A natural monopoly is a distinct type of monopoly that may arise when there are extremely high fixed costs of distribution, such as exist when large-scale infrastructure is required to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These costs are also sunk costs, and they deter entry and exit.
In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to duplicate all the fixed factors - that is, the infrastructure.
It may be more efficient to allow only one firm to supply to the market because allowing competition would mean a wasteful duplication of resources.

Economies of scale

With natural monopolies, economies of scale are very significant so that minimum efficient scale is not reached until the firm has become very large in relation to the total size of the market.
Minimum efficient scale (MES) is the lowest level of output at which all scale economies are exploited. If MES is only achieved when output is relatively high, it is likely that few firms will be able to compete in the market. When MES can only be achieved when one firm has exploited the majority of economies of scale available, then no more firms can enter the market.

Utility companies

Natural monopolies are common in markets for ‘essential services’ that require an expensive infrastructure to deliver the good or service, such as in the cases of water supply, electricity, and gas, and other industries known as public utilities.
Because there is the potential to exploit monopoly power, governments tend to nationalise or heavily regulate them.

Regulators

If public utilities are privately owned, as in the UK, since privatisation during the 1980s, they usually have their own special regulator to ensure that they do not exploit their monopoly status.
Examples of regulators include Ofgem, the energy regulator, and Ofcom, the telecoms and media regulator. Regulators can cap prices or the level of return gained.

Railways as a natural monopoly

Railways are often considered a typical example of a natural monopoly. The very high costs of laying track and building a network, as well as the costs of buying or leasing the trains, would prohibit, or deter, the entry of a competitor.
To society, the costs associated with building and running a rival network would be wasteful.

Avoiding wasteful duplication

The best way to ensure competition, without the need to duplicate the infrastructure, is to allow new train operators to use the existing track; hence, competition has been introduced, without duplication of costs. This is called opening-up the infrastructure.
This approach is frequently adopted to deal with the problem of privatising natural monopolies and encouraging more competition, such as:

Telecoms, the network is provided by BT
Gas, the network is provided by National Grid (previously Transco)
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What is a natural monopoly?

For a natural monopoly the long-run average cost curve (LRAC) falls continuously over a large range of output. The result may be that there is only room in a market for one firm to fully exploit the economies of scale that are available

There are several interpretations of what a natural monopoly us

It occurs when one large business can supply the entire market at a lower price than two or more smaller ones
A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices
It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale
An industry where the long run average cost curve falls continuously as output expands
Private utilities are natural monopolies in local markets

The key point is that a natural monopoly is characterized by increasing returns to scale at all levels of output – thus the long run cost per unit (LRAC) will drift lower as production expands. LRAC is falling because long run marginal cost is below LRAC. This can be illustrated in the diagram above. There may be room only for one supplier to reach the minimum efficient scale and achieve productive efficiency.

Regulation of monopoly

The government may wish to regulate monopolies to protect the interests of consumers. For example, monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through price capping, yardstick competition and preventing the growth of monopoly power.

Why the Government regulates monopolies

Prevent excess price. Without government regulation, monopolies could put prices above. This would lead to allocative inefficiency and a decline in consumer welfare.
Quality of service. If a firm has a monopoly over the provision of a particular service, it may have little incentive to offer a good quality service. Government regulation can ensure the firm meets minimum standards of service.
Monopsony power. A firm with monopoly selling power may also be in a position to exploit monopsony buying power. For example, supermarkets may use their dominant market position to squeeze profit margins of farmers.
Promote competition. In some industries, it is possible to encourage competition, and therefore there will be less need for government regulation.
Natural Monopolies. Some industries are natural monopolies – due to high economies of scale, the most efficient number of firms is one. Therefore, we cannot encourage competition and it is essential to regulate the firm to prevent the abuse of monopoly power.

How the government regulate monopolies

1. Price capping by regulators RPI-X
For many newly privatised industries, such as water, electricity and gas, the government created regulatory bodies such as:

OFGEM – gas and electricity markets
OFWAT – tap water.
ORR – Office of rail regulator.

Amongst their functions, they are able to limit price increases. They can do this with a formula RPI-X

X is the amount by which they have to cut prices by in real terms.
If inflation is 3% and X= 1%
Then firms can increase actual prices by 3-1 = 2%

If the regulator thinks a firm can make efficiency savings and is charging too much to consumers, it can set a high level of X. In the early years of telecom regulation, the level of X was quite high because efficiency savings enabled big price cuts.
RPI+/- K – for water industry
In water the price cap system is RPI -/+ K.
K is the amount of investment that the water firm needs to implement. Thus, if water companies need to invest in better water pipes, they will be able to increase prices to finance this investment.

Advantages of RPI-X Regulation

The regulator can set price increases depending on the state of the industry and potential efficiency savings.
If a firm cuts costs by more than X, they can increase their profits. Arguably there is an incentive to cut costs.
Surrogate competition. In the absence of competition, RPI-X is a way to increase competition and prevent the abuse of monopoly power.

Disadvantages of RPI-X Regulation

It is costly and difficult to decide what the level of X should be.
There is danger of regulatory capture, where regulators become too soft on the firm and allow them to increase prices and make supernormal profits.
However, firms may argue regulators are too strict and don’t allow them to make enough profit for investment.
If a firm becomes very efficient, it may be penalised by having higher levels of X, so it can’t keep its efficiency saving.

2. Regulation of quality of service
Regulators can examine the quality of the service provided by the monopoly. For example, the rail regulator examines the safety record of rail firms to ensure that they don’t cut corners.
In gas and electricity markets, regulators will make sure that old people are treated with concern, e.g. not allow a monopoly to cut off gas supplies in winter.

3. Merger policy
The government has a policy to investigate mergers which could create monopoly power. If a new merger creates a firm with more than 25% of market share, it is automatically referred to the Competition Commission. The Competition commission can decide to allow or block the merger.

4. Breaking up a monopoly
In certain cases, government may decide a monopoly needs to be broken up because the firm has become too powerful. This rarely occurs. For example, the US looked into breaking up Microsoft, but in the end the action was dropped. This tends to be seen as an extreme step, and there is no guarantee the new firms won’t collude.
5. Yardstick or ‘Rate of Return’ Regulation
This is a different way of regulating monopolies to the RPI-X price capping. Rate of return regulation looks at the size of the firm and evaluates what would make a reasonable level of profit from the capital base. If the firm is making too much profit compared to their relative size, the regulator may enforce price cuts or take one off tax.
A disadvantage of rate of return regulation is that it can encourage ‘cost padding’. This is when firms allow costs to increase so that profit levels are not deemed excessive. Rate of return regulation gives little incentive to be efficient and increase profits. Also, rate of return regulation may fail to evaluate how much profit is reasonable. If it is set too high, the firm can abuse its monopoly power.

6. Investigation of abuse of monopoly power
In the UK, the office of fair trading can investigate the abuse of monopoly power. This may include unfair trading practises such as:

Collusion (firms agree to set higher prices)
Collusive tendering. This occurs when firms enter into agreements to fix the bid at which they will tender for projects. Firms will take it in turns to get the contract and enable a much higher price for the contract.
Predatory pricing (setting low prices to try and force rival firms out of business)
Vertical restraints – prevent retailers stock rival products
Selective distribution For example, in the UK car industry firms entered into selective and exclusive distribution networks to keep prices high. The competition commission report of 2000 found UK cars were at least 10% higher than European cars

Natural Monopoly