice theory points out reasons why government might be inefficient in providing public goods and services. This is a theory developed from the study of taxation and public spending. It studies the decision-making behavior of voters, politicians and government officials from the viewpoint of economic theory. It can be considered as a bridge between economics and political science.

Public choice theory argues that governments fail to do right. The theory supposes that politicians, bureaucrats, citizens, and states do something totally from a self-interested point of view using their power and the authority of government for their own self ends.

Before the coming of the public choice theory, economists generally used to accept government’s role as “unquestionable controller with perfect information and unlimited power”, a “bureaucrat god”. However, in practice, bureaucrats and politicians are only humans and they often face incentives / motivations that pull them to decisions that produce inefficient outcomes. The basic assumption of the public choice theory is that humans are rational beings that act in a self-interested way. Therefore, public choice theorists say that the economic analysis of the political decision-making process might in fact that tell / reveal certain systematic trends towards inefficient government policies.

Supporters of public choice theory argue that:

• Citizens use political influence to get special benefits called “rents” from government policies (e.g., import licenses or rationed foreign exchange) that limit right of entry to important resources.
• Politicians use government resources to strengthen and maintain positions of power and authority.
• Bureaucrats and public officials use their positions to obtain bribes from rent-seeking citizens and to carry out protected businesses on the side.
• States use their power to seize / capture private property from individuals. The net result is not only a misallocation of resources but also a general reduction in individual freedoms.

The supporters of the public choice theory have developed their arguments on different bases.

1) Voters’ ignorance

The most important opinions of public choice theory are the lack of incentives for voters to monitor government effectively. Public choice promoters point out that voters are largely ignorant of political issues and that this ignorance is rational. Even though the result of an election may be very important, an individual’s vote rarely decides an election. Thus, the direct impact of casting a well-informed vote is almost nothing; the voter has virtually / realistically no chance to determine the outcome of the election. Spending decisions which are made by the politicians following the election is not personally useful for the voter.

Public choice economists point out that the incentive to be ignorant is rare in the private sector. Someone who buys a car naturally wants to be well informed about the car he or she selects. That is because the car buyer’s choice is decisive; he / she pays only for the one chosen. If the choice is wise / sensible, the buyer will benefit; if it is unwise, the buyer will suffer directly. Voting lacks that kind of direct result. Therefore, most voters are largely ignorant about the positions of the people for whom they vote. Except for a few highly publicized / revealed issues, they do not pay a lot of attention to what legislative bodies do; they have little incentive to get the background knowledge and analytic skill needed to understand the issues.

2) Interest groups and lobbying

Even if good government tends to be a pure public good for the mass of voters, there exists various interest groups that have strong motivations for lobbying the government to make inefficient policy-decisions that would benefit them at the cost of the general public. For example, lobbying by the sugar manufactures might result in an inefficient subsidy for the production of sugar, either direct or by protectionist measures. The costs of such inefficient policy fall over all citizens, and therefore unseen to each individual. On the other hand, the benefits are shared by a very small special interest group, who has very strong incentives to continue or keep alive the policy by further lobbying. The large majority of voters will be fully ignorant of the whole affair due to the tendency of rational ignorance. Therefore, it can be expected that numerous special interests groups will be able to successfully lobby for various inefficient policies.

3) Actions of legislators

Public choice economists also examine the actions of legislators. Although legislators are expected to work on the “public interest,” they make decisions on how to use other people’s resources, not their own. Furthermore, these resources must be provided by taxpayers. Politicians may try / seek to spend taxpayers money wisely. There is no direct reward for fighting with powerful interest groups in order to give benefits on a public that is not even conscious of the benefits or of who provided them. Thus, the incentives for good management in the public interest are weak. In contrast, interest groups are organized by people with very strong gains to be made from governmental action. They provide politicians with campaign funds and campaign workers. In return they receive at least the “ear” of the politician and often gain support for their goals. In other words, legislators have the power to tax and to get resources in others by coercive (using force) ways and because voters monitor their behavior poorly, legislators behave in ways that are costly to citizens.

4) The role of bureaucrats

Public choice theorists have also analyzed the role of bureaucrats in government. Their incentives explain why many regulatory agencies appear to be “captured” by special interests. Bureaucrats are captured by the government because they are appointed by the government for particular goal or mission. They depend on the government for their budgets and mostly the people who will benefit from their mission can influence the government body to provide more funds. Thus, interest groups become important to them. Such interrelationships can lead to bureaucrats being captured by interest groups.

With all these points of argument the public choice theory points out the case of government failure-a term similar to the market failure scenarios familiar from the traditional economic theory. The conclusion of the public choice theory is that self-interest guides all individual behavior and the behavior of the government also; governments are inefficient and corrupt because people use government to engage in (carry out) their own agendas. So, free market systems are supposed more efficient and more just. The suggestion, therefore, is that minimal government is the best government.

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