Natural Monopoly

Reviewed by Annapoorna | Updated on Sep 30, 2020

Introduction

A natural monopoly is a kind of monopoly that arises due to natural market forces. It often occurs in industries where capital costs are predominate, creating economies of big-scale concerning the size of the market. Examples of the natural monopoly include public utilities, such as water services and electricity.

Understanding Natural Monopoly

A natural monopoly is a form of monopoly that occurs in a given industry due to the high start-up costs or powerful economies of scale of conducting business. A company with a natural monopoly could be the only supplier in a market, geographic location, a product, or service.

A natural monopoly is that monopoly which occurs in an industry where high infrastructural costs and other barriers, relative to market size, give an overwhelming advantage over potential competitors to the biggest supplier in an industry, often the first supplier in a market.

Natural monopolies are allowed when a single company can supply a product or service at a lower cost than any potential competitor but are often heavily regulated to protect consumers.

As the name implies, a natural monopoly is, over time, a monopoly due to market conditions and without any unfair business practices that might stifle competition.

Collusion may involve two competing rivals working together to obtain an unfair market advantage by arranging price-fixing or raising.

Natural monopolies, however, take place in two forms.

Firstly, a business takes advantage of the high barriers to entering a market to build a "moat," or defensive wall, around its business operations. The high entry barriers are often due to a large amount of capital or cash needed to purchase fixed assets which are physical assets that a business needs to operate.

Manufacturing plants, advanced machinery and equipment are all fixed assets which, due to their high costs, may prevent a new company from entering an industry.

Secondly, large-scale production is so much more useful than small-scale production, that a single large producer is sufficient to meet all market demand available. Small producers obviously can never compete with the more significant, lower-cost producer because their costs are higher.

In this situation, the single large producer's natural monopoly is also the most economically efficient way of producing the good at the problem. This type of natural monopoly is not due to large-scale fixed assets or investment but may result from the simple first-mover advantage, through returns on centralizing knowledge and decision-making, or network effects.

Example of a Natural Monopoly

A natural monopoly happens when the most efficient number of firms in the industry is one. A natural monopoly will ideally have very high fixed costs implying that it is impractical to have multiple firms producing the good.

The case of tap water can be an example of a natural monopoly. It makes sense to have only one company providing a network of water pipes and sewers because the setting up of a national network of pipes and sewage systems entails very high capital costs.

It does not make sense to have two different companies providing water, as the average cost is very high compared to just one company and one network. Therefore, there would be the challenge of making two companies dig the road to lay a duplicate set of water pipes.

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