Consider that you are the only provider of public utilities with the capacity to provide the service at a very low cost in the overall industry. Due to your monopolistic status, you may be able to sell your products for a higher price even though you produce them at a cheaper cost. Or would you? Don't start celebrating just yet because the government is likely to step in and control pricing. Why do natural monopolies exist? Want to learn about natural monopoly and how the government should regulate it? Let's get straight into the article.
Definition of Natural Monopoly
Let's first review what a monopoly is and then go over the definition of a natural monopoly.
A monopoly emerges when there is just one seller of a non-substitutable product in a market. Sellers in a monopoly can affect the price of the product since they have no competitors and the products they sell cannot be easily substituted.
The monopoly has made it difficult for new firms to enter the market by exerting significant control over it. The barrier to entry in such a market can be due to government regulation, natural monopoly, or due to a single firm owning a rare resource that is not easily accessible to everyone.
A monopoly is a situation that occurs when there is only one supplier selling products that are difficult to substitute.
Need more of a refresher? Check out these explanations:- Monopoly
- Monopoly Power
Now, let's get started with the natural monopoly.
A natural monopoly arises when a single firm can produce a good or service at a lower cost and supply them at a lower price than if other two or more companies were involved in producing it. As the firm is capable of producing at a very low cost, they are not concerned about its competitors entering the market and hindering its position as a monopolist.
Economies of scale refer to the scenario in which the cost per unit of production decreases as the quantity produced increases.
A natural monopoly is formed when a single company can produce a good or service at a lower cost than if two or more companies were involved in making the same product.
Natural Monopoly Graph
Let's look at a couple of natural monopoly graphs.
We know that a natural monopoly operates at the economies of scale which enables the firm to produce more at a lower cost. This means that the average total cost curve of the firm keeps on decreasing.
Fig. 1 - Natural monopoly graph
Figure 1 illustrates the simplest form of a natural monopoly graph. As the average total cost (ATC) of the natural monopoly decreases, it takes advantage of the situation and sells products and services at a lower price than its would-be competitors. However, the government steps in to balance the market's competitiveness since it is fully aware of how natural monopolists operate.
Natural Monopoly Regulation
Now, let us understand how the government imposes regulations on natural monopolies. We know that a natural monopoly arises when a single firm is capable of serving the entire market at a lower total cost than if more firms are involved. When a single firm has such power, it must be regulated to ensure that prices are kept at a fair level.
Fig 2. Natural Monopoly Regulation
In Figure 2, we can see that if a firm is not regulated, it produces the quantity of QM and charges the price of PM. The price is set very high and will lead to market inefficiencies if it is not regulated properly. Now, the government needs to intervene to make sure the price is set at a fair level. It is challenging as the price shouldn't be set too low as doing will lead the firm to shut down. For instance, if the government sets the price ceiling at PC, it leaves the monopoly firm making a loss as this price is lower than the firm's average total costs, and the firm will not be able to sustain operations in the long run.
With proper market assessment, the government will set the price at PG where the average total cost curve intersects the average revenue curve (which is also the demand curve). This means that the firm will make neither a profit nor a loss. It will be just breaking even. This fair price will ensure that there will be no market inefficiencies in the long run.
A price ceiling is a method of government-enforced price regulation that establishes the highest price a seller can charge for a good or service.
There is also a form of monopoly which is created by the government granting it the exclusive right to operate in the market. To learn more, check out our explanation: Government Monopolies.
Natural Monopoly Examples
Let's have a look at some examples to learn about natural monopoly comprehensively.
The first is a classic example -- a public utility firm.
Consider a tap water distribution utility as an example. The firm must be able to efficiently build pipelines around the market to supply water. On the other hand, new firms would have to build their pipelines if they decide to engage in the tap water distribution market.
Each new competitor will have to bear separate fixed expenses for pipeline construction. The average overall cost of supplying drinking water rises as more firms enter the market. As a result, when just one firm serves the entire market, the average overall cost of delivering tap water is the lowest.
Then, we consider an example of railway tracks.
Marcus's firm owns the railway tracks in his region. The firm's rail tracks can serve the needs of the entire market. If more firms choose to enter the market, they will have to build separate tracks in the same market.
This means that they will incur separate fixed costs to serve the same market. This raises the average total cost of providing rail transportation services. As a result, if Marcus's firm is the only player in the market, the average overall cost of supplying railway transportation to the entire market is the lowest.
We don't usually think of software firms as examples of natural monopolies. However, in the case of really complicated software solutions, it can mean a high fixed cost for the firm in the initial development phase.
Joe is a software entrepreneur who has developed cutting-edge software solutions for businesses. He was the first to develop the product, hence the first mover advantage aided in his quick customer acquisition. In the long run, he was able to obtain economies of scale, which allowed him to manufacture the product at a low cost. As there is already one entrepreneur developing software solutions at a very minimum cost, having two or more firms develop the same product would only lead to increased total fixed costs. As a result, Joe eventually emerges as the natural monopolist.
Characteristics of a Natural Monopoly
- A natural monopoly exists when the average total cost of producing a product or service is lowest when only one company serves the entire market. However, sometimes the size of a market determines if the company will remain a natural monopoly or not.
Now, let's learn about some of the distinctive characteristics of a natural monopoly and why some of them are even supported by the government.
Government-backed public utility firms are the most common examples of natural monopolies.
Let's take an example of an electricity transmission company. The company must be able to efficiently construct electrical poles around the market for electricity transmission. If other public utility companies were to compete in the electricity transmission market, they would also have to build their separate electricity poles. Each new competing firm will have to incur separate fixed costs for building its electrical poles. As more firms enter the market, the average total cost of providing electricity increases. Therefore, the average total cost of providing electricity is lowest when only one company serves the entire market.
Now, you must be thinking, if a single firm serves the whole market, aren't they able to drive up the price as much as they want? Well, this is where the government intervenes. The government allows such public utility companies to be a natural monopoly as the firms will be able to produce at a very low cost in the long run. Doing so is in the best interest of the economy. To restrict the companies from driving up the price, the government often sets price ceilings and regulates those companies heavily. In many cases, these public utilities are owned by the government.
However, in some circumstances, the size of the market determines whether or not the company will continue to hold a natural monopoly. Let's suppose there is a company that offers internet services to a market with a small population. The market would need to have a fiber optic cable network installed, which is feasible given the low population. In this situation, the company is a natural monopoly. Now, what if the population of the market increases substantially and the company is not able to meet the demand even if they expand the fiber optic cable network? Now, it makes sense for more firms to enter the market. As a result, the market's expansion can transform the natural monopoly into an oligopoly.
Natural Monopoly - Key Takeaways
- A monopoly is a situation that occurs when there is only one supplier selling products that are difficult to substitute.
- A natural monopoly is formed when a single company can produce a good or service at a lower cost than if two or more companies were involved in making it.
- The government allows the natural monopoly to exist when the average total cost of producing a product or service is lowest when only one company serves the entire market. However, sometimes the size of a market determines if the company will remain a natural monopoly or not.
- A price ceiling is a method of government-enforced price regulation that establishes the highest price a seller can charge for a service or product.
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