Natural monopolies occur in those industries in which the total costs of production are lower if a single firm produces the whole output instead of having production divided amongst more than one firm. Although this is the usual definition, which is attributed to William Baumol, who provided it in his article “On the Proper Cost Tests for Natural Monopoly in a Multiproduct industry”, 1977, natural monopolies have been studied since the time of John Stuart Mill and Alfred Marshall. In 1923, economist J.M. Clark greatly contributed to the understanding of natural monopolies in his book “Studies in the Economics of Overhead Costs”, explaining how in manufacturing industries, since overhead costs are a significant fraction of total costs, a high number of firms will not mean lower prices.
Natural monopolies are brought by economic and technical reasons, such as high capital costs, economies of scale and other barriers to entry, and not by legal imperatives. Public utilities such as electricity and water services are some of the most common examples. Natural monopolies are characterized by subadditivity of a representative firm’s cost function. Subaddititvity will exist when
which is the essence of the idea behind natural monopolies. The demand function plays a key part in subadditivity and hence, the existence of natural monopolies depends on its position, and whether it will be more or less efficient, to have a single firm or more in the market.
However, subadditivity is considered a necessary but insufficient condition for a natural monopoly to be considered optimal, whereas if economies of scale exist, this is a sufficient but not necessary condition for a natural monopoly to be sustainable. Consider the figure below. The cyan demand curve, within the economy of scale region, indicates a viable natural monopoly. The red line would indicate a non-sustainable natural monopoly. The black line indicates the frontier of a profit generating monopoly (which would attract competitors) and the green line indicates a viable duopoly.
As in most imperfect competition market structures and especially in monopolistic ones, a firm who is in a position of natural monopoly may practice an abusive behaviour, which will translate into a loss of welfare. In such cases, government intervention will be praised both by consumers and those firms that seek for lower prices and a profitable share of the market. Regulations such as price setting, taxation or subsidies may be used in order to restore and maximise the initial efficiency of natural monopolies.
Nevertheless, the government must be cautious when setting and applying regulations, as an incorrect comprehension of the market structure may bring a higher cost to the total social welfare instead of the expected benefits. In order to achieve an optimal regulation level, governments should analyse and determine if natural monopolies can be sustained whenever they ensure a lower total cost. If this is the case, the government will have to guarantee that the firm earns no excessive revenues, and that fair prices are maintained. If on the contrary, the total costs of the industry would diminish if new firms entered the market, the government should regulate their entrance. Essentially, what governments should do is to correctly balance the conflict between the industry’s efficiency and its profitability.