Natural Monopoly

Natural Monopoly

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What Is a Natural Monopoly

A monopoly, in general, is a market that has only one seller and no close substitutes for that seller's product. A natural monopoly is a specific type of monopoly where economies of scale are so pervasive that the average cost of production decreases as the company increases output for all reasonable quantities of output. Put simply, a natural monopoly can keep producing more and more cheaply as it gets bigger and doesn't have to worry about eventual cost increases due to size inefficiency.

Mathematically, a natural monopoly sees its average cost decrease over all quantities of output because its marginal cost doesn't increase as the firm produces more output. Therefore, if marginal cost is always less than average cost, then average cost will always be decreasing.

A simple analogy to consider here is that of grade averages. If your first exam score is a 95 and each (marginal) score after that is lower, say 90, then your grade average is going to continue to decrease as you take more and more exams. Specifically, your grade average will get closer and closer to 90 but never quite get there. Similarly, a natural monopoly's average cost will approach its marginal cost as quantity gets very large but will never quite equal marginal cost.

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Efficiency of Natural Monopolies

Unregulated natural monopolies suffer from the same efficiency problems as other monopolies due to the fact that they have an incentive to produce less than would a competitive market would supply and charge a higher price than would exist in a competitive market.

Unlike regular monopolies, however, it doesn't make sense to break up a natural monopoly into smaller companies since the cost structure of a natural monopoly makes it so that one large company can produce at lower cost than multiple small companies can. Therefore, regulators have to think differently about appropriate ways to regulate natural monopolies.

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Average-Cost Pricing

One option is for regulators to force a natural monopoly to charge a price no higher than the average cost of production. This rule would force the natural monopoly to lower its price and would also give the monopoly an incentive to increase output.

While this rule would get the market closer to the socially optimal outcome (where the socially optimal outcome is to charge a price equal to marginal cost), it still has some deadweight loss since the price charged still exceeds marginal cost. Under this rule, however, the monopolist is making an economic profit of zero since price is equal to average cost.

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Marginal-Cost Pricing

Another option is for regulators to force the natural monopoly to charge a price equal to its marginal cost. This policy would result in the socially efficient level of output, but it would also result in a negative economic profit for the monopolist since marginal cost is always less than average cost. Therefore, it's entirely possible that restricting a natural monopoly to marginal-cost pricing will cause the company to go out of business.

In order to keep the natural monopoly in business under this pricing scheme, the government would have to provide the monopolist with either a lump-sum or a per-unit subsidy. Unfortunately, subsidies reintroduce inefficiency and deadweight loss both because subsidies are usually inefficient and because the taxes needed to fund the subsidies cause inefficiency and deadweight loss in other markets.

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Problems with Cost-Based Regulation

While either average-cost or marginal-cost pricing may be intuitively appealing, both policies suffer from a couple of drawbacks in addition to those already mentioned. First, it's very difficult to see inside a company to observe what its average costs and marginal costs are- in fact, the company itself may not know! Second, cost-based pricing policies don't give the companies being regulated an incentive to innovate in ways that reduce their costs, despite the fact that this innovation would be good for the market and for society overall.