Natural Monopoly

What It Means

In economics a natural monopoly is said to exist when a single business, rather than numerous competing businesses, is the most efficient producer of any good or service. A monopoly exists when a single business is the only seller of a good or service in a market (a market is any place or system allowing buyers and sellers to come together). Monopolies are usually believed to be harmful to society because, in the absence of competition, a company can raise prices to ensure itself profits and operate without any concern for efficiency. Some industries, however, are believed to tend naturally toward monopoly conditions because of the costs of doing business.

This has traditionally been true, for example, of public utilities such as electricity. The cost of building plants, transformers, and power lines is enormous, but once these necessary investments have been made, an electric company can sell increasing amounts of electricity without incurring great additional costs. Once a company has made the initial investment, then, it is in a position to provide electricity to an entire market (such as a city or region), and it can spread the costs of its initial investment among this large population. Thus, it can charge a lower price than would multiple competing companies, each of which would have to build its own plant, transformers, and lines and then pass these costs on to a smaller portion of the overall market. Other industries in which some degree of natural monopoly occurs include cable television, phone service, and rail transport

When Did It Begin

Monopolies have existed throughout history, often as a result of government authorization. For example, the large companies set up in the seventeenth century to facilitate trade between European countries and Asian and African peoples, such as England’s British East India Company and the Netherlands’ Dutch East India Company, were granted monopoly rights by the rulers of their countries. Other monopolies have arisen independently of government involvement. In the late nineteenth and early twentieth centuries, American industrialists such as John D. Rockefeller (the head of Standard Oil) intentionally set out to monopolize their markets by buying up the competition or forcing rivals out of business through a variety of aggressive tactics. Since this time the U.S. government has generally sought to prevent monopolies from forming or to regulate or dismantle those that have already formed.

The British philosopher and economist John Stuart Mill (1806-73) is generally credited with originating the concept of natural monopolies.

More Detailed Information

Natural monopolies arise because of what are called economies of scale. Simply put, economies of scale are the cost-cutting advantages that companies develop as they expand. Companies that produce an increasing number of goods are able to pay lower prices for raw materials, hire workers to specialize in particular tasks, get more money’s worth out of their advertising campaigns, and otherwise increase efficiency and cut costs. This allows companies to multiply their investments in workers and other resources and to grow faster than companies that are not producing a similar quantity of output. Thus, a small company cannot compete in an industry dominated by larger rivals even if it produces a similar product using similar materials and techniques. Economies of scale tend to occur in industries dominated by a handful of large companies, such as petroleum, chemicals, automobiles manufacturing, and steel; in some industries, however, they produce natural monopolies.

Natural monopolies result when economies of scale can only be realized at a very high level of production. In the example of the electric industry, the enormous investments required to enter the business mean that it is not profitable to produce electricity until a very large amount can be produced and sold. Beyond this minimum amount, however, electricity production becomes very profitable because of the decreasing costs associated with economies of scale. It happens, often, that this minimum amount is so large as to make it impractical for there to be more than one producer of electricity in one area. If there were two or three producers, they would divide the market among themselves and be unable to sell enough electricity to take advantage of economies of scale.

If electricity markets were divided among numerous competing firms, consumers would presumably have to pay higher prices for electricity than under monopoly conditions. Therefore, it is in society’s interest for such industries to function as monopolies. On the other hand, monopolies do not have to worry about competing firms taking away their customers, so they have unlimited power to raise prices and to cut production if these actions allow them more profits.

Governments have traditionally intervened in such industries with the intent of preserving the benefits arising from monopoly conditions without allowing companies to take undue advantage of their monopoly powers. In Europe and much of the world, governments in the twentieth century often assumed total control of public utilities such as electricity, natural gas, telephone service, railroads, subway systems, and airlines, running monopoly companies as public services, subject to pricing and production limits imposed by lawmakers. In the United States the tendency has been to allow private ownership of utilities but to use government at the local, state, and federal level both to support and regulate them, protecting them from competition while limiting changes in prices and production. When a government gives a company or itself exclusive access to an industry, it is known as a government-granted monopoly.

In most cases companies that tend toward becoming natural monopolies stop short of trying to establish an outright monopoly, because they do not wish to be the target of antitrust action (legal measures to break up monopoly power) by the federal government. Still, some companies are undaunted by the prospect of regulatory sanctions, including XM and Sirius, the only two satellite radio providers in the United States, which announced in February 2007 that they would to merge (or combine) into a single company.

Recent Trends

Beginning in the mid-1970s, dissatisfaction with the results of government regulation (not only of natural monopolies but of other industries as well, such as banking and finance) led to the trend known as deregulation. In 1978 the U.S. Congress authorized the deregulation of the airline and natural gas industries, opening them to competition, and in 1980 the trucking industry was similarly deregulated. In the 1980s the government likewise forced the breakup of the local and long-distance telephone monopoly AT&T, which had been previously believed to be a natural monopoly, into distinct regional companies providing local services. AT&T continued to provide long-distance service, but other long-distance providers were allowed to compete in this newly privatized industry. In the late 1990s some U.S. states began experimenting with deregulation of the electricity industry. Electricity deregulation consists of allowing numerous companies to compete for the business of consumers using existing power lines.

Deregulation of the trucking industry resulted in the rapid growth of the industry and enormous savings to producers and consumers. Likewise, in the market for long-distance phone service, deregulation resulted in a high level of competition among providers and a 72-percent decrease in consumer prices between 1985 and 1998. The trend has not been an unqualified success, however. In the airline industry deregulation increased the concentration of power in the industry as large airlines took over routes that had previously been protected by government-regulated monopoly rights, and the deregulation of the electricity industry proved a more gradual and complicated process than its proponents originally envisioned.