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. Natural monopolies are often contrasted with coercive monopolies, in which competition would be economically viable if allowed but potential competitors are barred from entering the market by law or by force.
Natural monopolies arise 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.
All industries have some costs of investment which must be met for firms to enter them - for example, building a widget factory to enter the market for widgets. Industries with higher investment costs tend to have less competition (compare airplane manufacture with a lawnmowing service). Some industries have investment costs which are so high that if more than one firm tries to supply the same market, all except one (the one with the deepest pockets) will be driven into bankruptcy, because none will be able to make a profit. Such industries are (for obvious reasons) known as natural monopolies.
Why can only one firm survive in a natural monopoly? Because prices will be driven down to a minimal profit level per customer, covering the daily costs of providing the service (marginal cost) but not the huge initial investment (fixed cost). Having made a huge investment, each firm is prepared to accept an absolute minimum price from each customer rather than have no income at all; each customer may contribute a little to paying off the investment, but not enough. In this situation, firms won't have the income to service the debts they took on to finance the investment. This will drive all into bankruptcy (or merger, or a cartel), except for the last one left standing, which can then charge a monopoly profit and recoup its investment costs.
In essence, a firm must be able to at least charge its average cost to survive in the long run. However, natural monopolies' cost functions are characterized by the fact that at no positive price (as per the demand schedule) does the marginal cost equal or exceed the average cost. Since competitive firms must charge marginal cost, they are bound to fail in their attempt to compete, and a monopolist will emerge.
Why does this not happen in other industries? It is a combination of very high costs and a standardised product or service (electricity from one company is no better than electricity from another). A standardised product means competition is very high; when there are quality differences, quality-focussed and value-focussed suppliers can coexist, as some customers prefer to pay extra for quality and others don't. In natural monopolies, the product is standard, and the industry's high costs cannot be covered if there is competition. Only a monopolist can charge high enough prices to sustain the industry.
Such a process happened in the water industry in nineteenth century Britain. Up until the mid-nineteenth century, Parliament discouraged municipal involvement in water supply; in 1851, private companies had 60% of the market. Competition amongst the companies in larger industrial towns lowered profit margins, as companies were less able to charge a sufficient price for installation of networks in new areas. In areas with direct competition (with two sets of mains), usually at the edge of companies' territories, profit margins were lowest of all. Such situations resulted in higher costs and lower efficiency, as two networks, neither used to capacity, were used. With a limited number of households that could afford their services, expansion of networks slowed, and many companies were barely profitable. With a lack of water and sanitation claiming thousands of lives in periodic epidemics, municipalisation proceeded rapidly after 1860, and it was municipalities which were able to raise the finance for investment which private companies in many cases could not. A few well-run private companies which worked together with their local towns and cities (gaining legal monopolies and thereby the financial security to invest as required) did survive, providing around 20% of the population with water even today. (NB The rest of the water industry in England and Wales was reprivatised in the form of 10 regional monopolies in 1989.)
Explanation using diagrams
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 also 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).
As with all monopolists, a monopolist who has gained his position through natural monopoly effects may engage in behavior that some may construe as abuse of his market position. This tends to lead to calls from consumers for government regulation. Equally, regulation may come about at the request of a business hoping to set up a monopoly (e.g. water supply in a city), in order to reduce risk and make it easier to obtain the finance needed for investment. As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed rates of return , and a reduced risk of long-term competition. (See also rate of return pricing).
- doing nothing
- setting legal limits on the firm's behaviour, either directly or through a regulatory agency
- setting up competition for the market (franchising)
- setting up common carriage type competition
- setting up surrogate competition ("yardstick" competition or benchmarking)
- requiring companies to be (or remain) quoted on the stock market
- public ownership
Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecoms industry is the leading example globally.
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.
Arguments from public choice suggest that regulatory capture is likely in the case of a regulated private monopoly. Moreover, in some cases, the costs to society of overzealous regulation may be higher than the costs of permitting an unregulated private monopoly. (Although the monopolist charges monopoly prices, much of this a transfer rather than a loss to society.)
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 government-granted 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 that has no historical precedent (given that monopoly, to be monopoly, must be a persistent rather than a transient situation). They claim that in a hypothetical case where a business became the sole supplier of a particular kind of product or service that competitive forces would very soonly emerge and begin diminishing market share. One of the most common criticisms of a laissez-faire free market is the claim that a natural monopoly results in market failure. The arguments given above, that a persistent natural monopoly is not viable, are a frequent response to this criticism. Many adherents of the Austrian school and others who oppose economic intervention by governments, such as mandatory price ceilings on what businesses may charge for their produce, assert that the concept of natural monopoly is merely a theoretical abstraction used to justify irrational government intrusions into the free market that are, ultimately, not in the best interest of consumers. Likewise, deregulation advocates assert that claims of "natural monopoly" are wrongly used to justify the creation of government monopolies, for instance in public utilities -- such as telephone service during much of the 20th century. In contrast to the operation of anti-trust law that seeks to break up or limit monopolistic behavior, utility regulation in the presence of a claimed natural monopoly can ensure longer-term competition-free revenue to the utility.
Franchising and outsourcing
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 (eg IT services), 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. Franchising different parts of the business on a regional basis (eg parts of a city) can bring in some features of "yardstick" competition (see below), as the performance of different contractors can be compared. See also water privatization.
Common carriage competition
This involves different firms competing to distribute goods and services via the same infrastructure - for example different electricity companies competing to provide services to customers over the same electricity network. For this to work requires government intervention to break up vertically integrated monopolies, so that for instance in electricity, generation is separated from distribution and possibly from other parts of the industry such as sales. The key element is that access to the network is available to any firm that needs it to supply its service, with the price the infrastructure owner is permitted to charge being regulated. (There are several competing models of network access pricing .) In the British model of electricity liberalization, there is a market for generation capacity, where electricity can be bought on a minute-to-minute basis or through longer-term contracts, by companies with insufficient generation capacity (or sometimes no capacity at all).
Such a system may be considered a form of deregulation, but in fact it requires active government creation of a new system of competition rather than simply the removal of existing legal restrictions. The system may also need continuing government finetuning, for example to prevent the development of long-term contracts from reducing the liquidity of the generation market too much, or to ensure the correct incentives for long-term security of supply are present. See also California electricity crisis. Whether such a system is more efficient than possible alternatives is unclear; the cost of the market mechanisms themselves are substantial, and the vertical de-integration required introduces additional risks. This raises the cost of finance - which for a capital intensive industry (as natural monopolies are) is a key issue. Moreover, such competition also raises equity and efficiency issues, as large industrial consumers tend to benefit much more than domestic consumers.
One regulatory response is to require that private companies running natural monopolies be quoted on the stock market. This ensures they are subject to certain financial transparency requirements, and maintains the possibility of a takeover if the company is mismanaged. The latter should help ensure that company is efficiently run. By way of example, the UK's water economic regulator, Ofwat, sees the stock market as an important regulatory instrument for ensuring efficient management of the water companies.
A traditional solution to the regulation problem, especially in Europe, is public ownership. This 'cuts out the middle man': instead of government restricting a firm's behaviour, it simply takes it over (usually by buy-out), and sets itself limits within which to act.
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.
- 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)  (Spanish version)
- Filippini, Massimo (1998), "Are Municipal Electricity Distribution Utilities Natural Monopolies?", Annals of Public and Cooperative Economics 69 (2) (Based on analysis of cost structure of Swiss municipal electricity distribution - Yes)
- 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.
Last updated: 06-01-2005 22:41:37