Natural monopolies

Natural monopolies are a special case of monopoly where the 'normal' rules regarding regulation may not apply. Monopolies are the only firm in a market, and because of competition is absent there is no automatic check on their power.

Competition is absent

When competition is absent, monopolies may exert their market power by charging excessively high prices or severely restricting supply onto the market. In both cases consumer's will experience a fall in the welfare available to them - consumers pay more than the competitive market price, or they receive less than the competitive market supply. Hence, regulators are likely to seek ways to limit their dominance, such as by forcing the break-up of the monopoly, capping prices, or taxing super-normal profits.

However, with 'natural' monopolies the case for extreme regulation is much weaker. This is because competition against a natural monopolist might not be possible, or it might lead to a loss of welfare.

Continuous economies of scale

A key feature of markets or industries where natural monopolists exist is that only one firm can benefit from economies of scale.

These markets are characterised by very high fixed costs of supply, and include industries which rely on large-scale infrastructure such as cables, pipelines and networks, including gas and water supply, electricity and railways.

In these industries production costs continue to fall in the long run as the producer experiences continuous economies of scale. Once the first firm in the market has built the infrastructure (perhaps over many decades) it must supply as much as possible to benefit from economies of scale. For example, once an energy company has built its infrastructure is will have incurred a large proportion of its total costs. Every extra customer added will add very little to variable cost, but will make a contribution to revenue, and add possibly add to profits.

Now imagine that, in order to break-even, the energy supplier must supply to at least 51% of potential customers. Indeed, there is an incentive to sell as much as possible as every unit sold continues to reduce long run average costs. If the incumbent has already met or exceed this threshold, then it would be commercially impossible for a rival firm to enter the market.

Hence, when industries rely on supplying through the use of large scale infrastructure, there is an incentive to grab as much of the market as possible, and in so doing deny access to potential entrants.

The problem from a regulators point of view is that anything which opens up the market to competition might result in increased inefficiency as it means that the benefit of economies of scale may be lost.

Natural monopolies

If unregulated they can make excessive super-normal profits, at 'Q' in the diagram, with profits at PABC.

Given high barriers to entry it is likely that these profits will continue into the long run.

However, because they often supply essential public utilities, such as water and electricity, it is argued that natural monopolists may operate against the public’s interest - not only as a result of excessive profits, but also in that they can limit output going on to the market - hence, intervention is a likely result.

Intervention strategies

The single most significant problem in attempting to introduce competition is that a new entrant will have to create a completely new infrastructure to run alongside the infrastructure of the existing firm.

This will cause a wasteful duplication of the infrastructure - hence, opening-up to competition is costly and potentially very wasteful.

A regulator could intervene by setting price to achieve efficiency (where P=MC) resulting in an output level at Q1 - however, at this output the firm will be making a loss of area KLMN - a considerable dilemma for regulators.

As a solution to this problem it is possible to have the ownership and maintenance of the infrastructure controlled separately from the operating companies.

This means that there is competition but without a wasteful duplication of infrastructure. This is now a commonly accepted approach in the case of railways, gas and electricity supply.

Infrastructure can continue to be owned by a private operator, and tightly regulated, with competition encouraged between several 'operating' companies. Alternative, the infrastructure can be owned and controlled by the state, or by a not-for-profit organisation with competition at the 'retail' end of the supply chain.

However, this can create conflicts of objectives between parts of the industry. For example, operating companies may focus on maximising returns for shareholders, while the owners of the infrastructure may be more concerned with safety.

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