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Sustainable and Unsustainable Natural Monopoly

Natural monopoly is said to be sustainable if market forces would result in the survival of only one firm. In the case of sustainable natural monopoly, entry is unprofitable as well as socially inefficient.

In technical terms, sustainable natural monopoly occurs when the residual demand curve facing a potential entrant lies everywhere below the long run average cost function--thus rendering entry unprofitable.

In the sustainable case, the monopolist supplies 0Q* units at price P*, leaving the residual demand curve (d) below the LAC schedule of a potential entrant. Note that the conventional depiction of natural monopoly meets our definition of sustainable natural monopoly.

In the case of unsustainable natural monopoly, entry is profitable even though it is socially inefficient. In the unsustainable case, an incumbent monopolist is vulnerable to creamskimming by opportunistic firms. From the diagram we see that:

bulletThe natural monopolist supplies units at price P2.
bulletTC = 0P2KQ3, where TC is the total cost of supplying 0Q3 units.
bulletLet 0Q1 = 0Q3 - 0Q2. If natural monopoly is unsustainable, an entrant can cream skim the market by offering 0Q2 units at a price equal to minimum unit cost (P1).Thus with entry 

             TC = (0P1NQ2) + (0P3JQ1)

Thus in the unsustainable case, entry raises the total cost of supplying the socially optimal output (0Q3).

Issue: What is the appropriate public policy with respect to unsustainable natural monopoly? 

Answer: Legal restrictions on entry.

  Relevance of the concept of unsustainability to the MCI-AT&T legal dispute [MCI v. AT&T (1969)].

bulletFCC's "Above 890" Decision in 1959 stripped AT&T of exclusive rights to microwave frequencies above 890 megacycles--opening the way for MCI to enter the long distance market using microwave technology.
bulletTo enter the long distance market, however, MCI had to interconnect with local service lines controlled by AT&T's regional affiliates (Atlantic Bell, et al.). AT&T's affiliates set entry-deterring prices for local interconnection service charges.
bulletAT&T argued that MCI, free of a common carrier obligation, could cream skim the long distance market--undermining AT&T's universal service objective.
bulletEconomists paid by AT&T claimed the long distance market offered up the classic real world example of unsustainable natural monopoly.

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