Natural monopoly

A monopoly describes a situation where all (or most) sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient (involving the lowest long-run average cost) for production to be concentrated in a single form. In some cases, this gives the largest supplier in an industry, often the first supplier in a market, an overwhelming cost advantage over other actual and potential competitors. This tends to be the case in industries where capital costs predominate, creating economies of scale that are large in relation to the size of the market, and hence high barriers to entry; examples include public utilities such as water services and electricity. It is very expensive to build transmission networks (water/gas pipelines, electricity and telephone lines); therefore, it is unlikely that a potential competitor would be willing to make the capital investment needed to even enter the monopolist's market.

However, it is also possible that oligopolistic competition arises even when an industry's cost conditions involve natural monopoly characteristics.

Explanation

All industries have costs associated with entering them. Often, a large portion of these costs is required for investment. Larger industries, like utilities, require enormous initial investment. This barrier to entry reduces the number of possible entrants into the industry regardless of the earning of the corporations within. 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 fixed costs predominate, creating economies of scale that are large in relation to the size of the market, as is the case in water and electricity services. The cost of constructing a competing transmission network is so high that it effectively bars potential competitors from the monopolist's market, acting as an early insurmountable barrier to entry into the market place.

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.

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 industries, 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 decreases and increases. 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 roughly constant, and small.

A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment. This is where economies of scale become important. Since each firm has large initial costs, as the firm gains market share and increases its output 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.

Formal definition of a natural monopoly

William Baumol (1977) ^[1]provided the current formal definition of a natural monopoly we “[a]n industry in which multiform production is more costly than production by a monopoly” (p.810). He linked the definition to the mathematical concept of subadditivity; specifically of the cost function. Baumol also noted that for a firm producing a single profit scale economies were a sufficient but not a necessary condition to prove subadditivity.

Industries with a natural monopoly

Utilities are often natural monopolies. In industries with a standardized product and economies of scale, a natural monopoly often arises. 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, up to a point. Adding one more customer may increase the company's revenue and lowers the average cost of providing for the company's customer base. So long as the average cost of serving customers is decreasing, the larger firm more efficiently serves the entire customer base. Of course, this might be circumvented by differentiating the product, making it no longer a pure commodity. For example, firms may gain customers who pay more by selling "green" power, or non-polluting power, or locally-produced power.

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 municipalities were able to raise finance for investment, which private companies often could not. A few well-run private companies that worked together with 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.

Origins of the term

Competition law
Basic concepts
History of competition law Monopoly Coercive monopoly Natural monopoly Barriers to entry Herfindahl–Hirschman Index Market concentration Market power SSNIP test Relevant market Merger control
Anti-competitive practices
Monopolization Collusion Formation of cartels Price fixing Bid rigging Product bundling and tying Refusal to deal Group boycott Essential facilities Exclusive dealing Dividing territories Conscious parallelism Predatory pricing Misuse of patents and copyrights
Enforcement authorities and organizations
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The original concept of natural monopoly is often attributed to John Stuart Mill, who (writing before the marginalist revolution) believed that prices would reflect the costs of production in absence of an artificial or natural monopoly.^[2] In Principles of Political Economy Mill criticised Smith's neglect^[3] of an area that could explain wage disparity. Taking up the examples of professionals such as jewellers, physicians and lawyers, he said,^[4]

"The superiority of reward is not here the consequence of competition, but of its absence: not a compensation for disadvantages inherent in the employment, but an extra advantage; a kind of monopoly price, the effect not of a legal, but of what has been termed a natural monopoly... independently of... artificial monopolies [i.e. grants by government], there is a natural monopoly in favour of skilled labourers against the unskilled, which makes the difference of reward exceed, sometimes in a manifold proportion, what is sufficient merely to equalize their advantages. If unskilled labourers had it in their power to compete with skilled, by merely taking the trouble of learning the trade, the difference of wages might not exceed what would compensate them for that trouble, at the ordinary rate at which labour is remunerated. But the fact that a course of instruction is required, of even a low degree of costliness, or that the labourer must be maintained for a considerable time from other sources, suffices everywhere to exclude the great body of the labouring people from the possibility of any such competition.

So Mill's initial use of the term concerned natural abilities, in contrast to the common contemporary usage, which refers solely to market failure in a particular type of industry, such as rail, post or electricity. Mill's development of the idea is that what is true of labour is true of capital.^[5]

"All the natural monopolies (meaning thereby those which are created by circumstances, and not by law) which produce or aggravate the disparities in the remuneration of different kinds of labour, operate similarly between different employments of capital. If a business can only be advantageously carried on by a large capital, this in most countries limits so narrowly the class of persons who can enter into the employment, that they are enabled to keep their rate of profit above the general level. A trade may also, from the nature of the case, be confined to so few hands, that profits may admit of being kept up by a combination among the dealers. It is well known that even among so numerous a body as the London booksellers, this sort of combination long continued to exist. I have already mentioned the case of the gas and water companies.

Mill also applied the term to land, which can manifest a natural monopoly by virtue of it being the only land with a particular mineral, etc.^[6] Furthermore, Mill referred to network industries, such as electricity and water supply, roads, rail and canals, as "practical monopolies", where "it is the part of the government, either to subject the business to reasonable conditions for the general advantage, or to retain such power over it, that the profits of the monopoly may at least be obtained for the public."^[7][8] So, a legal prohibition against competition is often advocated and rates are not left to the market but are regulated by the government.

For an excellent discussion of the historical origins of the term 'natural monopoly' see Mosca^[9].

Regulation

As with all monopolies, a monopolist who has gained his position through natural monopoly effects may engage in behavior that abuses his market position, which often leads to calls from consumers for government regulation. Government regulation may also come about at the request of a business hoping to enter a market otherwise dominated by a natural monopoly.

Common arguments in favor of regulation include the desire to control market power, facilitate competition, promote investment or system expansion, or stabilize markets. In general, though, regulation occurs when the government believes that the operator, left to his own devices, would behave in a way that is contrary to the government's objectives. In some countries an early solution to this perceived problem was government provision of, for example, a utility service. However, this approach raised its own problems. Some governments used the state-provided utility services to pursue political agendas, as a source of cash flow for funding other government activities, or as a means of obtaining hard currency. These and other consequences of state provision of services often resulted in inefficiency and poor service quality. As a result, governments began to seek other solutions, namely regulation and providing services on a commercial basis, often through private participation.^[10]

As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed through 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 gives it a 12% return on its capital investment. If not constrained by the public utility commission, 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 carrier 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 telecommunications industry is a leading example.

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 future competition to limit monopolistic behavior to deter new competitors. 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 permanent natural monopolies are merely theoretical. Economists from the Austrian school claim that governments take ownership of the means of production in certain industries and ban competition under the false pretense that they are natural monopolies.^[11]

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 (e.g. 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 (e.g. parts of a city) can bring in some features of "yardstick" competition (see below^{[citation needed]}), 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. 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.

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.

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.

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.^{[citation needed]}

Notes and references

1. ^ Baumol, William J., 1977. On the Proper Cost Tests for Natnral Monopoly in a Multiproduct Industry, American Economic Review 67, 809-22.
2. ^ Principles of Political Economy, Book IV 'Influence of the progress of society on production and distribution', Chapter 2 'Influence of the Progress of Industry and Population on Values and Prices', para. 2
3. ^ Wealth of Nations (1776) Book I, Chapter 10
4. ^ Principles of Political Economy Book II, Chapter XIV 'Of the Differences of Wages in different Employments', para. 13-4
5. ^ Principles of Political Economy Book II, Chapter XV, 'Of Profits', para. 9
6. ^ Principles of Political Economy, Book II, Chapter XVI, 'Of Rent', para. 2 and 16
7. ^ Principles of Political Economy, Book V, Chapter XI 'Of the Grounds and Limits of the Laisser-faire or Non-Interference Principle'
8. ^ On subways, see also, McEachern, Willam A. (2005). Economics: A Contemporary Introduction. Thomson South-Western. pp. 319. 
9. ^ Mosca, M. 2008. On the origins of the concept of natural monopoly, The European Journal of the History of Economic Thought, 45 (2), 317-353.>
10. ^ Body of Knowledge on Infrastructure Regulation "General Concepts : Introduction."
11. ^ DiLorenzo, Thomas J. (1996). "The Myth of Natural Monopoly". The Review of Austrian Economics 9 (2): 43–58. doi:10.1007/BF01103329. http://www.mises.org/journals/rae/pdf/rae9_2_3.pdf. 

See also

• Market forms
• Currency
• Standardization
• Public goods
• Anti-competitive practices
• Coercive monopoly
• Tipping point
• Quasi-rent
• LoopCo

References

• Berg, Sanford; John Tschirhart (1988). Natural Monopoly Regulation: Principles and Practices. Cambridge University Press. ISBN 9780521338936. 
• Baumol, William J.; Panzar, J. C., and Willig, R. D. (1982). Contestable Markets and the Theory of Industry Structure. New York: Harcourt Brace Jovanovich. ISBN 978-0155139107. 
• Filippini, Massimo (June 1998). "Are Municipal Electricity Distribution Utilities Natural Monopolies?". Annals of Public and Cooperative Economics 69 (2): 157. doi:10.1111/1467-8292.00077. 
• Foldvary, Fred E.; Daniel B. Klein (2003). The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues. Cato Institute. http://lsb.scu.edu/~dklein/Half_Life/Half_Life.htm. 
• Sharkey, W. (1982). The Theory of Natural Monopoly. Cambridge University Press. ISBN 9780521271943. 
• Thierer, Adam D (1994). "Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly". The Cato Journal 14 (2). http://www.cato.org/pubs/journal/cjv14n2-6.html. 
• Train, Kenneth E. (1991). Optimal regulation: the economic theory of natural monopoly. Cambridge, MA, USA: MIT Press. ISBN 978-0262200844. 
• Waterson, Michael (1988). Regulation of the Firm and Natural Monopoly. New York, NY, USA: Blackwell. ISBN 0-631-14007-7.