Economics: Natural Monopoly
Key Terms
Monopoly: A situation, by legal privilege or other agreement, in which solely one party (firm) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.
Price Maker: A firm that has the ability to choose its desired selling point of their good or services, as they face a downward-sloping demand curve.
Natural Monopoly: Control over the market for a product which occurs when a firm gains large benefit from economies of scale, or from a superior business model or product, and is thus able to produce a very large percentage of the total market demand for a given product and unintentionally exclude meaningful competition via price structures.
Nationalisation: The act of taking formerly private assets into public or state ownership.
Privatisation: The act of giving public enterprises back to private ownership.
Arbitrage: A market activity in which a security, commodity, currency, or other tradable item is bought in one market and sold simultaneously in another, in order to profit from price differences between the markets.
Barrier to Entry: A cost (or characteristic of the market i.e., patent) that must be incurred by a new entrant into a market, but which does not apply to incumbents.
What is a Natural Monopoly?
A natural monopoly occurs in an industry where there are significant fixed costs but low marginal costs. Imagine your local water supplier, when they entered the market, they incurred significant costs, building the piping’s, water stations etc. However, the price of water does not reflect the true size of the costs involved hence the aspect of low marginal costs. Same could be said about railways, to construct a railway system costs millions however a train ticket is only around £30.
In a natural monopoly it is actually more efficient if there is only one seller rather than multiple, which goes against our normal idea that competition is good. However, it would be a waste of resources to have another seller incur such high entry costs only be sold out the market due to the high economies of scale of the incumbent firms.
The Natural Monopoly Model
The model for natural monopoly is significantly different from that of a normal monopoly, this is due to the high fixed costs incurred by the natural monopoly.
As can be seen above the long run average cost curve is above the long run marginal cost curve as is our initial assumption that costs are higher than marginal costs (mentioned in the first paragraph). The marginal revenue and average revenue curves are similar to that of monopoly.
Natural monopolies also aim to maximise profit, so their initial price is where MC=MR resulting in the price of P* and hence a supernormal profit.
How did Natural Monopolies Come About?
Majority of natural monopolies started out as nationalised firms, such as those providing postal services, transport, etc. It seemed much more reasonable to have them state owned as most of them ended on a loss in order to ensure they provided viable prices to consumers.
However, this idea later became more criticised, stating that despite the losses made the actual system was highly in-efficient. Managers were not held sufficiently accountable for their actions and there was major organisational slack as the losses were all incurred by the government who didn’t expect a profit in the first place. This led to the rising of X-inefficiency and other quality issues.
Hence in the 21st century more firms started being privatised and put into the hands of private owners with the idea that managers will now be held accountable to shareholders who demanded profits and efficiency.
However, this did not change the fact that these were still natural monopolies…
Natural Monopolies, Efficiency and Regulation
As we have discussed earlier natural monopolies can produce a supernormal profit, and not have anything to worry about. However, you don’t pay £500 for a train ticket, do you? This is because regulators can’t allow such high prices to arise hence, they will ask natural monopolies to meet a certain price usually at the allocative efficiency levels.
In the diagram above we can see that happening where the price has been set at allocative efficiency, however, as can be seen this results in a loss for the natural monopoly. However, the natural monopoly will go bankrupt if the keep on sustaining such losses hence usually regulators subsidise the loss to allow natural monopolies to make a normal profit and stay in the market.
Pros and Cons of Natural Monopolies
A main advantage of natural monopoly is the sheer size of its economies of scale, it allows firms to produce good at a relatively low cost. However, a major disadvantage of this is that it puts a lot power into the hands of the firm operating the natural monopoly which may be tempted to increases price and generate a supernormal profit if not regulated correctly.
Hence it is important that regulatory capture - the situation where a regulatory agency, created by government to act in the public interest, instead advances the commercial or political concerns of special interest groups that dominate the affected industry or sector – does not occur in such market as majority of natural monopolies provide essential goods to society.
References/ Further Reading:
Natural Monopoly – Wikipedia - https://en.wikipedia.org/wiki/Natural_monopoly