Question

What is a natural monopoly?

Short answer

A natural monopoly is a market condition where one firm can provide the entire market's demand at a lower cost than multiple smaller firms. This situation is often due to economies of scale, high fixed costs, or decreasing production costs with increased output. High entry and exit barriers, typically due to substantial startup costs, are another characteristic feature. A classic example is a utility company, like a water supplier, which can deliver services at lower costs than multiple firms owning separate infrastructures. As natural monopolies can lead to high customer prices due to the absence of competition, they are usually regulated by government bodies to prevent the abuse of monopoly power and ensure fair pricing.

Step-by-step solution

Definition of a Natural Monopoly

A natural monopoly represents a situation in the market where a single firm is able to serve the entire market demand at a lower cost than any combination of two or more smaller firms. This is often due to a high level of fixed costs or startup costs in the industry, or scenarios where the cost of production decreases as output increases.

Characteristics of a Natural Monopoly

A natural monopoly typically has three main characteristics. 1. One firm is able to produce the market's entire output at a lower cost than multiple firms. This is due to economies of scale where the average costs of production fall as output increases. 2. High barriers to entry and exit exist in the market, generally due to substantial infrastructure or start-up costs, making it difficult for new companies to enter. 3. They often occur in industries that require substantial infrastructure, such as utilities.

Examples of a Natural Monopoly

One of the common examples of a natural monopoly is a utility company. For example, in a geographical region, one water utility company is often able to deliver water to all households at a lower cost per unit than if multiple firms were to build their own separate water supply infrastructures. In such a case, it’s more cost-efficient and also practical for one company to provide the service.

Regulation of Natural Monopolies

Due to their nature, natural monopolies are often regulated by governments. Without regulation, monopolies could charge customers excessively high prices as they are the only supplier. Therefore, to ensure fair prices and prevent the abuse of monopoly power, regulatory bodies often set price limits or oversee the operations of these monopolies.