Natural monopoly

In economics, a natural monopoly occurs when, due to the economies of scale of a particular industry, the maximum efficiency of production and distribution is realized through a single supplier . Some free market-oriented economists argue that natural monopoly exists only in theory, and not in practice. Claims of natural monopoly are typically used to justify the legal prohibition of competition.

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 capital costs predominate, creating economies of scale which are large in relation to the size of the market, and hence high barriers to entry; 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 potential competitor would be willing to make the capital investment needed to even enter the monopolists market.

It may also depend on control of a particular natural resource. 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.

Explanation

All industries have costs associated with entering them. Often, a large portion of these costs is required for investment. Larger industries, like utilities and software, require enormous initial investment. This high level of investment (a barrier to entry) reduces the number of possible entrants into the industry regardless of the earning of the corporations within. In a natural monopoly a single firm will typically dominate; this occurs for one main reason: once established the extra cost to the company to serve one additional customer is extremely small when compared to the initial investment.

A further discussion and understanding requires more microeconomics.

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 constant, fixed, 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 adds output as it gains market share 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.

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.

Industry with a Natural Monopoly

Utilities are often natural monopolies (electricity from one company is no better than electricity from another). 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. Adding one more customer increases the company's revenue and lowers the average cost of providing for the company's customer base. Since the average cost of serving customers is always decreasing, the larger firm will more efficiently serve the entire customer base.

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.

Regulation

As with all monopolists, 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. Equally, regulation may 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.

As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed though 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 commision, 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 carriage 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 telecoms industry is the leading example globally.

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 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 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.

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).

Advocates of laissez-faire capitalism, such as libertarians, typically say that a natural monopoly is a practical impossibility that has no historical precedent (given that monopoly, to be monopoly, must be a persistent rather than a transient situation). They claim that in a hypothetical case where a business became the sole supplier of a particular kind of product or service that competitive forces would very soonly emerge and begin diminishing market share. One of the most common criticisms of a laissez-faire free market is the claim that a natural monopoly results in market failure. The arguments given above, that a persistent natural monopoly is not viable, are a frequent response to this criticism. Many adherents of the Austrian school and others who oppose economic intervention by governments, such as mandatory price ceilings on what businesses may charge for their produce, assert that the concept of natural monopoly is merely a theoretical abstraction used to justify irrational government intrusions into the free market that are, ultimately, not in the best interest of consumers.

Likewise, deregulation advocates assert that claims of "natural monopoly" are wrongly used to justify the creation of government monopolies, for instance in public utilities -- such as telephone service during much of the 20th century (In 1921, a U.S. Senate Commerce Committee hearing stated: "telephoning is a natural monopoly.") An extraordinary example of deregulation in the telecommunications industry occurred in Somalia. After the collapse of the central government in 1991 and the resulting lack of enforced privilege for the government-granted monopoly, the industry became absolutely unregulated. As an apparent consequence, the industry has flourished according to a BBC news report. In contrast to the operation of anti-trust law that seeks to break up or limit monopolistic behavior, utility regulation in the presence of a claimed natural monopoly can ensure longer-term competition-free revenue to a utility. Alvin Lowi Jr. and Clyde Wayne Crews Jr. (in Foldvary and Klein 2003), conclude that "Natural monopoly is a myth."

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.

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).

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.

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.

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.

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. Typically government enterprises are much less effecient than private enterprises because of the lack of profit motive.

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.

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) ([http://www.mises.org/journals/rae/monopolio.pdf 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 ^*
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 ^*
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.

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