What is a 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
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:
Possible conflicts between efficiency and economic 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
For many utilities, the government introduced industry regulators to oversee these businesses when they were privatized in the 1980s and early 1990s
For many years utility businesses were subject to price capping– most of these have now finished although some remain
Check out this revision video