What Is a Natural Monopoly

Monopoly in general terms means the ability of a single to meet the total demand of the market. Natural monopoly refers to a situation where a single firm meets the total demand of a product or service because of certain cost advantages that would occur only when a single firm takes it up. This means that if the production of that product or service is taken up by more than one firm then the cost of production would be very high and the revenues generated may lower down.

The cost refers to fixed cost and variable cost. The fixed cost is high in such firms irrespective of the output. The variable cost refers to the cost that depends on the number of units produced. With an increase in the production the average cost per unit will come down drastically. This advantage is called the economies of scale.

The concept of economies of scale is used in the natural monopoly market. When there is a single firm serving the entire demand, the production becomes high. Due to this the average cost comes down. With this the firm can ensure higher revenue. The cost of including a new or an additional customer will also not be too high.

The natural monopoly stays as a monopoly because no other competitor or prospective competitor can set up the similar production or service. This is because natural monopoly is characterized by a high fixed cost which means a high initial investment. No prospective competitor would take the risk of the high investment. When the monopolist has his customers fixed the chances of the new customer coming to the competitor becomes very bleak.

As already known the natural monopoly can occur only in the industries where the ratio of the fixed cost and the variable is very high. Hence it is mostly associated with the utilities. In the past only water and telephone industry enjoyed natural monopoly. With time many more utilities have been enjoying natural monopolies and making higher revenues. These utilities include electricity, gas pipelines, water supply and other public utilities.

The reason behind this can be explained with the example. Let us consider the electricity supply. The transmission networks that have to be built for any of the public utilities for that matter will cost a lot. These can be set up just once. This acts as a barrier for other entrants. This initial cost will not increase with increase in the number of customers. In case of these public utilities the government also wants the natural monopoly to be present so that the customers get the best service at the best prices.