Natural monopoly

In small countries like New Zealand, electricity transmission is a natural monopoly. Due to large fixed costs and a small market size, one seller can serve the entire market at the downward-sloping section of its average cost curve.

A monopoly describes a situation where all (or most) sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient (involving the lowest long-run average cost) for production to be concentrated in a single firm. In some cases, this gives the largest supplier in an industry, often the first supplier in a market, an overwhelming cost advantage over other actual and potential competitors. This tends to be the case in industries where capital costs predominate, creating economies of scale that are large in relation to the size of the market, and hence high barriers to entry; examples include public utilities such as water services and electricity.

Explanation

All industries have costs associated with entering them. Often, a large portion of these costs is required for investment. Larger industries, like utilities, require enormous initial investment. This barrier to entry reduces the number of possible entrants into the industry regardless of the earning of the corporations within. Natural monopolies arise where the largest supplier in an industry, often the first supplier in a market, has an overwhelming cost advantage over other actual or potential competitors; this tends to be the case in industries where fixed costs predominate, creating economies of scale that are large in relation to the size of the market, as is the case in water and electricity services. The cost of constructing a competing transmission network is so high that it effectively bars potential competitors from the monopolist's market, acting as an early insurmountable barrier to entry into the market place.

A graphical explanation of the inefficiencies of having several competitors in a naturally monopolistic market.

Companies that 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 minimized. If that ideal size is large enough to supply the whole market, then that market is a natural monopoly.

A further discussion and understanding requires more microeconomics:

Two different types of cost are important in microeconomics: marginal cost, and fixed cost. The marginal cost is the cost to the company of serving one more customer. In an industry where a natural monopoly does not exist, the vast majority of industries, the marginal cost decreases with economies of scale, then increases as the company has growing pains (overworking its employees, bureaucracy, inefficiencies, etc.). Along with this, the average cost of its products decreases and increases. A natural monopoly has a very different cost structure. A natural monopoly has a high fixed cost for a product that does not depend on output, but its marginal cost of producing one more good is roughly constant, and small.

A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment. This is where economies of scale become important. Since each firm has large initial costs, as the firm gains market share and increases its output the fixed cost (what they initially invested) is divided among a larger number of customers. Therefore, in industries with large initial investment requirements, average total cost declines as output increases over a much larger range of output levels.

Once a natural monopoly has been established because of the large initial cost and that, according to the rule of economies of scale, the larger corporation (to a point) has lower average cost and therefore a huge advantage. With this knowledge, no firms attempt to enter the industry and an oligopoly or monopoly develops.

Formal definition of a natural monopoly

William Baumol (1977) provided the current formal definition of a natural monopoly where “[a]n industry in which multiform production is more costly than production by a monopoly” (p. 810). He linked the definition to the mathematical concept of subadditivity; specifically of the cost function. Baumol also noted that for a firm producing a single product, scale economies were a sufficient but not a necessary condition to prove subadditivity.

Etymology

The original concept of natural monopoly is often attributed to John Stuart Mill, who (writing before the marginalist revolution) believed that prices would reflect the costs of production in absence of an artificial or natural monopoly. In Principles of Political Economy Mill criticised Smith's neglect of an area that could explain wage disparity. Taking up the examples of professionals such as jewellers, physicians and lawyers, he said,

"The superiority of reward is not here the consequence of competition, but of its absence: not a compensation for disadvantages inherent in the employment, but an extra advantage; a kind of monopoly price, the effect not of a legal, but of what has been termed a natural monopoly... independently of... artificial monopolies [i.e. grants by government], there is a natural monopoly in favour of skilled labourers against the unskilled, which makes the difference of reward exceed, sometimes in a manifold proportion, what is sufficient merely to equalize their advantages. If unskilled labourers had it in their power to compete with skilled, by merely taking the trouble of learning the trade, the difference of wages might not exceed what would compensate them for that trouble, at the ordinary rate at which labour is remunerated. But the fact that a course of instruction is required, of even a low degree of costliness, or that the labourer must be maintained for a considerable time from other sources, suffices everywhere to exclude the great body of the labouring people from the possibility of any such competition.

So Mill's initial use of the term concerned natural abilities, in contrast to the common contemporary usage, which refers solely to market failure in a particular type of industry, such as rail, post or electricity. Mill's development of the idea is that what is true of labour is true of capital.

"All the natural monopolies (meaning thereby those which are created by circumstances, and not by law) which produce or aggravate the disparities in the remuneration of different kinds of labour, operate similarly between different employments of capital. If a business can only be advantageously carried on by a large capital, this in most countries limits so narrowly the class of persons who can enter into the employment, that they are enabled to keep their rate of profit above the general level. A trade may also, from the nature of the case, be confined to so few hands, that profits may admit of being kept up by a combination among the dealers. It is well known that even among so numerous a body as the London booksellers, this sort of combination long continued to exist. I have already mentioned the case of the gas and water companies.

Mill also applied the term to land, which can manifest a natural monopoly by virtue of it being the only land with a particular mineral, etc. Furthermore, Mill referred to network industries, such as electricity and water supply, roads, rail and canals, as "practical monopolies", where "it is the part of the government, either to subject the business to reasonable conditions for the general advantage, or to retain such power over it, that the profits of the monopoly may at least be obtained for the public." So, a legal prohibition against competition is often advocated and rates are not left to the market but are regulated by the government.

For an excellent discussion of the historical origins of the term 'natural monopoly' see Mosca.

Regulation

As with all monopolies, a monopolist who has gained his position through natural monopoly effects may engage in behavior that abuses his market position, which often leads to calls from consumers for government regulation. Government regulation may also come about at the request of a business hoping to enter a market otherwise dominated by a natural monopoly.

Common arguments in favor of regulation include the desire to control market power, facilitate competition, promote investment or system expansion, or stabilize markets. In general, though, regulation occurs when the government believes that the operator, left to his own devices, would behave in a way that is contrary to the government's objectives. In some countries an early solution to this perceived problem was government provision of, for example, a utility service. However, this approach raised its own problems. Some governments used the state-provided utility services to pursue political agendas, as a source of cash flow for funding other government activities, or as a means of obtaining hard currency. These and other consequences of state provision of services often resulted in inefficiency and poor service quality. As a result, governments began to seek other solutions, namely regulation and providing services on a commercial basis, often through private participation.

Advocates of laissez-faire capitalism generally argue that permanent natural monopolies are merely theoretical. Economists from the Austrian school claim that governments take ownership of the means of production in certain industries and ban competition under the false pretense that they are natural monopolies.

See also

• Market forms
• Currency
• Standardization
• Public goods
• Anti-competitive practices
• Coercive monopoly
• Quasi-rent
• LoopCo

References

• Berg, Sanford; John Tschirhart (1988). Natural Monopoly Regulation: Principles and Practices. Cambridge University Press. ISBN 978-0-521-33893-6. 
• Baumol, William J.; Panzar, J. C., and Willig, R. D. (1982). Contestable Markets and the Theory of Industry Structure. New York: Harcourt Brace Jovanovich. ISBN 978-0-15-513910-7. 
• Filippini, Massimo (June 1998). "Are Municipal Electricity Distribution Utilities Natural Monopolies?". Annals of Public and Cooperative Economics 69 (2): 157. doi:10.1111/1467-8292.00077. 
• Foldvary, Fred E.; Daniel B. Klein (2003). The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues. Cato Institute. 
• Sharkey, W. (1982). The Theory of Natural Monopoly. Cambridge University Press. ISBN 978-0-521-27194-3. 
• Thierer, Adam D (1994). "Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly". The Cato Journal 14 (2). 
• Train, Kenneth E. (1991). Optimal regulation: the economic theory of natural monopoly. Cambridge, MA, USA: MIT Press. ISBN 978-0-262-20084-4. 
• Waterson, Michael (1988). Regulation of the Firm and Natural Monopoly. New York, NY, USA: Blackwell. ISBN 0-631-14007-7. 
• Perloff, Jeffrey, M. (2012). Microeconomics. Pearson Education. ISBN 978-0-273-75460-2.