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Economics of a Natural Monopoly

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 18 Mar 2023

This revision video applies and analyses the economics of a natural monopoly

A natural monopoly is a special case where one large business can supply the entire market at a lower long run average cost contrasted with multiple providers.

This is because of the nature of costs in a natural monopoly. Typically, there are very high fixed costs and low marginal costs.

With a natural monopoly, the internal economies of scale available to the largest firms mean that there is a tendency for one business to dominate the market in the long run.

If a state-owned natural monopoly is required to price at marginal cost to achieve allocative efficiency, then this can lead to large losses since price will be below AC.

Many natural monopolies operate in the national interest. The quality of service provided makes a big difference to the everyday lives of millions of households and businesses.

Are digital platforms such as Facebook natural monopolies? Like natural monopolies, the economic characteristics of digital platforms include large and increasing returns to scale.

Economics of a Natural Monopoly

A natural monopoly occurs when it is more efficient for a single firm to provide a good or service to the entire market due to high fixed costs and low marginal costs of production. In this case, the long-run average cost (LRAC) curve of a natural monopoly is downward sloping throughout its entire range, unlike the LRAC curve of a standard monopoly, which is U-shaped.

The reason for the different shape of the LRAC curve is due to the nature of the industry and the barriers to entry that exist. In a natural monopoly, the high fixed costs of production create significant barriers to entry, making it difficult for new firms to enter the market and compete with the existing firm. This allows the natural monopoly to produce at a larger scale than any potential competitors, which leads to lower average costs.

In contrast, a standard monopoly may have lower costs in the short run due to economies of scale, but it is possible for new firms to enter the market in the long run and compete with the monopolist. As a result, the monopolist faces a downward-sloping demand curve but must choose an output level where marginal revenue equals marginal cost, which leads to a higher price and higher average cost than a natural monopoly.

In summary, a natural monopoly has a different shaped LRAC curve than a standard monopoly due to the presence of significant barriers to entry that prevent new firms from entering the market and competing with the existing firm. This allows the natural monopoly to produce at a larger scale and lower average costs than a standard monopoly.

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