Natural monopolies

Natural monopolies are monopolies where the 'normal' rules regarding the regulation of monopolies may break down.

This is because they face large and continuous economies of scale and it may be inefficient to allow competition into the market.

Natural monopolies are characterised by high fixed costs of supply, including large-scale infrastructure such as cables, pipelines and networks, including gas and water supply, electricity and railways.

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 they 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

The single most significant problem with 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 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 be owned by a private operator, or come under public ownership or public control.

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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