What is a Natural Monopoly?

Referencing from SSRN

The term "natural monopoly," originating with T. Malthus in 1815, initially referred to monopolies arising from fixed quantities of natural factors of production, seen as barriers to entry. J. S. Mill's definition characterized them as circumstances-created, not law-made, distinguishing them from artificial monopolies. Mill recognized diverse situations, including barriers related to capital requirements, within natural monopolies. Baumol's formal definition, based on cost subadditivity, became pivotal. The British railways in the 19th century serve as a complex case study, highlighting the challenges of regulating these monopolies.

Natural monopolies often emerge when fixed costs, possibly sunk, are high, and marginal costs are low or zero. In such cases, the incumbent firm's cost is lower than any potential competitor, leading to market dominance. Unlike perfect competition, monopolies set prices above marginal costs for profit maximization. The academic definition, as outlined by Baumol (1977), revolves around cost subadditivity, where production costs for any set of outputs are less than the sum of producing those outputs separately.

Scholars quickly recognized the inevitability of monopolies in transport networks like railways and roads. Dupuit attributed it to the massive upfront infrastructure investment, limiting new entries. Walras argued that government decisions on land expropriation for networks lead to monopolies. In transport, multiple small businesses are deemed inefficient.

While some natural monopolies persist due to strong regulations, others, even deemed "natural," can be challenged by firms using innovative technologies. The Austrian School, represented by scholars like Mises and Hayek, argues that natural monopolies are often outcomes of regulation or state protection. Instances like Uber entering the taxi market in France demonstrate how innovative technologies can challenge established monopolies, even when historically entry barriers were high.

Formal Definition of Natural Monopoly: A market structure where a single firm produces a good or service without close substitutes. Sources include legal barriers, capital requirements, economies of scale, etc. Natural monopolies occur when a single firm can offer a good or service to an entire market at a lower cost than two or more firms could, potentially resulting from unrestricted competition.

Efforts to regulate natural monopolies stem from their inherent inefficiencies, aiming to reduce prices and boost output. Policymakers face the challenge of determining a regulated price that balances efficiency and sustainability.

One approach is marginal-cost pricing, aligning the price with the monopoly's marginal cost to restore efficiency. However, this policy risks pushing the monopoly out of the market due to losses. Government subsidies or allowing a price slightly above marginal cost can address this, albeit with associated deadweight losses.

While marginal-cost pricing lacks incentives for cost reduction, designing contracts can motivate monopolies to cut costs. Implementing such schemes is complex, given the unobservable nature of a monopoly's effort. Estimating cost functions and verifying subadditivity, a condition for natural monopolies, is challenging. Fortunately, in multiproduct cases, cost complementarity, where increased production of one good decreases the incremental cost of another, offers a practical indicator of subadditivity.

Strategic regulation becomes essential, balancing economic efficiency with the monopolistic nature of certain industries.

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