Natural Monopolies and the Price Cap in the UK

Types of Market Structures

The four major types of market structures constitute the oligopolistic, monopoly, monopolistic and perfect competition. When critically analyzed, these types of market structures have different types of price structures, outputs, and determination of profits, depending on how demand and supply forces play within the markets. From this understanding, the market structures have distinct characteristics that separate one from the other. The four types of market structures and their distinctive characteristics are further discussed below:

Perfect Competition

A perfectly competitive market is difficult to attain because the structures that define its existence are impossible to attain. A perfectly competitive market actually represents the ideal type of market structure most economies would seek to achieve but because of artificial inequalities created by firm activities; this goal remains a dream for now. However, when analyzed theoretically, this type of market structure is supposed to have structures supporting multiple firms operating in the same market but selling identical types of products and services (Investopedia 2010, p. 2).

The number of firms operating in such type of market is assumed to be numerous and therefore no single firm can effectively influence market operatives to own its own. This is because the influence of one firm is often negligible. In addition, because the kind of products produced in this type of market is the same, consumers have no reason for choosing one firm from another. This means that product differentiation is almost nonexistent.

The major characteristics of this type of market are the free mobility of firms and resources in the market and the free exchange of information (Investopedia 2010, p. 2). Without these two characteristics, it is impossible to realize a perfect market. Firms in perfect market structures normally have a horizontal market curve but it is usually elastic, meaning that firms do not have to reduce their prices to sell more products because they can sell the optimum number of products at the prevailing market conditions (Investopedia 2010, p. 2). This is a major advantage of this type of market.


In a monopoly, the kind of situations existent depict the opposite of what is observed in a perfect market scenario. This is true because a monopoly depicts imperfect competition between firms but a perfect competition is just that: perfect. However, the biggest difference between a monopoly and a perfectly competitive market is that in a monopoly, the demand curve is essentially inelastic (Investopedia 2010, p. 2).

In a monopoly, the demand curve represents a line bending downwards to the right-hand side of the graph, depicting a perfectly inelastic demand curve. This is evident because there are structural barriers inhibiting competitors from making the same type of product as a firm would. The profit levels are also abnormally high as compared to a perfect competition (Investopedia 2010, p. 2). However, it is important to note that in this type of market, firms do not run at optimum levels of efficiency which is enjoyed by firms in perfect markets.


In an oligopoly, firms tend to pursue competitive activities based on multiple economic parameters, except for prices. The major traits of this type of market structure are that; the industry is basically typified by a diminutive number of big companies sell matching or differentiable products and lastly, firms maintain strong market control by establishing strong obstacles to market entry (Investopedia 2010, p. 4). The large firms characterizing this type of market structure usually operate in a coordinated manner so that a stronger market control is evident. However, with regard to their products and services, oligopolies tend to produce similar products (as evidenced in perfect competition) or differentiated products (as evidenced in a monopolistic market) (Investopedia 2010, p. 4).

Monopolistic Market

In a monopolistic market, one industry or firm usually has a lot of control over the market in terms of product or service provision. This type of situation is usually observed when the single firm or industry employs strategies which impose a strong barrier to entry, such as vast economies of scale, government regulation (and the likes); however, they do not necessarily produce enough to maximize the social welfare of the industry (Baumol 2008, p. 237).

One of the clearest distinctions characterizing a monopolistic market is a lack of clear distinction between the firm and the industry; thereby contradicting the market dynamics of a perfect market. Also, in a monopolistic market, there is no close substitute for the products and services available in the market and the producers are usually the price fixers and not the price takers because they experience almost negligible competition from other firms (Baumol 2008, p. 237). The demand curve in this type of market is a downward sloping demand curve because there is no clear distinction between the firm and the industry plus the failure by the firm to increase its sales (unless it reduces its prices).

Why Monopolies Lead to Inefficient Outcomes

In analyzing market structures, economic efficiency is one of the most basic determinants of analyzing and formulating policies in the market. Monopolies are normally assumed to have high levels of inefficiency, majorly because their view of marginal benefits is normally contradictory to the consumers’ view of the same (Investopedia 2010, p. 3). Conversely, its economic inefficiency can also be traced to the fact that firms in monopolies normally prevent the production of product mixes which have the highest value in the market.

This loss of consumer surplus, brought about by the prevention of hybrid product mixes in the economy is what constitutes the deadweight loss (Investopedia 2010, p. 3). This means that the profit accrued in a monopoly is never usually enough to offset the deadweight loss. When analyzed on another platform, the deadweight loss refers to the loss in social welfare that a monopolistic market denies the consumers, due to the imposition of restrictions in the production of hybrid outputs.

Why Competition Leads to a Better Outcome than a Monopoly

Competition normally thrives in liberal markets. Competition comes with a number of advantages to consumers because it provides them with desirable products while forcing producers to keep their prices at sustainable levels because of the risk of loss of market. These advantages are usually enjoyed from the point of view that in competitive markets, when manufacturers produce or sell the same product, they are inclined to modify their products to look more appealing to the consumers, thereby increasing consumer welfare.

Most of the time, producers do so through price flexibility. However, another advantage competition brings to consumers is that it increases market diversity because producers tend to produce goods and services which are targeted to a specific market group; thereby increasing the social welfare value of the consumers. Monopolies however do not allow such sort of market dynamics because they limit the number of firms operating in such markets and therefore, the need for product innovation is usually barely existent (Investopedia 2010, p. 4).

Difference between a Natural and Normal Monopoly

There is a clear distinction between a natural and normal monopoly because, in a natural monopoly, the economic nature of the market does not come about because of the company’s strategy to induce such characteristics but because there is a clear lack of formidable competitor. However, in most cases, natural economies are usually existent merely because it would be inefficient to have more than one firm in the market (Mankiw 2008, p. 315).

This type of monopoly usually has a flat-bottomed curve. On the other hand, a normal monopoly is that which is characterized by artificial forces that create the monopolistic nature of the market in the first place. In this type of monopoly, there is a coordination by existing large firms to create barriers to entry for other competitors but most importantly, it is crucial to note that there are firms willing to enter into such markets but they are prevented from doing so by the mere nature of the market (Mankiw 2008, p. 315).

Government Options to Monopoly Issues

Governments across the globe are usually faced with the problem of dealing with monopolies because, in a monopoly, there is a widespread misallocation of resources and a poor redistribution of income.

The government usually has a number of alternatives to deal with such problems. First, it can adopt behavioral regulations by first understanding the behavior of monopolies and imposing certain regulations such as price controls to enable it to implement policies against anti-competitive behaviors and environmental regulations so that the interests of the society are factored into the overall operation of firms in the economy (Hillman 2003, p. 563). Secondly, the government can alter the structures of the market so that it is able to create conditions that are favorable to competition (Hillman 2003, p. 563). Such structural changes may include a change in the cost structures, taxation structures, and the likes.

Example of Monopoly

Probability of Dead Weight Loss

The London Underground Company is a perfect example of a monopoly in the UK because there is no other train service running a competitive underground train service in the country. However, despite the negative connotations attributed to monopolies, the London Underground Company is a natural monopoly and therefore there is a very low probability of deadweight loss. When analyzed critically, the probability of deadweight loss is almost nonexistent because if there was another company running the same services, customers would frequently be faced with the problem of specific firm tickets, destinations, and such as challenges (Helium 2010, p. 1).

For instance, when analyzing the operations of the train company, we can see that the marginal rates of shipping two passengers are very dismal when compared to the overall costs of buying the train and building tracks.

What the Government has done

Since it remains unviable to add another firm in the industry, the government has done nothing to change the monopoly London Underground Company enjoys. The main reason for the government’s reluctance is obviously the high level of inefficiency that may be suffered by existing firms when many are allowed to operate in the same market. Secondly, it is probably important to first analyze the need for government regulation when London Underground operates in solitude (in a natural monopoly).

First of all, if the government attempts to impose regulations, there may be a counter-reaction by the firm to hike its prices and consumers will be forced to pay the high prices because they won’t have any other alternative (since only London Underground Company offers train services in the country). In addition, despite the fact that regulation is bound to improve efficiency, promote competition and increase the overall welfare of the population, it is important to note that in a natural monopoly, like the one London Underground enjoys, the situation may not be the same.

This is true because, from an analysis of the cost-benefit of the industry, the cost of imposing government regulations in the market is bound to surpass the overall expected benefits of doing so (Helium 2010, p. 2). It is therefore important for the government to refrain from regulating the activities of the company.

Alternative Strategies

All factors withstanding, there are some unexplored avenues the government can use to improve the London train industry. One of the most viable options is the price-cap mechanism which has been advanced by a sizeable number of economists as an antidote for natural monopolies. Helium (2010) explains that:

“This Price-Cap method uses the formula RPI-X. Here, RPI is used to measure the inflation rate, and X is equal to the expected efficiency savings. Whatever the result is, after using this formula, it represents the maximum percentage that the firm is allowed to increase its prices by. For example, if inflation is 3%, and X equals 1%, then the firm is allowed to increase prices by a maximum of 2%” (p. 3).

The price cap mechanism is therefore bound to increase the overall sense of efficiency in the industry by creating more incentives for London Underground Company because any efficiency saving the company makes are made beyond the percentage RPI-X stipulates and this will imply increased profits for the company (Helium 2010, p. 3). According to Helium (2010), “This strategy will obviously lead to reduced prices for train services, thereby increasing the overall social welfare in the industry, since the value of X will subtract some of the increased cost of the services after inflation”.

However, the government should be wary of the downsides of this kind of strategy because since the regulation is aimed at increasing the overall efficiency of the London Underground train service, there is a high probability of the company becoming highly ineffective before the government comes to review its performance. Helium (2010) explains that the reason behind this risk is that “if the regulator saw that the firm was a lot more inefficient, then they would not have to cut their price by as much” (p. 7).

A Positive Externality

Positive externalities are usually observed when the marginal cost-benefit of production surpasses the overall social benefit enjoyed at a private level (Mankiw 2008, p. 207). This means that the overall production advantages existent in the external benefit may result in deadweight loss because it may be undervalued in the market (Mankiw 2008, p. 207). Examples of situations where the overall benefit may be observed include instances where industrial training by firms results in deadweight loss through a reduction in the overall costs experienced by other firms (thereby leading to a loss in labor productivity).

Higher levels of output can therefore only be evidenced in instances where there is a higher rate of growth productivity which will in turn increase the overall social welfare of consumers operating within the market in the long run.

Another example where positive externalities can be evidenced could be through research in new technologies where the final outcome can be stolen and utilized by other producers. Other producers can therefore use this new technology to improve their overall efficiencies, thereby leading to decreased costs and a subsequent passing down of lower costs to the consumers. Also when educating the general population, increased competencies are likely to lead to increased efficiencies in production, also leading to increased external benefits through an increase in the overall social welfare of the population.

Currently, policymakers are only starting to realize that increased benefits in production can be achieved through the employment of the input of an educated workforce (Mankiw 2008, p. 207). The same positive externalities can also be evidenced in health provision, employment creation, and the likes.

Case Study Analysis

In the South West region of the UK, there is a clear depiction of a positive externality because most residents in the region claim they get a raw deal in terms of water provisions in the entire country (Pearson Education 2008, p. 1). This is evidenced by their low rate of average salaries when compared to the entire country and their abnormally high water bills (also when compared to the entire country). South Coast Company is the only company in the region that enjoys the monopoly of water provision in the region and they, unfortunately, charge extortionist prices in the provision of their services (Pearson Education 2008, p. 1).

It is however unfortunate that the abnormally high water bills paid by most South Coast residents are used to benefit everyone else in the country except them. Since the privatization of the South Coast water company, it has been charged with the responsibility of cleaning close to half of all UK beaches and this activity amounts to approximately two million pounds in total overheads (Pearson Education 2008, p. 3).

Unfortunately, South Coast residents shoulder most if not all of this cost. The situation is further aggravated by the fact that the South Coast has a small population and the overall cost South Coast Water Company incurs in the maintenance of beaches cannot be spread justifiably across the entire population. This means that the small population of the South Coast has to incur all the costs the company uses to clean the beaches.

The “high water bill” issue has over the years been a concern in South Coast and currently, no reprieve has been found to solve the problem. Proposals have been traded between the locals and the authorities; like seeking government grants to avert the high cost of water bills incurred by the population, but such proposals have not been ratified yet. Moreover, there is a very low likelihood that the government will come in to shoulder the cost the South Coast company has to pay in cleaning up the beaches.

Alternative Strategies

A majority of the citizens in the South Coast haven’t pondered deeper on public- private options they can take to reduce the severity of the situation. First, the government can reduce the taxes levied on the citizens of the South Coast with regard to the payment of their water bills because it is the overall responsibility of the government to protect the citizens from unfair practices in the market (Worth Publishers 2010, p. 136).

Alternatively, the government can give subsidies to the South Coast Company for its operations so that the company and the residents are not affected in any way by a change of the status quo (Worth Publishers 2010, p. 136). In this manner, South Coast Company can still remain in business by easily paying its bills (from the subsidy) without necessarily having to impose high water charges on the residents.

Also, since the residents of the South Coast don’t really have the details as to how South Coast Company operates, with regards to its costs and profits, the government can come in to directly regulate the activities of the company (Worth Publishers 2010, p. 136). This will be done by first establishing the optimal operating levels of the company with regards to its beach clean-up activities and from this point, establish an optimum price to charge the citizens. This option can be especially useful if the company was unjustified in charging high water costs because it may have been taking the residents for a ride by unjustifiably charging high prices for water provision because of the monopoly they enjoy.


Baumol, W. (2008) Economics: Principles and Policy. London, Cengage Learning.

Helium. (2010) Natural Monopolies and the Price Cap in the UK. Web.

Hillman, A. (2003) Public Finance and Public Policy: Responsibilities and Limitations Of Government. Cambridge, Cambridge University Press.

Investopedia. (2010) Economics Basics: Monopolies, Oligopolies and Perfect Competition. Web.

Mankiw, G. (2008) Principles of Economics. London, Cengage Learning.

Pearson Education. (2008) A Watery Smile in the South West. Web.

Worth Publishers. (2010) Externalities: Problems and Solutions. Web.