Natural Monopoly

For a natural monopoly the long-run average cost curve (LRAC) falls continuously over a large range of output. The result may be that there is only room in a market for one firm to fully exploit the economies of scale that are available.There are several interpretations of what a natural monopoly us

1. It occurs when one large business can supply the entire market at a lower price than two or more smaller ones
2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices
3. It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale
4. An industry where the long run average cost curve falls continuously as output expands
5. Private utilities are natural monopolies in local markets

The key point is that a natural monopoly is characterized by increasing returns to scale at all levels of output – thus the long run cost per unit (LRAC) will drift lower as production expands. LRAC is falling because long run marginal cost is below LRAC. This can be illustrated in the diagram above. There may be room only for one supplier to reach the minimum efficient scale and achieve productive efficiency.

Because there is no single definition of a natural monopoly, none of the examples below are purely national monopolies – their cost structure does take them close to a common-sense interpretation:

1. British Telecom building and maintaining the UK telecommunications network for the broadband industry – especially the ‘final mile’ copper wiring from the local exchanges to each household
2. The Royal Mail’s postal distribution network – collection / sorting / delivery
3. Camelot operating the UK lottery
4. National Rail owning, maintaining and leasing out the UK rail network
5. National Grid owns and operates the National Grid high-voltage electricity transmission network in England and Wales. Since 2005 it also operates the electricity transmission network in Scotland. Owns and operates the gas transmission network (from terminals to distributors)
6. London Underground, Tyne and Wear Metro, Manchester Tram Network

Key point:
• A natural monopoly does not mean that there is only one business operating in the market
• There may be many smaller businesses operating profitably in smaller ‘niche’ segments of a market (however that is defined)
• With a natural monopoly the economies of scale available to the largest firms mean that there is a tendency for one business to cominate the market in the long run

Possible conflicts between efficiency and economic welfare
• It is often said that a natural monopoly raises difficult questions for competition policy because
• On the one hand – it is more productively efficient for there to be one dominant provider of a national infrastructure e.g. a rail network or electricity generating system
• Natural monopolies require enormous investment spending to maintain and improve the networks
• Businesses monopoly power (huge barriers to entry) might be tempted to exploit that power by raising prices and making huge supernormal profits – damaging consumer welfare

The profit-maximizing price is P1 at an output of Q1. Price is well above the marginal cost of supply and high supernormal profits are made – but output is high too and there is still a sizeable amount of consumer surplus because of the internal economies of scale that have brought down the unit cost for all consumers. (We are ignoring the possibility of price discrimination here).

Options for competition policy in industries that resemble a natural monopoly

Nationalization: Bringing some of these industries into state ownership
Network Rail is a not-for-profit business (formerly Railtrack plc) – nationalized in 2001
National Air Traffic Services – Owned by the UK government (49%); The Airline Group (42%) which is a consortium of British Airways, BMI, easy Jet, Monarch Airlines, Thomas Cook Airlines, Thomsonfly and Virgin Atlantic; BAA (4%); and NATS employees (5%).
Price controls by the regulatory agencies