In economics, a natural monopoly is a persistent situation where a single company is the only supplier of a particular kind of product or service due to the fundamental cost structure of the industry.

This applies where the largest supplier in an industry, or the first supplier in a local area, has an overwhelming cost advantage over other actual or potential competitors. This tends to be the case in industries where capital costs predominate, creating economies of scale which are large in relation to the size of the market, and hence high barriers to entry; examples include water services and electricity. It may also depend on control of a particular natural resource. Companies that grow to take advantage of economies of scale often run into problems of bureaucracy; these factors interact to produce an "ideal" size for a company, at which the company's average cost of production is minimised. If that ideal size is large enough to supply the whole market, then that market is a natural monopoly.

Technical definition

A natural monopoly occurs in a market where the average cost curve is decreasing over the entire relevant range of outputs. In the diagram, a typical "U" shaped long-run average cost curve (LRAC) is shown. It reflects the common tendency for average costs to first fall then rise as output increases. In the case of a natural monopoly, the entire relevant part of the LRAC curve (that is, the range of outputs where demand for the product exists) is downward sloping.

If a single company supplies the entire market, the output it produces will correspond approximately to the amount Q. If two firms supply the market, each firm will produce approximately Q/2, and if there are three firms each will produce Q/3. The more firms in the industry, the less each firm will produce, and the greater will be the cost structure for each firm.

If a natural monopolist is free to set prices or output levels, it would tend to produce approximately Q1 units of output and charge a price of about P1 (second diagram). This price and quantity combination is considered suboptimal by most economists: as the diagram suggests, it creates windfall profits for the monopolist and also generates less than socially optimal quantities of the good (that is, less product than would be demanded if the price was lower). It aslo creates what economists call a "dead-weight loss" to society. For these reasons governments tend to restrict the prices that a natural monopolist can charge. Typically governments set the price at P2 (determined by the largest quantity of output that the market demands and that can be produced profitably).

Existence and permanence

Because the existence of a natural monopoly depends on an industry's cost structure, which can change dramatically through new technology (both physical and organizational/institutional), the nature or even existence of natural monopoly may change over time. A classic example is the undermining of the natural monopoly of the canals in eighteenth century Britain by the emergence in the nineteenth century of the new technology of railways. A natural monopoly may also be changed deliberately by government setting up systems of competition, for example in the case of electricity liberalization. This may be considered a form of deregulation, although in a natural monopoly sector it may involve an active government creation of a new system of competition rather than simply the removal of existing legal restrictions.

Although competition within a natural monopoly market is costly, it is possible to set up competition for the market. This has been, for example, the dominant organizational method for water services in France, although in this case the resulting degree of competition is limited by contracts often being set for long periods (30 years), and there only being three major competitors in the market. Equally, competition may be used for part of the market, through outsourcing contracts; some water companies outsource a considerable proportion of their operations. The extreme case is Welsh Water, which outsources virtually its entire business operations, running just a skeleton staff to manage these contracts.

More fundamentally, the theory of contestable markets developed by Baumol and others argues that monopolists (including natural monopolists) may be forced over time by the mere possibility of competition at some point in the future to limit their monopolistic behaviour, in order to deter entry. In the limit, a monopolist is forced to make the same production decisions as a competitive market would produce. A common example is that of airline flight schedules, where a particular airline may have a monopoly between destinations A and B, but the relative ease with which in many cases competitors could also serve that route limits its monopolistic behaviour. The argument even applies somewhat to legal monopolies, as although they are protected from competitors entering the industry, in a democracy excessively monopolistic behaviour may lead to the monopoly being revoked, or given to another party.

Advocates of laissez-faire capitalism, such as libertarians, typically say that a natural monopoly is a practical impossibility when there is no regulatory government intervention, citing what they deem to be a almost certain probability of an emergence of competitive forces that would begin diminishing market share of one who became the sole supplier of a particular kind of product or service. They claim that it in the case of nationalization (or deprivatization) it is the government intervention itself that creates and sustains a monopoly where one actually did not exist. Many of those who oppose economic intervention by governments, such as mandatory price ceilings on what businesses may charge for its produce, assert that a natural monopoly has no historical precedent (given that a monopoly, to be a monopoly, must be a persistent rather than a transient situation), and that the concept is merely a theoretical abstraction used to justify an irrational intrusion into the free market by government, and, in the case of nationalization, ensuring "competition-free" revenue to the same.

Regulation

Main article: Regulation

Where natural monopolies are privately-owned - either from inception, or following privatization - they are often subject to regulation. As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices, constant returns for their shareholders, and a reduced risk of long-term competition. Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation; the telecoms industry is the leading example globally.

Network effects

Network effects are considered separately from natural monopoly status. Natural monopoly effects are a property of the producer's cost curves, whilst network effects arise from the benefit to the consumers of a good from standardization of the good. Many goods have both properties, like operating system software and telephone networks.

Software is often taken to be a natural monopoly, due to the high cost of making the first copy and the low cost of replication. These factors create an average cost curve that typically decreases for any quantity greater than one. This argument has been used to justify arguments relating both to Microsoft's current personal computer software market domination, and to suggest the possibility of its replacement by a future natural monopoly of free software. However, Microsoft's dominance is largely due to network effects rather than economies of scale; the costs of production are high compared to costs of distribution, but low compared to the price the market will bear (hence Microsoft's large profits). Absent benefits for consumers from standardization, it is highly unlikely that Microsoft's share of the PC software market (90%+ for operating systems) would be so high.

See also

• market forms
• currency
• standardization
• public goods
• anti-competitive behaviour
• tipping point

References

• Berg, S.. and Tschirhart, J., (1988), Natural Monopoly Regulation: Principles and Practices, Cambridge University Press.
• Baumol, W. J., Panzar, J. C., and Willig, R. D., (1982), Contestable Markets and the Theory of Industry Structure, New York, Harcourt Brace Jovanovich.
• DiLorenzo, Thomas J. (1996), "The Myth of the Natural Monopoly", The Review of Austrian Economics 9(2) [1] (Spanish version)
• Sharkey, W., (1982), The Theory of Natural Monopoly, Cambridge University Press.
• Train, K. (1991), Optimal regulation: the economic theory of natural monopoly, Cambridge, Mass.: MIT Press
• Waterson, M., (1988), Regulation of the Firm and Natural Monopoly, New York: Blackwell.