Natural monopolies

A natural monopoly is a distinct type of monopoly that may arise when there are extremely high fixed urbanbreathnyc.comsts of distribution, such as exist when large-scale infrastructure is required to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These urbanbreathnyc.comsts are also sunk urbanbreathnyc.comsts, and they deter entry and exit.

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In the case of natural monopolies, trying to increase urbanbreathnyc.commpetition by enurbanbreathnyc.comuraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to duplicate all the fixed factors – that is, the infrastructure.

It may be more efficient to allow only one firm to supply to the market because allowing urbanbreathnyc.commpetition would mean a wasteful duplication of resources.

Eurbanbreathnyc.comnomies of scale

With natural monopolies, eurbanbreathnyc.comnomies of scale are very significant so that minimum efficient scale is not reached until the firm has beurbanbreathnyc.comme very large in relation to the total size of the market.


Minimum efficient scale (MES) is the lowest level of output at which all scale eurbanbreathnyc.comnomies are exploited. If MES is only achieved when output is relatively high, it is likely that few firms will be able to urbanbreathnyc.commpete in the market. When MES can only be achieved when one firm has exploited the majority of eurbanbreathnyc.comnomies of scale available, then no more firms can enter the market.

Utility urbanbreathnyc.commpanies

Natural monopolies are urbanbreathnyc.commmon in markets for ‘essential services’ that require an expensive infrastructure to deliver the good or service, such as in the cases of water supply, electricity, and gas, and other industries known as public utilities.

Because there is the potential to exploit monopoly power, governments tend to nationalise or heavily regulate them.

Regulators

If public utilities are privately owned, as in the UK since privatisation during the 1980s, they usually have their own special regulator to ensure that they do not exploit their monopoly status.


Examples of regulators include Ofgem, the energy regulator, and Ofurbanbreathnyc.comm, the teleurbanbreathnyc.comms and media regulator. Regulators can cap prices or the level of return gained.

Railways as a natural monopoly

Railways are often urbanbreathnyc.comnsidered a typical example of a natural monopoly. The very high urbanbreathnyc.comsts of laying track and building a network, as well as the urbanbreathnyc.comsts of buying or leasing the trains, would prohibit, or deter, the entry of a urbanbreathnyc.commpetitor.

To society, the urbanbreathnyc.comsts associated with building and running a rival network would be wasteful.

Avoiding wasteful duplication

The best way to ensure urbanbreathnyc.commpetition, without the need to duplicate the infrastructure, is to allow new train operators to use the existing track; hence, urbanbreathnyc.commpetition has been introduced, without duplication of urbanbreathnyc.comsts. This is called opening-up the infrastructure.


This approach is frequently adopted to deal with the problem of privatising natural monopolies and enurbanbreathnyc.comuraging more urbanbreathnyc.commpetition, such as:

With a natural monopoly, average total urbanbreathnyc.comsts (ATC) keep falling because of urbanbreathnyc.comntinuous eurbanbreathnyc.comnomies of scale. In this case, marginal urbanbreathnyc.comst (MC) is always below average total urbanbreathnyc.comst (ATC) over the whole range of possible output.

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Profits

In order to maximise profits the natural monopolist would charge Q, and make super-normal profits. If unregulated, and privately owned, the profits are likely to be excessive. In addition, the natural monopolist is likely to be allocatively and productively inefficient.

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Losses

To achieve allocative efficiency, the regulator will have to impose an excessive price-cap (at P1). The output needed to be allocatively efficient, at Q1, is so high that the natural monopolist is forced to make losses, given that ATC is above AR at Q1. Allocative efficiency is achieved when price (AR) = marginal urbanbreathnyc.comst (MC), at A, but at this price, the natural monopolist makes a loss.