Natural monopoly

Natural monopoly

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A monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

 describes a situation where all (or most) sales in a market are undertaken by a single firm. A natural monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

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 form. 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 cost
Capital cost
Capital costs are costs incurred on the purchase of land, buildings, construction and equipment to be used in the production of goods or the rendering of services, in other words, the total cost needed to bring a project to a commercially operable status. However, capital costs are not limited to...

s predominate, creating economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

 that are large in relation to the size of the market, and hence high barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...

; examples include public utilities
Public utility
A public utility is an organization that maintains the infrastructure for a public service . Public utilities are subject to forms of public control and regulation ranging from local community-based groups to state-wide government monopolies...

 such as water services and electricity
Electricity
Electricity is a general term encompassing a variety of phenomena resulting from the presence and flow of electric charge. These include many easily recognizable phenomena, such as lightning, static electricity, and the flow of electrical current in an electrical wire...

. 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 monopolist's market.

However, it is also possible that oligopolistic competition arises even when an industry's cost conditions involve natural monopoly characteristics.

Explanation



All industries have costs associated with entering them. Often, a large portion of these costs is required for investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

. 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 cost
Fixed cost
In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs...

s 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.

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
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to 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 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 we “[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 profit scale economies were a sufficient but not a necessary condition to prove subadditivity.

Industries with a natural monopoly



Utilities are often natural monopolies. In industries with a standardized product and economies of scale, a natural monopoly often arises. 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 more efficiently serves 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 pay more by selling "green" power, or non-polluting power, or locally-produced power.

Historical example


Such a process happened in the water industry
Water industry
The water industry provides drinking water and wastewater services to residential, commercial, and industrial sectors of the economy. The water industry includes manufacturers and suppliers of bottled water...

 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 municipalities were able to raise finance for investment, which private companies often could not. A few well-run private companies that worked together with 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
England
England is a country that is part of the United Kingdom. It shares land borders with Scotland to the north and Wales to the west; the Irish Sea is to the north west, the Celtic Sea to the south west, with the North Sea to the east and the English Channel to the south separating it from continental...

 and Wales
Wales
Wales is a country that is part of the United Kingdom and the island of Great Britain, bordered by England to its east and the Atlantic Ocean and Irish Sea to its west. It has a population of three million, and a total area of 20,779 km²...

 was reprivatised in the form of 10 regional monopolies in 1989.

Origins of the term



The original concept of natural monopoly is often attributed to John Stuart Mill
John Stuart Mill
John Stuart Mill was a British philosopher, economist and civil servant. An influential contributor to social theory, political theory, and political economy, his conception of liberty justified the freedom of the individual in opposition to unlimited state control. He was a proponent of...

, 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
Principles of Political Economy
Principles of Political Economy by John Stuart Mill was arguably the most important economics or political economy textbook of the mid nineteenth century. It was revised until its seventh edition in 1871, shortly before Mill's death in 1873, and republished in numerous other editions...

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
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...

. 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.

As a quid pro quo
Quid pro quo
Quid pro quo most often means a more-or-less equal exchange or substitution of goods or services. English speakers often use the term to mean "a favour for a favour" and the phrases with almost identical meaning include: "give and take", "tit for tat", "this for that", and "you scratch my back,...

 for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed through limited rates of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...

, and a reduced risk of long-term competition. (See also rate of return pricing
Rate of return pricing
Target rate of return pricing is a pricing method used almost exclusively by market leaders or monopolists. You start with a rate of return objective, like 5% of invested capital, or 10% of sales revenue...

). For example, an electric utility may be allowed to sell electricity at price that gives it a 12% return on its capital investment. If not constrained by the public utility
Public utility
A public utility is an organization that maintains the infrastructure for a public service . Public utilities are subject to forms of public control and regulation ranging from local community-based groups to state-wide government monopolies...

 commission, the company would likely charge a far higher price and earn an abnormal profit on its capital.

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
    Common carrier
    A common carrier in common-law countries is a person or company that transports goods or people for any person or company and that is responsible for any possible loss of the goods during transport...

     type competition
  • setting up surrogate competition ("yardstick" competition or benchmarking
    Benchmarking
    Benchmarking is the process of comparing one's business processes and performance metrics to industry bests and/or best practices from other industries. Dimensions typically measured are quality, time and cost...

    )
  • requiring companies to be (or remain) quoted on the stock market
    Stock market
    A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

  • public ownership


Since the 1980s there is a global trend towards utility deregulation
Deregulation
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...

, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecommunications industry is a leading example.

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.

Arguments from public choice suggest that regulatory capture
Regulatory capture
In economics, regulatory capture occurs when a state regulatory agency created to act in the public interest instead advances the commercial or special interests that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as...

 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.)

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 future competition to limit monopolistic behavior to deter new competitors. 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.

Nobel economist Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

, 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
Capitalism and Freedom
Capitalism and Freedom is a book by Milton Friedman originally published in 1962 by the University of Chicago Press which discusses the role of economic capitalism in liberal society. It sold over 400,000 copies in the first 18 years and more than half a million since 1962. It has been translated...

). 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
Antitrust
The United States antitrust law is a body of laws that prohibits anti-competitive behavior and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace. These competition laws make illegal certain practices deemed to hurt businesses or consumers or both,...

 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).

Advocates of laissez-faire capitalism, such as libertarians, typically say that permanent natural monopolies are merely theoretical. Economists from the Austrian school
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 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.

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
France
The French Republic , The French Republic , The French Republic , (commonly known as France , is a unitary semi-presidential republic in Western Europe with several overseas territories and islands located on other continents and in the Indian, Pacific, and Atlantic oceans. Metropolitan 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 (e.g. IT
Information technology
Information technology is the acquisition, processing, storage and dissemination of vocal, pictorial, textual and numerical information by a microelectronics-based combination of computing and telecommunications...

 services), through outsourcing
Outsourcing
Outsourcing is the process of contracting a business function to someone else.-Overview:The term outsourcing is used inconsistently but usually involves the contracting out of a business function - commonly one previously performed in-house - to an external provider...

 contracts; some water companies outsource a considerable proportion of their operations. The extreme case is Welsh Water
Welsh Water
Dŵr Cymru Welsh Water is a company which supplies drinking water and wastewater services to most of Wales and parts of western England.It is regulated under the Water Industry Act 1991.-History:...

, 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 (e.g. 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
Water privatization
Water privatization is a short-hand for private sector participation in the provision of water services and sanitation, although sometimes it refers to privatization and sale of water resources themselves . As water services are seen as such a key public service, water privatization is often...

.

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
Vertical integration
In microeconomics and management, the term vertical integration describes a style of management control. Vertically integrated companies in a supply chain are united through a common owner. Usually each member of the supply chain produces a different product or service, and the products combine to...

 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
Electricity liberalization
Electricity liberalization refers to the liberalization of electricity markets. As electricity supply is a natural monopoly, this entails complex and costly systems of regulation to enforce a system of competition....

, 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
Deregulation
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...

, 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
California electricity crisis
The California electricity crisis, also known as the Western U.S. Energy Crisis of 2000 and 2001 was a situation in which California had a shortage of electricity caused by market manipulations and illegal shutdowns of pipelines by Texas energy consortiums...

. 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
Equity (economics)
Equity is the concept or idea of fairness in economics, particularly as to taxation or welfare economics. More specifically it may refer to equal life chances regardless of identity, to provide all citizens with a basic minimum of income/goods/services or to increase funds and commitment for...

 and efficiency
Efficiency (economics)
In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another if it can provide more goods and services for society without using more resources...

 issues, as large industrial consumers tend to benefit much more than domestic consumers.

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
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...

 if the company is mismanaged. The latter in theory 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.

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.

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.

Network effects


Network effect
Network effect
In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it.The classic example is the telephone...

s 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.

See also

  • Market forms
  • Currency
    Currency
    In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

  • Standardization
    Standardization
    Standardization is the process of developing and implementing technical standards.The goals of standardization can be to help with independence of single suppliers , compatibility, interoperability, safety, repeatability, or quality....

  • Public goods
  • Anti-competitive practices
    Anti-competitive practices
    Anti-competitive practices are business or government practices that prevent or reduce competition in a market .- Anti-competitive practices :These can include:...

  • Coercive monopoly
    Coercive monopoly
    In economics and business ethics, a coercive monopoly is a business concern that prohibits competitors from entering the field, with the natural result being that the firm is able to make pricing and production decisions independent of competitive forces...

  • Tipping point
    Tipping point
    In sociology, a tipping point is the event of a previously rare phenomenon becoming rapidly and dramatically more common. The phrase was coined in its sociological use by Morton Grodzins, by analogy with the fact in physics that adding a small amount of weight to a balanced object can cause it to...

  • Quasi-rent
    Quasi-rent
    Quasi-rent is an analytical term in economics, for the income earned, in excess of post-investment opportunity cost, by a sunk cost investment...

  • LoopCo
    LoopCo
    LoopCo is an economic model created in the mid 1990s as a proposal to 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...