10.2: Natural Monopoly

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Martin Medeiros
Chabot College

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Market structure measures the level of market power and competitiveness in an industry. We learned in earlier lessons that perfect competition was the market structure with the highest level of efficiency and monopoly with the lowest. See figure 3.

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Figure 3

The intense level of competition in the perfect competition structure is the reason behind its higher level of efficiency. Competition puts pressure on firms to make better use of scarce resources to lower their average costs. See figure 4.

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Figure 4

Perfect competitor A has a lower cost structure than perfect competitor B. Since firms in this market structure have no market power, they cannot affect the market price. Firm B has only one course of action if it is to survive - It must lower its costs.

The survival of the most efficient is the essence of this market structure. The monopoly market structure, on the other hand, does not have any competitive pressure to keep costs down.

But there is one exception to the typical relationship efficiency has with market structure: Natural Monopoly.

A natural monopoly develops when a single company becomes the only supplier of a product or service over time because the nature of that product or service makes a single supplier more efficient than multiple, competing ones. For example, it is inefficient to have several electrical distribution systems covering the same area, or several pipelines going in the same direction. It is more efficient to build and operate a single large pipeline. In other words, bigger is better.

Companies that experience lower average costs as they grow are said to be experiencing economies of scale. Most firms can achieve economies of scale at the early stages of output. See figure 5.

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Figure 5

A typical average total cost (ATC) curve has a U-shape. At the early stage of output most of the costs are fixed costs. And since average fixed costs fall as production expands, this has the effect of lowering average total costs. Figure 3 shows that if this firm produced 150 units, it would cost, on average, $4.50 per unit. But if the firm increases the rate of output to 175, then ATC falls to $4.00 per unit. This firm can continue to lower its average costs by increasing output until it reaches 250 units. At this rate of output ATC is minimized. If this firm produces beyond 250 units, then average costs will start to rise. So, from 0-250 units, this firm is experiencing economies of scale.

Natural monopolies also experience economies of scale but do so at all rates of output. See figure 6.

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Figure 6

This firm also shows average costs falling as output increases. But in this case, ATC falls for the entire rate of output (not just up to 250 units).

Lighthouses provide an example of service with a downward sloping ATC. Once the lighthouse has been built there only remains operating costs, which in turn are completely unrelated to the number of ships that use the service. This means that no matter how many ships use the service there are no additional costs (i.e., there are no variable costs).

So, it should be clear now that there can be a circumstance, though rare, where a monopoly could be the most efficient market structure. But just because a natural monopoly can achieve efficient outcomes does not mean it will. A natural monopoly is, after all, still a profit maximizing monopoly and the profit maximizing rate of output is not necessarily the most efficient rate.

The natural monopoly creates a dilemma. How can an economic system, like the free market, function properly when its most efficient market structure yields inefficient outcomes? This is a question that must be answered, or the natural monopoly will lead to market failure.

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