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Chapter 29: Theory of the firm – natural
monopoly (1.5)
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Economies of scale
Definition of a natural monopoly
Different possible pricing and output decisions
Natural monopoly
•
With reference to economies of scale, and using
examples, explain the meaning of the term “natural
monopoly”
•

Draw a diagram illustrating a natural monopoly
Economies of scale
When there are very large fixed/initial costs and a very large potential for economies of scale based on
technological gains, a monopoly might well have a profitmax point which renders a lower price and higher
output than a perfectly competitive market. We now relax our earlier two assumptions added-on in
comparing a monopoly with a perfectly competitive market. The sum of the MC curves for PCM firms are
not the MC curve for the monopoly; and there are indeed economies of scale to be had.
Fig. 2.3.40 Economies of scale in a monopoly
P, costs ($)
P, costs ($)
SPCM = ΣMCPCM
MC
SRAC
PPCM
MCSRAC
Pmon
MCmon
LRAC
QPCM
MR
QPCM Qmon
D, AR
Q/t
Qmon
A monopoly firm which can
attain economies of scale results
in a lower price and higher
output than is possible when
competing firms have too small
a portion each to benefit from
scale economies.
Q/t
Figure 2.3.40 illustrates the outcome when a monopoly can enjoy economies of scale. The supply curve for
the perfectly competitive market (left diagram) is the sum of the MC curves shown in the LRAC diagram to
the right. Scale economies allow the monopoly to move along the LRAC (diagram on the right), allowing
the monopoly to decrease MC and AC. The monopoly can produce a higher quantity and lower price –
Qmon and Pmon – than the perfectly competitive market. Simply put, a large quantity of (smaller) competing
firms could not attain large enough scale to be able to compete with a single monopoly firm.
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Definition of a natural monopoly
A natural monopoly has nothing to do with ‘organic ’, in case any of you neo-hippies were wondering. A
natural monopoly is when the barriers to other firms entering the market are in some way built-in to the
environment, infrastructure or the nature of the good itself. In this, the single firm will have very large
benefits of scale which competing firms could never acquire – this enables the incumbent (= “sitting”,
“current”) monopoly firm to continuously undercut potential rivals and (intentionally or unintentionally)
prohibit them from entering the market.
The concept of a natural monopoly is an extension of the scale benefit model done above. However, a
natural monopoly will have such large scale benefits, that no single firm can fully exploit them. “Natural”
in usage here means that the economies of scale make it more efficient for one firm to produce the good
than for any other constellation in the industry. 1 Easily understandable examples of natural monopolies are
gas networks for households, water lines, electricity, telecommunications and cable TV – imagine the costs
in having each individual gas or electricity company having their own lines into each house! My favourite
example is railways; imagine having two competing companies with their own tracks – side by side –
running between two cities. How about two bridges…side by side?!
There are of course very high barriers to entry in industries characterised by natural monopolies. This is
due to two common characteristics of natural monopolies:
1) Extremely high fixed costs and low variable costs
2) High initial (start-up) costs – often infrastructural
Definition: “Natural monopoly”
A natural monopoly is a situation (not a firm!) where the market is most efficiently served by
a single firm since the benefits of scale are so large that not even a single firm can fully
exploit the potential economies of scale. Gas, water and electricity lines to homes are
examples of natural monopolies.
On one of my trips through Ireland in the mid-eighties, I visited a far-northern town called
Glencolombcille. It soon became apparent that getting there involved taking a series of buses – which were
mostly provided by non-competing bus companies which had local monopolies for a number of town-totown routes. It also became apparent that there was no cooperation between the companies since arriving
1
It is noteworthy that the term natural monopoly does not in fact refer to the dominant firm but rather to the
industry itself. There can be many competing firms in a natural monopoly situation and in using the term
natural monopoly we are claiming that one firm would increase efficiency in the industry. This is a
common political argument put forward in favour of nationalising water works, electricity and train
services.
buses invariably arrived ten minutes after connecting buses had departed!2 Bus services have high fixed
costs since it basically costs the same to drive an empty bus from point A to point B as a bus full of
inebriated Irish fiddle-players and confused tourists. The route I was travelling simply could not have
supported competing bus lines, and it would be ludicrous to think that competitive forces could have
lowered the market price while firms still covered their costs.
Part of the network of gas pipelines in
the Australian ‘outback’.
Natural monopolies do tend to occur where fixed costs are very high, giving potential economies of scale
only to firms which can exploit sheer size to some extent and spread the fixed costs over large output; one
firm can satisfy market demand at a lower cost than competing firms. The markets for cable TV, water/
gas/ electrical utilities, railroad tracks and local bus services all have strong elements of natural monopoly.
Just imagine how inefficient it would be to have several hundred competing gas pipes to each household or
fifteen firms each laying down competing railroad tracks! The Öresund Bridge connecting Sweden to
Denmark is also a natural disaster monopoly3 …and two bridges would basically be a monument to
financial stupidity – and that might explain why politicians at this very moment are planning yet another
connection via a tunnel4.
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Different possible pricing and output decisions
The issue of is illustrated by the continuously falling LRAC curve in figure 2.3.41; as average costs fall
throughout the entire boundary of market demand, LRMC too continues to fall. This renders three possible
pricing outcomes – all of which are lower than for a PCM:
1) Profitmax pricing; where the monopoly sets price according to the MC = MR condition. This
creates an output of QΠ-max and a price of PΠ-max. The firm makes an abnormal profit of the blue
area. Examples include private telecoms companies and gas companies.
2) Average cost pricing; is when the monopoly sets the price at the break-even point of AC = AR.
2
I strongly suspect collusion between the bus companies and local pubs – which were always right next to
the bus stations. It was all very Irish and very fun; we’d all get off one bus, tumble into the pub for a few
pints, singing, joke-telling and fiddle-playing, and off we’d go on the next bus. I spent more in the pubs
than on the bus tickets.
3
The bridge was initially a monumental failure in terms of recouping the immense initial costs of building it. It ran
at a loss for almost seven years since its inauguration in July 2000 – in part because of the high price for those in
the vehicles that use it.
4
I am not making this up!
3) Marginal cost pricing; at an output of QMC, the monopolist would incur a loss of the purple
shaded area. Marginal cost pricing is commonly done in order to achieve social benefits – for
example, providing water – and often involve public ownership or government funding via
subsidies.
Fig. 2.3.41 Natural monopoly
P, costs ($)
If the industry is forcibly turned into a
duopoly, each firm would have ACduo
and losses (grey area).
Profitmax: the monopoly enjoys an
abnormal profit (blue area) at P π-max
and Q π-max.
Pduo
PΠ-max
AC pricing: The firm sets output at
break-even point, earning a normal
profit.
PAC
PMC
MR
Qduo QΠ-max
QAC
AC
MC
D, AR
Q/t
QMC
MC pricing: Setting price at MC means
a loss (purple area) for the firm, which is
only tenable in SR. (Or via subsidies and
price discrimination in LR)
What would happen if the natural monopoly was broken up in order to establish a competitive market?
Assume an existing monopoly at the profitmax price of PΠ-max. If government forced the firm to break up
into two parts – a duopoly – each firm would have a far higher AC than the monopoly; the two firms would
have an average cost of ACduo and an output of Qduo. This is clearly economically impractical. (Note the
suboptimal productive efficiency in all three pricing scenarios, and the suboptimal allocative efficiency in
all cases but MC pricing.)
(Type 4 Smaller heading) Public and merit goods
Goods provided and/or produced by government monies, i.e. public and merit goods such as roads and
health care are often priced at AC or MC. Societal welfare is deemed to benefit so much by the provision of
such goods that the profitmax condition is not considered applicable. Instead, the good is priced at cost or –
via subsidies – at below marginal cost.
Whether public/merit goods warrant government support or provision or not is subject to very heated
debate. The trend over the past 20 years has been increasingly in favour of market openness and
privatization, where a number of traditionally government-controlled markets have been sold off or
otherwise subjected to open market competition. State-owned telecom companies, electricity and railroads
are notable examples. In certain cases the results have been rather dismaying, for example England ’s
privatisation of British Rail, completed in 1997, was called a ‘Disaster ’ by Time Magazine5 ; over 100
5
Time, July 14 2003, pages 54 – 57.
different competing rail-service providers saw how costs spiralled upwards continuously leading to fewer
departures and lower levels of service. There are increasingly loud cries for re-nationalisation. A very
similar debate raged in California during 2002, as overloaded private electricity companies led to daily
blackouts. You can just imagine how popular sudden power interruptions were to the programmers in
Silicon Valley.
Summary and revision
1. A large monopoly might enjoy significant economies of scale and therefore be able to
produce at a lower price and higher quantity than competitive market firms.
2. A natural monopoly is a market situation (rather than a specific firm) where there are
considerable entry barriers (very high fixed and start-up costs) and no single firm would
be able to fully exploit these scale benefits. Common examples are electricity and gas
lines.
3. The economies of scale result in falling or constant average and marginal costs
throughout the realm of demand.
4. A natural monopoly can set price and output at different levels: 1) At profitmax price
and output (MC = MR); 2) At breakeven price and output (AR = AC); 3) At a level
considered approaching the societally optimal – where a loss can be made up for via
subsidies or price discrimination (AR = MC).
5. Natural monopolies are frequently controlled/operated by government. Price and
output is commonly set at breakeven or marginal cost price to maximise social benefits.
Good examples of government run natural monopolies include railroads and electricity
networks.