What is Natural Monopoly ?
Natural monopoly emerges when natural interactions between market forces permits a single firm (its ownership may be single or joint) to produce or sell a particular commodity. The essential condition for a natural monopoly in the production of a commodity or a service is that its production involves huge fixed costs. Huge fixed/ establishment cost ensures that there are only a few takers for whom this project will be viable. Even the market size falling short of matching supplies also ensures a natural monopoly.
Examples :
As examples we can see the cases of public utilities like electricity, telephone, cooking gas etc. Even cable TV operation can be an example of local natural monopoly.
How efficient is natural monopoly?
Any kind of monopoly is undesirable from the point of view of consumer welfare and economic efficiency. Especially natural monopolies are really difficult to deal with when regulations and controls are concerned. Governments can use various approaches to raise the market size by some appropriate policies but that is definitely not an easy task. Natural monopolies do exist even after Government measures.
Practically, the government uses two measures to regulate natural monopoly –
- Regulate the natural monopoly by setting a break-even price such that price equals average cost
- The Government can control the natural monopoly directly and set the competitive pricing i.e. price equals marginal cost, subject to some lumpsum subsidy.
How does Natural Monopoly emerge?
A natural monopoly usually arises when there are strong economies of scale i.e. declining average and marginal costs over its entire range of output. If Government regulate its price to a competitive level, then the firm would lose money and go out of business. Setting the price equals to average cost yields the largest possible output which will keep the firm in business and excess profit will come down to zero.