A natural monopoly is a type of monopoly that occurs when an industry’s high infrastructural costs and other barriers make it difficult for new firms to enter.
In such a case, a single firm becomes the only provider of a product/service in the industry or geographic region. An industry is a natural monopoly if the cost of one firm—producing the entire output—is less than the cost of two or more firms doing the same.
A natural monopoly usually occurs in industries that require huge fixed costs and have large economies of scale. Such a scenario gives the monopolizing firm an incredible advantage over its (potential) competitors, and it can abuse its market position.
So, government regulations are often necessary to address this, which we will discuss later. Before that, let us learn more about natural monopoly and its examples.
Definition of Natural Monopoly
William Baumol defined a natural monopoly as:
“[a]n industry in which multi-firm production is more costly than production by a monopoly” (1977).
So, a single firm is able to supply a good/service to the entire industry at a lower cost than any potential competitor(s). In such a scenario, it is impractical for more than one firm to produce the good/service.
A natural monopoly can occur in two ways:
- First, when there are high barriers to entry in an industry, such as large capital requirements needed to buy fixed assets. This helps the single firm create a “moat” (protective barrier) around its business operations.
- The second cause is large economies of scale. The single firm produces at such a large scale that its average cost of production is significantly lower than small-scale producers. This can be due to reasons other than investment such as first-mover advantage, network effects, etc.
In either case, this ultimately results in a situation where it is “more efficient for production to be concentrated in the hands of one firm than to be divided among many.” (Belleflamme & Peitz, 2015).
Natural monopolies were recognized as early as the 19th century when John Stuart Mill considered them to be a form of market failure (1848). He argued that natural monopolies lead to unfair prices & inefficiency, and, therefore, should be addressed by government intervention.
Natural Monopoly Examples
- Telephone lines: Telephone phone lines are natural monopolies because the cost of setting up and maintaining transmission lines is quite high. This makes it quite difficult for any new firm to enter the market. Plus, customers would also not want to switch to a new provider if it involves paying for a new network to be built.
- Railways: Not only are their huge capital costs in railways but there are also limited resources in the industry, making it a natural monopoly. The resources needed, such as land for rail tracks, stations, and their expensive structures cannot support multiple firms. Therefore, railways are monopolized and usually state-sponsored.
- Electricity: Once an electric grid has been set up, it is neither practical nor sensible to create another competing grid. If the established electric grid is already providing power to all the houses in the community, constructing another grid would be quite redundant. Therefore, electricity transmission is a natural monopoly.
- Water: Water and sewage systems are natural monopolies because the cost of setting up and maintaining water systems (water treatment plants, reservoirs, and pipelines) is huge. Moreover, governments also need to ensure that everyone gets safe, reliable, and affordable water, so its local bodies usually manage water supply. Some private companies may be involved, but they are also regulated by the state.
- Digital platforms: Digital platforms like Uber have significant influence over their markets. In most of these cases, the monopoly is not due to fixed costs but due to other reasons such as better technology, network economies, lower average prices, etc.
- Postal services: Postal services are a natural monopoly because they require huge capital investment and are a universal service. The infrastructure needed for postal service (building post offices, sorting facilities, delivery routes, etc.) involves massive costs. Plus, postal service must reach every person, irrespective of location or status; this makes it difficult for new firms to reach everywhere.
- Public education system: Building schools, hiring teachers, and developing curriculums cost a huge amount of money, which is why public education is a natural monopoly. It is typically operated by the government, and private institutions working alongside are also regulated.
- Internet Service Provider: The cost of setting up internet service (building wireless towers, laying cables, etc.) is massive, making it a natural monopoly. Plus it also requires regular repairs and upgrades. ISPs are typically run by private companies and regulated by government agencies.
- Hospitals in rural areas: Unlike goods that can be transported, medical care is a local service. This makes it quite difficult for new firms to build hospitals in distant, rural places and operate profitably. Therefore, they are are usually run by the government.
- Online services: Many online services have now been monopolised by large companies, such as Google (search engine), Amazon (retailing), etc. Here, too, the monopoly is not so much from fixed costs as from first-mover advantages, network effects, and the economies of scale from handling a large data (Investopedia, 2022).
Cost Structure of Natural Monopolies
The cost structure of an industry with a natural monopoly is quite different from that of other industries.
In an industry without a natural monopoly, the marginal cost—the cost of producing one additional unit of output—typically increases as the production increases. As the firm produces more, it reaches the limits of its production capacity and must invest in more technology and/or capital to produce more.
Moreover, with increased production, the availability of inputs (raw materials, labour, etc.) can get constrained, and it also suffers from diminishing returns to scale. Because of all these reasons, a normal industry faces increasing marginal costs when it produces more.
In contrast, natural monopolies have a decreasing or constant marginal cost because they achieve economies of scale. For example, an electric utility company has a high capital cost (setting up power plants and transmission lines) but it can spread such fixed costs over several customers. The more customers, the lower the average cost per customer.
Natural monopolies also get cost advantages from bulk purchasing, technological advancements, and specialization of labour. So, once the initial setup is done, the marginal cost of serving an additional customer is low (Economides, 1996).
Natural monopolies also exhibit economies of scope. It refers to the cost advantages a firm achieves by producing multiple related goods/services. For example, a single firm may be able to produce electricity and gas at lower costs than two separate firms producing each.
Impact & Regulation
A natural monopoly, as the name suggests, is a kind of monopoly that occurs due to natural market conditions. It does not involve monopolies created by businesses trying to gain an unfair advantage (coordinated price hikes etc.) through collusion, mergers, or hostile takeovers.
Instead, high capital cost requirements and large economies of scale create natural monopolies. They are often quite advantageous because they offer a stable and reliable source of goods/services. They also use limited resources efficiently to offer goods/services at the lowest price to customers (Majumdar, 2005)
However, a firm with a natural monopoly can also take advantage of its market position by inflating prices or restricting supply. It can also undertake other unfair tactics, say an internet service provider influencing what people see on the internet.
Therefore, natural monopolies are usually regulated through government intervention. This is usually done through price regulation, where the government fixes the price that the firm can charge for its goods/services.
Regulatory agencies also oversee natural monopolies to ensure the public interest is maintained. Local government bodies are responsible for utility services. There are also national bodies, such as the U.S. Department of Transportation, which ensures railroad safety in the US.
They also maintain quality standards and ensure that essential goods/services reach everyone without discrimination.
A natural monopoly is a situation when one firm can produce goods/services for the entire industry at a lower cost than multiple firms. This occurs when there are huge capital requirements or large economies of scale.
We discussed how, in recent times, digital platforms and online services have been monopolized by large companies. Unlike traditional monopolies (railways, electricity, etc.), these new-age monopolies have not been regulated by government action till now.
Perhaps, eventually, we will see them come under an alternate form of regulation such as open-source license or co-operative management. The internet, for example, is based on open standards, which is why it is not owned by a single company and has grown massively.
Some scholars have recently a mix of open-source and co-operative managements as an alternative to tech monopolies. For example, a taxi app (like Uber) that is owned by drivers and runs on open-source software.
All in all, natural monopolies can be advantageous in certain situations as they operate efficiently. However, they often need to be regulated to ensure public interest.
Baumol, William J. (1977). “On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry”. American Economic Review 67. American Economic Association.
Belleflamme, P., & Peitz, M. (2015). Industrial organization: Markets and strategies. Cambridge University Press.
Economides, N. (1996). The Economics of Networks. International Journal of Industrial Organization, 14(6). Elsevier Inc.
Majumdar, S. K. (2005). Natural Monopoly and Its Regulation. Journal of Economic Surveys, 19(2). Wiley.