Overview
A natural monopoly arises not from law or collusion but from the cost structure of an industry. John Stuart Mill, in Principles of Political Economy (1848), used London's gas and water companies to argue that laying several sets of pipes along the same street is wasteful. Typical cases are industries that need a physical network: electricity transmission and distribution, water supply, gas pipelines and rail track.
Definition: scale economies and subadditivity
Traditionally, natural monopoly was tied to economies of scale, with average cost falling over the whole range of market demand. William Baumol (1977) offered the more precise test of subadditivity of the cost function: an industry is a natural monopoly if any output can be produced more cheaply by one firm than by any combination of several firms. He showed that in multiproduct industries scale economies are neither necessary nor sufficient for natural monopoly.
Causes
- Large fixed and sunk costs: power plants, grids and water mains require huge initial investments that cannot easily be redeployed.
- Low marginal cost: once the network exists, supplying one more unit is cheap, so average cost falls as output rises.
- Network effects: when a service becomes more valuable as more users connect, network effects can reinforce a single supplier.
Price regulation options
- Marginal-cost pricing: setting price equal to marginal cost achieves allocative efficiency, but where average cost is falling marginal cost lies below average cost, so the firm makes a loss that must be covered by subsidy.
- Average-cost pricing: price equals average cost, so the firm earns only normal profit; there is no loss, but output is below the efficient level.
- Two-part tariff: a fixed charge recovers fixed costs while the usage charge is set near marginal cost, as in many electricity and gas tariffs.
- Rate-of-return regulation: the firm is allowed a fixed return on invested capital. Averch and Johnson (1962) showed that this encourages over-investment in capital, the Averch-Johnson effect.
- Price caps: prices may rise only by inflation minus a productivity factor (X), giving the firm an incentive to cut costs.
- Public ownership: the state owns and runs the network, as with Korea's power grid operated by KEPCO.
Critiques and debates
Harold Demsetz, in "Why regulate utilities?" (1968), argued that even with scale economies, competitive bidding for the franchise can prevent monopoly pricing, so regulation is not automatically justified. Richard Posner (1969) also stressed the costs and inefficiencies of regulation. Without any control, however, a monopolist would raise prices and restrict output, creating welfare losses. Many countries now keep only the network itself as a regulated monopoly while opening generation, supply or train operation to competition.
References
- Mill, J. S. (1848). Principles of Political Economy. London: John W. Parker.
- Averch, H., & Johnson, L. L. (1962). Behavior of the firm under regulatory constraint. American Economic Review, 52(5), 1052–1069.
- Demsetz, H. (1968). Why regulate utilities? Journal of Law and Economics, 11(1), 55–65.
- Posner, R. A. (1969). Natural monopoly and its regulation. Stanford Law Review, 21(3), 548–643.
- Baumol, W. J. (1977). On the proper cost tests for natural monopoly in a multiproduct industry. American Economic Review, 67(5), 809–822.
- Sharkey, W. W. (1982). The Theory of Natural Monopoly. Cambridge: Cambridge University Press.