Study notes

Explaining Natural Monopoly

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

In this study note we explore the key concept of natural monopoly.

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 and therefore achieve productive efficiency.

Examples of industries that might fit the definition of a natural monopoly

There are several interpretations of what a natural monopoly us

  1. It occurs when one large business can supply the entire market at a lower price than two or more smaller ones
  2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices
  3. It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale
  4. An industry where the long run average cost curve falls continuously as output expands
  5. Private utilities are natural monopolies in local markets

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 below. There may be room only for one supplier to reach the minimum efficient scale and achieve productive efficiency.

Natural monopoly analysis diagram

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:

  1. British Telecom building and maintaining the UK telecommunications network for the broadband industry – especially the 'final mile' copper wiring from the local exchanges to each household
  2. The Royal Mail's postal distribution network – collection / sorting / delivery
  3. Camelot operating the UK lottery
  4. National Rail owning, maintaining and leasing out the UK rail network
  5. National Grid owns and operates the National Grid high-voltage electricity transmission network in England and Wales. Since 2005 it also operates the electricity transmission network in Scotland. Owns and operates the gas transmission network (from terminals to distributors)
  6. London Underground, Tyne and Wear Metro, Manchester Tram Network

Key point:

  • A natural monopoly does not mean that there is only one business operating in the market
  • There may be many smaller businesses operating profitably in smaller 'niche' segments of a market (however that is defined)
  • With a natural monopoly the economies of scale available to the largest firms mean that there is a tendency for one business to cominate the market in the long run

Possible conflicts between efficiency and economic welfare

  • It is often said that a natural monopoly raises difficult questions for competition policy because
  • On the one hand – it is more productively efficient for there to be one dominant provider of a national infrastructure e.g. a rail network or electricity generating system
  • Natural monopolies require enormous investment spending to maintain and improve the networks
  • Businesses monopoly power (huge barriers to entry) might be tempted to exploit that power by raising prices and making huge supernormal profits – damaging consumer 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

  1. Fines for anti-competitive behaviour: In 2008 the Microsoft computer software company was fined €1.68 billion by the EU Competition Commission for pre-installing its browser, Internet Explorer, on computers running the Windows operating system. In December 2009, Microsoft agreed to allow consumers to choose their web browser on setup. Removing the pre-installation of the software will mean that more firms will be able to enter the market.
  2. Introducing competition into the industry -this has been a favoured policy. This means separating out infrastructure from the final service to the consumer e.g.
  • British Telecom was eventually forced to open-up local telecom exchanges and allow rivals to install equipment ('unbundling the local loop') – who then sell services such as broadband to households – competitors pay BT an access charge designed to give BT a 10% rate of return from running the network.
  • BAA: In 2009 the UK Competition Commission required British Airports Authority to sell off three of its seven airports, starting with Gatwick and then Stansted
  • National Rail runs the network – but train-operating companies have to bid for the franchise to run passenger services – and the industry regulator can take their franchise away if the quality of service isn't good enough. The government took the East Coast line into public ownership in July 2009 following the financial problems facing National Express.
  • Camelot has successfully bid to operate the National Lottery until 2017

Evaluation Skills: Natural Monopoly Revision Video


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