What is a Natural Monopoly?

We all know what a monopoly is, right? No, I am not talking about the card game! Monopoly, here, refers to the phenomenon of one supplier dominating the market and being the sole determinant of the product price in absence of competition and competition related market forces. Absence of competition is the chief characteristic of a monopolistic situation. However, what is a natural monopoly? What are its chief characteristics? Well, to put it in simple terms, a natural monopoly is an economic condition under which a single supplier in a particular industry becomes the largest supplier owing to a gigantic cost advantage that it holds over all other suppliers in the industry.

The cost advantage is so great that all other suppliers in the same industry are hardly considered a competition, whether actual or potential. After all what does market monopoly mean other than being the sole player in the entire market? This natural monopolist or the largest supplier is often the first supplier to have entered the said industry. Let's take a detailed look at this phenomenon and its underlying microeconomic mechanisms to understand what a natural monopoly is.

What Causes Natural Monopoly?

There are a couple of cost factors that are responsible for the rise of a natural monopoly. The initial cost of setting up a business, although generally large for all enterprises, varies in magnitude from industry to industry. In case of a prospect venturing into a business involving a public utility, the initial investment cost is gigantic. This acts as an entry barrier for most enterprises despite the prospects of tremendous earnings once the revenues start rolling in and that is the reason why we see very few entrants in the utilities sector. Talking about cost advantages, we need to take into consideration the fixed costs, marginal costs and their interactions during the course of the business timeline. In case of natural monopolies, the tremendous cost advantage that the natural monopolist holds over its actual or potential competitors comes from this interaction between fixed costs and marginal costs which differ in case of utility suppliers as compared to suppliers of conventional products and services.

In conventional, output based industries, as a supplier continues with his production operations, the marginal costs (cost of catering to one additional customer unit) decline as the company increases its scale of production, thereby earning economies of scale. The marginal costs break even with the revenue after some time and proceed on an upwards trend as various diseconomies settle in after the course of many years of being in business. The fixed costs remain stable throughout this entire business cycle. However, in case of naturally monopolistic industries, the businesses are not output based and the fixed costs are huge. A decent return on investment is only possible if the natural monopolist is able to cater to a large customer base. The marginal costs are more or less constant throughout. In such a cost structure, the fixed cost earns economies of scale as the customer base grows because the same amount of cost gets divided among a larger units of commercial consumers every time.

This ultimately leads to the average total cost to decline overall with an increase in output as the level of such an increase takes place across a vaster range than purely output based industries. Therefore, any supplier who is capable of transcending the initial entry barrier of gigantic setup cost finally comes to reap enormous economies of scale owing to this quantum fixed cost advantage. An excellent example of natural monopoly would be an electric power supplier. The set up costs are huge, the marginal cost of gaining an additional consumer unit is insignificant and the revenue generated by adding one more consumer unit will only serve to increase the supplier's revenue and lower the average cost.

I guess that explains what a natural monopoly is according to cost and scale economies as laid down by microeconomics. As in case of any monopoly or monopolistic undertaking, natural monopolies are also not free from regulations. Regulation of monopoly is necessary for preventing market exploitation and anti-consumer associations. This is the reason why most countries of the world still insist on having public utility services such as power, railways, water supply, etc., under state control and these utilities function under strict government regulations.