What Is a Natural Monopoly?

A natural monopoly is a type of monopoly that exists due to the high start-up costs or powerful economies of scale of conducting a business in a specific industry. A company with a natural monopoly might be the only provider or a product or service in an industry or geographic location. Natural monopolies can arise in industries that require unique raw materials, technology, or similar factors to operate.

Key Takeaways

  • A natural monopoly is a type of monopoly that arises due to natural market forces.
  • A company with a natural monopoly might be the only provider or a product or service in an industry or geographic location.
  • Natural monopolies are allowed when a single company can supply a product or service at a lower cost than any potential competitor, but are often heavily regulated to protect consumers.

Understanding Natural Monopolies

A natural monopoly, as the name implies, becomes a monopoly over time due to market conditions and without any unfair business practices that might stifle competition. Some monopolies use tactics to gain an unfair advantage by using collusion, mergers, acquisitions, and hostile takeovers. Collusion might involve two rival competitors conspiring together to gain an unfair market advantage through coordinated price fixing or increases.

Instead, natural monopolies occur in two ways. First, is when a company takes advantage of an industry's high barriers to entry to create a "moat", or protective wall, around its business operations. The high barriers to entry are often due to the significant amount of capital or cash needed to purchase fixed assets, which are physical assets a company needs to operate. Manufacturing plants, specialized machinery, and equipment are all fixed assets that might prevent a new company from entering an industry due to their high costs.

The second is where producing at a large scale is so much more efficient than small scale production, that a single large producer is sufficient to satisfy all available market demand. Because their costs are higher, small scale producers can simply never compete with the larger, lower cost producer. In this case, the natural monopoly of the single large producer is also the most economically efficient way to produce the good in question. This kind of natural monopoly is not due to large scale fixed assets or investment, but, can be the result of the simple first mover advantage, increasing returns to centralizing information and decision making, or network effects

Why Natural Monopolies Are Allowed

Natural monopolies are allowed when a single company can supply a product or service at a lower cost than any potential competitor, and at a volume that can service an entire market. Since natural monopolies use an industry's limited resources efficiently to offer the lowest unit price to consumers, it is advantageous in many situations to have a natural monopoly.

For example, the utility industry is a natural monopoly. The utility monopolies provide water, sewer services, electricity, and energy such as natural gas and oil to cities and towns across the country. The start-up costs associated with establishing utility plants and the distribution of their products are substantial. As a result, the capital cost is a strong deterrent for potential competitors.

Also, society can benefit from having utilities as natural monopolies. Multiple utility companies wouldn't be feasible since there would need to be multiple distribution networks such as sewer lines, electricity poles, and water pipes for each competitor. Since it's economically sensible to have utilities operate as natural monopolies, governments allow them to exist. However, the industry is heavily regulated to ensure that consumers get fair pricing and proper services.

Another example of a natural monopoly is a railroad company. The railroad industry is government-sponsored, meaning their natural monopolies are allowed because it's more efficient and the public's best interest to help it flourish. Further, the industry can't support two or more major players given the unique resources needed, such as land for railroad tracks, train stations, and their high-cost structures. However, just because a company operates as a natural monopoly does not explicitly mean it is the only company in the industry. The company might have a monopoly in one region of the country. Cable companies, for example, are often regionally-based, although there has been consolidation in the industry creating national players.

More modern examples of natural monopolies include social media platforms, search engines, and online retailing. Companies such as Facebook, Google, and Amazon have built natural monopolies for various online services due in large part to first mover advantages, network effects, and natural economies of scale involved with handling large quantities of data and information. Unlike traditional utilities, these types of natural monopolies so far have gone virtually unregulated in most countries.

Important

A natural monopoly usually exists when it's efficient to have only one company or service provider in an industry or geographic location.

Regulating Natural Monopolies

Companies that have a natural monopoly may sometimes exploit the benefits by restricting the supply of a good, inflating prices, or by exerting their power in damaging ways other than though prices.

For example, a utility company might attempt to increase electricity rates to accumulate excessive profits to owners or executives. Or an internet service platform might use its monopoly power over information, online interactions, and commerce to exercise undue influence over what people can see, say, or sell online. Regulations over natural monopolies are often established to protect the public from any misuse by natural monopolies.

Under the common law many natural monopolies operate as common carriers, whose business is recognized as having risks of monopoly abuse but allowed to do business as long as they serve the public interest. Common carriers are typically required to allow open access to their services without restricting supply or discriminating among customers and in return are allowed to operate as monopolies and given protection from liability for potential misuse by customers. For example, landline telephone companies are required to offer households within their territory phone service without discriminating based on the manner or content of a person’s phone conversations and are in return generally not held liable if their customers abuse the service by making prank phone calls. 

In most cases of government-allowed natural monopolies, there are regulatory agencies in each region to serve as a watch-dog for the public. Utilities are typically regulated by the state-run departments of public utilities or public commissions. The U.S. Department of Transportation has broad responsibilities for the safety of travel for railroads while the U.S. Department of Energy is responsible for the oil and natural gas industries. So far no equivalent agencies in the U.S. have been empowered to similarly regulate tech and information monopolies, nor are they governed as common carriers, though this may be a trend in the future.