In economics, the term natural monopoly is used to refer to two different things. This has been a source of some ambiguity in discussions of "natural monopoly."^[1] The two definitions follow: Face-to-face trading interactions on the New York Stock Exchange trading floor. ...

• An industry is said to be a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms—that is, there are economies of scale in social costs.^{[2] [1]} Unlike in the ordinary understanding of a monopoly, a natural monopoly situation does not mean that only one firm is providing a particular kind of good or service. Rather it is the assertion about an industry, that multiple firms providing a good or service is less efficient (more costly to a nation or economy) than would be the case if a single firm provided a good or service. There may, or may not be, a single supplier in such an industry. This is a normative claim which is used to justify the creation of statutory monopolies, where government prohibits competition by law. Examples of claimed natural monopolies include railways, telecommunications, water services, electricity, and mail delivery. Some claim that the theory is a flawed rationale for state prohibition of competition.^[3], ^[4]

• An industry is said to be a natural monopoly (also called technical monopoly) if only one firm is able to survive in the long run, even in the absence of legal regulations or "predatory" measures by the monopolist. "^[1] It is said that this is the result of high fixed costs of entering an industry which causes long run average costs to decline as output expands (i.e. economies of scale in private costs).

Social cost, in economics, is the total of all the costs associated with an economic activity. ... The increase in output from Q to Q2 causes a decrease in the average cost of each unit from C to C1. ... A monopoly (from the Greek language monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a product or service, in other words a firm that has no competitors in its industry. ... A legal monopoly, statutory monopoly, or de jure monopoly is a monopoly that is protected by law from competition. ... Telecommunication involves the transmission of signals over a distance for the purpose of communication. ... Categories: Stub | Water | Sewerage | Industries ... Lightning strikes during a night-time thunderstorm. ... It has been suggested that first class mail be merged into this article or section. ...

Overview

The original concept of natural monopoly is often attributed to John Stuart Mill, who argued that it was wasteful to have multiple providers of utility services, although he did not refer to the situation as a "natural monopoly." John Stuart Mill (20 May 1806 – 8 May 1873), British philosopher, political economist and Member of Parliament, was an influential liberal thinker of the 19th century. ...

One example of a claimed natural monopoly would be the subway industry. It is said that there would be greater social costs to have two competing subway systems running in parallel, given the costs of digging pathways that go to the same place. The average cost per trip would be less if there is only one subway system.^[5] So, a legal prohibition against competition is often advocated and rates are not left to the market but are regulated by the government.

Though a claim that an industry is a natural monopoly does not mean that there is only one provider, it is often argued that in a natural monopoly industry only a single firm will be able to survive.

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 which are large in relation to the size of the market - examples include water services and electricity. It is very expensive to build transmission networks (water/gas pipelines, electricity and telephone lines), therefore it is unlikely that a potential competitor would be willing to make the capital investment needed to even enter the monopolists market. Invest redirects here. ... Barriers to entry is a term used in economics and especially the theory of competition to refer to obstacles placed in the path of a firm who wants to enter a given market. ... Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. ... The increase in output from Q to Q2 causes a decrease in the average cost of each unit from C to C1. ...

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 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: Microeconomics is a branch of Economics that studies how individuals, households, and firms make decisions to allocate limited resources,[1] typically in markets where goods or services are being bought and sold. ...

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 industry, 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 will decrease and then increase again. 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 will require a large number of customers in order to retrieve a meaningful return on their initial 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. The increase in output from Q to Q2 causes a decrease in the average cost of each unit from C to C1. ... Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. ... Average total cost is the cost of making all of the widgets divided by the number of widgets made. ...

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.

A natural monopoly and a monopoly are not the same concept. A natural monopoly describes a firm's cost structure (high fixed cost, extremely low constant marginal cost). A monopoly describes market share and market power; the two are not synonymous. A monopoly (from the Greek language monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a product or service, in other words a firm that has no competitors in its industry. ...

Industry with a Natural Monopoly

Utilities are often natural monopolies. In industries with a standardized product and economies of scale, a natural monopoly will often arise. In the case of electricity, all companies provide the same product, the infrastructure required is immense, and the cost of adding one more customer is negligible (up to a point.) Adding one more customer may increase the company's revenue and lowers the average cost of providing for the company's customer base. So long as the average cost of serving customers is decreasing, the larger firm will more efficiently serve the entire customer base. Of course, this might be circumvented by differentiating the product, making it no longer a pure commodity. For example, firms may gain customers who will pay more by selling "green" power, or non-polluting power, or locally-produced power.

Historical example

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. The rest of the water industry in England and Wales was reprivatised in the form of 10 regional monopolies in 1989. Categories: Stub | Water | Sewerage | Industries ... Municipalization is the transfer to municipal ownership of corporations or other assets. ... Motto (French) God and my right Anthem No official anthem specific to England — the anthem of the United Kingdom is God Save the Queen. See also Proposed English National Anthems. ... This article is about the country. ...

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. This tends to lead to calls from consumers for government regulation, while at the same time opening up opportunities for competitors to offer better service. Government regulation may also come about at the request of a business hoping to set up a monopoly position for itself (e.g. electricity supply in a city). Having a monopoly greatly reduces risk and makes it easier to obtain the finance needed for investment. Lets talk about risk control strategies, anyone with more information and willing to share, please do so. ...

As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed through limited rates of return, and a reduced risk of long-term competition. (See also rate of return pricing). For example, an electric utility may be allowed to sell electricity at price that will give it an 12% return on its capital investment. If not constrained by the public utility commission, the company would likely charge a far higher price and earn an abnormal profit on its capital. Quid pro quo (Latin for something for something [1]) indicates a more-or-less equal exchange or substitution of goods or services. ... This article or section is in need of attention from an expert on the subject. ... Target rate of return pricing is a pricing method used almost exclusively by market leaders or monopolists. ... A public utility is a company that maintains the infrastructure for a public service. ... Supernormal Profit, also referred to as abnormal profit or pure profit, is an economic term of profit exceeding the normal profit. ...

Regulatory responses:

• 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 carrier 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 telecommunications industry is a leading example globally. A common carrier is an organization that transports persons or goods, and offers its services to the general public. ... Benchmarking (also best practice benchmarking or process benchmarking) is a process used in management and particularly strategic management, in which organizations evaluate various aspects of their processes in relation to best practice, usually within their own sector. ... A stock market is a market for the trading of company stock, and derivatives of same; both of these are securities listed on a stock exchange as well as those only traded privately. ... Deregulation is the process by which governments remove, reduce, or simplify restrictions on business and individuals in order to (in theory) encourage the efficient operation of markets. ... Telecommunication involves the transmission of signals over a distance for the purpose of communication. ...

Doing nothing

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. Categories: Water-transport stubs | Canals | Water transport ...

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 the price increase is a transfer rather than a loss to society.) Public choice theory is a branch of economics that studies the decision-making behavior of voters, politicians and government officials from the perspective of economic theory. ... Regulatory capture is an economic phenomenon in which a government regulatory agency becomes dominated by the interests of the industry that it oversees. ...

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. Contestable markets refer to a market situation where there are very few, perhaps even only one, firm yet perfectly competitive market outcomes may still be observed (as opposed to expected monopolistic or oligopolostic outcomes). ... In economics, a government-granted monopoly (also called a de jure monopoly) is a monopoly of a product or service granted by government to an individual or organization/company. ...

Nobel economist Milton Friedman, said that in the case of natural monopoly that "there is only a choice among three evils: private unregulated monopoly, private monopoly regulated by the state, and government operation." He said "the least of these evils is private unregulated monopoly where this is tolerable." He reasons that the other alternatives are "exceedingly difficult to reverse," and that the dynamics of the market should be allowed the opportunity to have an effect and are likely to do so (Capitalism and Freedom). In a Wincott Lecture, he said that if the commodity in question is "essential" (for example: water or electricity) and the "monopoly power is sizeable," then "either public regulation or ownership may be a lesser evil." However, he goes on to say that such action by government should not consist of forbidding competition by law. Friedman has taken a stronger laissez-faire stance since, saying that "over time I have gradually come to the conclusion that antitrust laws do far more harm than good and that we would be better off if we didn’t have them at all, if we could get rid of them" (The Business Community's Suicidal Impulse). Milton Friedman (July 31, 1912 – November 16, 2006) was a prominent American economist and public intellectual. ... This article is about anti-competitive business behavior. ...

Advocates of laissez-faire capitalism, such as libertarians, typically say 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. [1] Laissez-faire capitalism is, roughly stated, the doctrine that the free market functions to the greatest good when left unfettered and unregulated by government. ... This article deals with the libertarianism as defined in America and several other nations. ... The Austrian School, also known as the Vienna School or the Psychological School, is a school of economic thought that advocates adherence to strict methodological individualism. ...

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. Information and communication technology spending in 2005 Information technology (IT), as defined by the Information Technology Association of America (ITAA), is the study, design, development, implementation, support or management of computer-based information systems, particularly software applications and computer hardware. ... Outsourcing became part of the business lexicon during the 1980s and refers to the delegation of non-core operations from internal production to an external entity specializing in the management of that operation. ... Dwr Cymru / Welsh Water (DCWW) is a company which supplies drinking water and wastewater services to most of Wales and parts of western England. ... Water privatization is a short-hand for the privatization of water services, although more rarely it refers to privatization of water resources themselves. ...

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). It has been suggested that Vertical expansion be merged into this article or section. ... Electricity liberalization refers to the liberalization of electricity markets. ...

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. Deregulation is the process by which governments remove, reduce, or simplify restrictions on business and individuals in order to (in theory) encourage the efficient operation of markets. ... Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ... The California electricity crisis (also known as the Western Energy Crisis) of 2000 and 2001 followed a failed partial-deregulation, in 1996, of the electricity market in the state. ... Equity is the concept or idea of fairness or justice in economics, particularly in terms of taxation and welfare economics. ... Economic efficiency is a general term for the value assigned to a situation by some measure designed to capture the amount of waste or friction or other undesirable economic features present. ...

Stock market

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 in theory should help ensure that company is efficiently run. A takeover in business refers to one company (the acquirer, or bidder) purchasing another (the target). ...

In practice, the notorious short-termism of the stock market may be antithetical to appropriate spending on maintenance and investment in industries with long time horizons, where the failure to do so may only have effects a decade or more hence (which is typically long after current chief executives have left the company). 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. The Office of Water Services (Ofwat) is the body which is responsible for economic regulation of the privatised water industry in England and Wales. ...

Public ownership

A traditional solution to the regulation problem, especially in Europe, is public ownership. This 'cuts out the middle man': instead of government regulating a firm's behaviour, it simply takes it over (usually by buy-out), and sets itself limits within which to act. This article is about state ownership. ...

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. A network effect is a characteristic that causes a good or service to have a value to a potential customer which depends on the number of other customers who own the good or are users of the service. ...

Notes and References

See also

• market forms
• currency
• standardization
• public goods
• anti-competitive practices
• coercive monopoly
• tipping point
• quasi-rent
• LoopCo

In economics, the main criteria by which one can distinguish between different market forms are: the number and size of producers and consumers on the market, the type of goods and services being traded, and the degree to which information can flow freely. ... Standardization, in the context related to technologies and industries, is the process of establishing a technical standard among competing entities in a market, where this will bring benefits without hurting competition. ... In economics, a public good is one that cannot or will not be produced for individual profit, since it is difficult to get people to pay for its large beneficial externalities. ... Anti-competitive practices are business or government practices that prevent and/or reduce competition in a market. ... In economics and business ethics, a coercive monopoly is any monopoly maintained by coercion. ... The phrase tipping point or angle of repose is a sociology term that refers to that dramatic moment when something unique becomes common. ... Quasi-rent is an economics term that describes earnings of capital, which is fixed in supply in the short run. ... LoopCo is an economic model created in the mid 1990s as a proposal the Federal Communications Commission and the US Congress for the healthy development of competition in the local and long distance industries in the US. While there was widespread support among competitors in the industry, it was not...

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) [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)
• Fred E. Foldvary and Daniel B. Klein (2003, eds), The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues, Cato Institute, New York University Press, 2003 [3]
• Sharkey, W., (1982), The Theory of Natural Monopoly, Cambridge University Press.
• Thierer, Adam D. (1994), "Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly," The Cato Journal Vol 14 Num 2 [4]
• 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.

Fred Foldvary is a Lecturer in Economics at Santa Clara University, California, and a Research Fellow at The Independent Institute. ... The Cato Institute is a libertarian think tank headquartered in Washington, D.C. The Institutes stated mission is to broaden the parameters of public policy debate to allow consideration of the traditional American principles of limited government, individual liberty, free markets, and peace by striving to achieve greater involvement...

External links

• Natural Monopoly Definition