Natural monopoly

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In small countries like New Zealand, electricity transmission is a natural monopoly. Due to enormous fixed costs and small market size, one seller can serve the entire market at the downward-sloping section of its average cost curve, meaning that it will have lower average costs than any potential entrant. NIGU transmision line near Te Kauwhata.JPG
In small countries like New Zealand, electricity transmission is a natural monopoly. Due to enormous fixed costs and small market size, one seller can serve the entire market at the downward-sloping section of its average cost curve, meaning that it will have lower average costs than any potential entrant.

A natural monopoly is a monopoly in an industry in which high infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming advantage over potential competitors. Specifically, an industry is a natural monopoly if the total cost of one firm, producing the total output, is lower than the total cost of two or more firms producing the entire production. This frequently occurs in industries where capital costs predominate, creating large economies of scale about the size of the market; examples include public utilities such as water services, electricity, telecommunications, mail, etc. [1] Due to resource scarcity, economies of scale, and scope of economic benefits. Therefore, the probability that a company that provides a single product and service or a company that jointly provides most products and services will form a company (monopoly) or a minimal number of companies (oligopoly) is very probable. Natural monopolies were recognized as potential sources of market failure as early as the 19th century; John Stuart Mill advocated government regulation to make them serve the public good.

Contents

Definition

Two different types of cost are important in microeconomics: marginal cost , and fixed cost . The marginal cost is the cost to the company of serving one more customer. In an industry where a natural monopoly does not exist, the vast majority of industries, the marginal cost decreases with economies of scale, then increases as the company has growing pains (overworking its employees, bureaucracy, inefficiencies, etc.). Along with this, the average cost of its products decreases and increases. A natural monopoly has a very different cost structure. A natural monopoly has a high fixed cost for a product that does not depend on output, but its marginal cost of producing one more good is roughly constant, and small.

It is generally believed that there are two reasons for natural monopolies: one is economies of scale, and the other is economies of scope.

A graphical explanation of the inefficiencies of having several competitors in a naturally monopolistic market. Natural monopoly.jpg
A graphical explanation of the inefficiencies of having several competitors in a naturally monopolistic market.

All industries have costs associated with entering them. Often, a large portion of these costs is required for investment. Larger industries, like utilities, require an enormous initial investment. This barrier to entry reduces the number of possible entrants into the industry regardless of the earning of the corporations within. The production cost of an enterprise is not fixed, except for the effect of technology and other factors; even under the same conditions, the unit production cost of an enterprise can also tend to decrease with the increase in the total production output. The reason is that the actual product of the enterprise As it continues to expand, the original fixed costs are gradually diluted. This is particularly evident in companies with significant fixed-cost investments. Natural monopolies arise where the largest supplier in an industry, often the first supplier in a market, has an overwhelming cost advantage over other actual or potential competitors; this tends to be the case in industries where fixed costs predominate, creating economies of scale that are large in relation to the size of the market, as is the case in water and electricity services. The fixed cost of constructing a competing transmission network is so high, and the marginal cost of transmission for the incumbent so low, that it effectively bars potential competitors from the monopolist's market, acting as a nearly insurmountable barrier to entry into the market place.

A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment. This is where economies of scale become important. Since each firm has large initial costs, as the firm gains market share and increases its output the fixed cost (what they initially invested) is divided among a larger number of customers. Therefore, in industries with large initial investment requirements, average total cost declines as output increases over a much larger range of output levels.

In real life, companies produce or provide single goods and services but often diversify their operations. Suppose the cost of having multiple products by one enterprise is lower than making them separately by several enterprises. In that case, it indicates that there is an economy of scope. Since the unit product price of a company that produces a specific product alone is higher than the corresponding unit product price of a joint production company, the companies that make it separately will lose money. These companies will either withdraw from the production field or be merged, forming a monopoly. Situation. Therefore, well-known American economists Samuelson and Nordhaus pointed out that economies of scope can also produce natural monopolies. Theoretically speaking, the economy of content can explain the natural monopoly in the broad field of products.

Companies that take advantage of economies of scale often run into problems of bureaucracy; these factors interact to produce an "ideal" size for a company, at which the company's average cost of production is minimized. If that ideal size is large enough to supply the whole market, then that market is a natural monopoly.

Once a natural monopoly has been established because of the large initial cost and that, according to the rule of economies of scale, the larger corporation (to a point) has a lower average cost and therefore an advantage over its competitors. With this knowledge, no firms will attempt to enter the industry and an oligopoly or monopoly develops.

Formal definition

William Baumol (1977) [2] provides the current formal definition of a natural monopoly. He defines a natural monopoly as "[a]n industry in which multi-firm production is more costly than production by a monopoly" (p. 810). Baumol linked the definition to the mathematical concept of subadditivity; specifically, subadditivity of the cost function. Baumol also noted that for a firm producing a single product, scale economies were a sufficient condition but not a necessary condition to prove subadditivity, the argument can be illustrated as follows:

Proposition: Strict economies of scale are sufficient but not necessary for ray average cost to be strictly declining. [3]

Proposition: Strictly declining ray average cost implies strict ray subadditivity.

Proposition: Neither ray concavity nor ray average costs that decline everywhere are necessary for strict subadditivity.

Combining all propositions gives:

Proposition: Global scale economies are sufficient but not necessary for (strict) ray subadditivity, the condition for natural monopoly in the production of a single product or in any bundle of outputs produced in fixed proportions.

Multiproduct case

On the other hand if firms produce many products scale economies are neither sufficient nor necessary for subadditivity:

Proposition: Strict concavity of a cost function is not sufficient to guarantee subadditivity.

Therefore:

Proposition: Scale economies are neither necessary nor sufficient for subadditivity.

Mathematical Notation of Subadditivity

A cost function c is subadditive at an output x if such that , with all x being non-negative. In other words, if all companies have the same production cost function, the one with the better technology should monopolize the entire market such that the total cost is minimized, thus causing natural monopoly due to its technological advantage or condition.

Examples

  1. Railways:
    The costs of laying tracks and building networks coupled with that of buying or leasing the trains prohibits or deters the entry of any competitor. Rail transport also fits other characteristics of a natural monopoly because it is assumed to be an industry with significant long run economies of scale.
  2. Telecommunications and Utilities:
    The costs of building telecommunication poles and growing a cell network would just be too exhausting for other competitors to exist. Electricity requires grids and cables whilst water services and gas both require pipelines whose costs are just too high to be able to have existing competitors in the public market. However, natural monopolies are usually regulated and they face increasing competition from private networks and specialty carriers.

History

The development of the concept of natural monopoly is often attributed to John Stuart Mill, who (writing before the marginalist revolution) believed that prices would reflect the costs of production in absence of an artificial or natural monopoly. [4] In Principles of Political Economy Mill criticised Smith's neglect [5] of an area that could explain wage disparity (the term itself was already in use in Smith's times, but with a slightly different meaning). Taking up the examples of professionals such as jewellers, physicians and lawyers, he said, [6]

The superiority of reward is not here the consequence of competition, but of its absence: not a compensation for disadvantages inherent in the employment, but an extra advantage; a kind of monopoly price, the effect not of a legal, but of what has been termed a natural monopoly... independently of... artificial monopolies [i.e. grants by government], there is a natural monopoly in favour of skilled labourers against the unskilled, which makes the difference of reward exceed, sometimes in a manifold proportion, what is sufficient merely to equalize their advantages.

Mill's initial use of the term concerned natural abilities. In contrast, common contemporary usage refers solely to market failure in a particular type of industry such as rail, post or electricity. Mill's development of the idea that 'what is true of labour, is true of capital'. [7] He continues;

All the natural monopolies (meaning thereby those which are created by circumstances, and not by law) which produce or aggravate the disparities in the remuneration of different kinds of labour, operate similarly between different employments of capital. If a business can only be advantageously carried on by a large capital, this in most countries limits so narrowly the class of persons who can enter into the employment, that they are enabled to keep their rate of profit above the general level. A trade may also, from the nature of the case, be confined to so few hands, that profits may admit of being kept up by a combination among the dealers. It is well known that even among so numerous a body as the London booksellers, this sort of combination long continued to exist. I have already mentioned the case of the gas and water companies.

Mill also applied the term to land, which can manifest a natural monopoly by virtue of it being the only land with a particular mineral, etc. [8] Furthermore, Mill referred to network industries, such as electricity and water supply, roads, rail and canals, as "practical monopolies", where "it is the part of the government, either to subject the business to reasonable conditions for the general advantage or to retain such power over it, that the profits of the monopoly may at least be obtained for the public." [9] [10] So, a legal prohibition against non-government competitors is often advocated. Whereby the rates are not left to the market but are regulated by the government; maximising profits, and subsequently societal reinvestment.

For a discussion of the historical origins of the term 'natural monopoly' see Mosca. [11]

Regulation

As with all monopolies, a monopolist that has gained its position through natural monopoly effects may engage in behaviour that abuses its market position. In cases where exploitation occurs, it often leads to calls from consumers for government regulation. Government regulation may also come about at the request of a business hoping to enter a market otherwise dominated by a natural monopoly.

Common arguments in favour of regulation include the desire to limit a company's potentially abusive [12] or unfair market power, facilitate competition, promote investment or system expansion, or stabilise markets. This is especially true in the case of essential utilities like electricity where a monopoly creates a captive market for a product few can refuse. In general, though, regulation occurs when the government believes that the operator, left to his own devices, would behave in a way that is contrary to the public interest. [13] In some countries an early solution to this perceived problem was government provision of, for example, a utility service. Enabling a monopolistic company with the ability to change prices without regulation can have devastating effects in society. Ramifications of which can be displayed in Bolivia’s 2000 Cochabamba protests. [14] A situation whereby a firm with a monopoly on the supply of water, excessively increased water rates to fund a dam; leaving many unable to afford the essential good.

History

A wave of nationalisation across Europe after World War II created state-owned companies in each of these areas, many of which operate internationally bidding on utility contracts in other countries. However, this approach can raise its own problems. In the past, some governments have used the state-provided utility services as a source of cash flow for funding other government activities, or as a means of obtaining hard currency. As a result, governments seeking funding began to seek other solutions, namely regulation and providing services on a commercial basis, often through private participation. [15]

In recent years, bodies of information have observed the correlation between utility subsidies and welfare improvements. [16] Today, across the world, Public utilities are widely used to provide state-run water, electricity, gas, telecommunications, mass-transportation and postal services.

Alternative regulation

Alternatives to a state-owned response to natural monopolies include both open source licensed technology and co-operatives management where a monopoly's users or workers own the monopoly. For instance, the web's open-source architecture has both stimulated massive growth and avoided a single company controlling the entire market. The Depository Trust and Clearing Corporation is an American co-op that provides the majority of clearing and financial settlement across the securities industry ensuring they cannot abuse their market position to raise costs. In recent years a combined cooperative and open-source alternative to emergent web monopolies has been proposed, a Platform coop, [17] where, for instance, Uber could be a driver-owned cooperative developing and sharing open-source software. [18]

See also

Related Research Articles

Economies of scale Cost advantages obtained via scale of operation

In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced. A decrease in cost per unit of output enables an increase in scale. At the basis of economies of scale there may be technical, statistical, organizational or related factors to the degree of market control.

Microeconomics Behavior of individuals and firms

Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as whole, which is studied in macroeconomics.

A monopoly is as described by Irving Fisher, a market with the "absence of competition", creating a situation where a specific person or enterprise is the only supplier of a particular thing. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly and duopoly which consists of a few sellers dominating a market. Monopolies are thus characterized by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process by which a company gains the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant market power, that is, the power to charge overly high prices, which is associated with a decrease in social surplus. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A small business may still have the power to raise prices in a small industry.

Monopolistic competition Imperfect competition of differentiated products that are not perfect substitutes

Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. If this happens in the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition. Further work on monopolistic competition was undertaken by Dixit and Stiglitz who created the Dixit-Stiglitz model which has proved applicable used in the sub fields of international trade theory, macroeconomics and economic geography.

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market, resulting in market failure.

Public utility Organization which maintains the infrastructure for a public service

A public utility company is an organization that maintains the infrastructure for a public service. Public utilities are subject to forms of public control and regulation ranging from local community-based groups to statewide government monopolies.

Economies of scope are "efficiencies formed by variety, not volume". In economics, "economies" is synonymous with cost savings and "scope" is synonymous with broadening production/services through diversified products. Economies of scope is an economic theory stating that average total cost of production decrease as a result of increasing the number of different goods produced. For example, a gas station that sells gasoline can sell soda, milk, baked goods, etc. through their customer service representatives and thus gasoline companies achieve economies of scope.

The following outline is provided as an overview of and topical guide to industrial organization:

In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have not had to incur. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies and oligopolies, or give companies market power.

Monopoly profit is an inflated level of profit due to the monopolistic practices of an enterprise.

In economics, average cost or unit cost is equal to total cost (TC) divided by the number of units of a good produced :

In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, held that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibrium because of the existence of potential short-term entrants.

Free entry

In economics, free entry is a condition in which firms can freely enter the market for an economic good by establishing production and beginning to sell the product. The assumption of free entry implies that if there are firms earning excessively high profits in a given industry, new firms that also seek a high profit are likely to start to produce or change into a production of the same good to join the market. In such a case there are no barriers preventing a start-up firm from competing. Where an opportunity of a profit arises we assume that there will also be firms entering the market for the certain good and compete for it. In most markets this condition is present only in the long run.

Competition (economics) Rivalry between firms; ability of companies to take each others market share in a given market

In economics, competition is a scenario where different economic firms are in contention to obtain goods that are limited by varying the elements of the marketing mix: price, product, promotion and place. In classical economic thought, competition causes commercial firms to develop new products, services and technologies, which would give consumers greater selection and better products. The greater the selection of a good is in the market, prices are typically lower for the products, compared to what the price would be if there was no competition (monopoly) or little competition (oligopoly). According to Antoine Augustin Cournot, the definition of competition is the situation in which price does not vary with quantity, or in which the demand curve facing the firm is horizontal. The level of competition that exists within the market is dependent on a variety of factors both on the firm/ seller side; the number of firms, barriers to entry, information, and availability/ accessibility of resources. The number of buyers within the market also factors into competition with each buyer having a willingness to pay, influencing overall demand for the product in the market.

Rate-of-return regulation is a system for setting the prices charged by government-regulated monopolies, such as public utilities. Its main premise is that monopolies must charge the same price that would ideally prevail in a perfectly competitive market, equal to the efficient costs of production, plus a market-determined rate of return on capital.

Minimum efficient scale

In industrial organization, the minimum efficient scale (MES) or efficient scale of production is the lowest point where the plant can produce such that its long run average costs are minimized. It is also the point at which the firm can achieve necessary economies of scale for it to compete effectively within the market.

In economics, a government-granted monopoly and the monopoly to be served under government is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service; potential competitors are excluded from the market by law, regulation, or other mechanisms of government enforcement. As a form of coercive monopoly, government-granted monopoly is contrasted with a coercive monopoly or an efficiency monopoly, where there is no competition but it is not forcibly excluded.

Socially optimal firm size

The socially optimal firm size is the size for a company in a given industry at a given time which results in the lowest production costs per unit of output.

History of microeconomics

Microeconomics is the study of the behaviour of individuals and small impacting organisations in making decisions on the allocation of limited resources. The modern field of microeconomics arose as an effort of neoclassical economics school of thought to put economic ideas into mathematical mode.

References

  1. Perloff, J, 2012. Microeconomics, Pearson Education, England, p. 394.
  2. Baumol, William J., 1977. "On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry", American Economic Review 67, 809–22.
  3. W. J. Baumol, 1976. "Scale Economies, Average Cost and the Profitability of Marginal-Cost Pricing"
  4. Principles of Political Economy , Book IV 'Influence of the progress of society on production and distribution', Chapter 2 'Influence of the Progress of Industry and Population on Values and Prices', para. 2
  5. Wealth of Nations (1776) Book I, Chapter 10
  6. Principles of Political Economy Book II, Chapter XIV 'Of the Differences of Wages in different Employments', para. 13-4
  7. Principles of Political Economy Book II, Chapter XV, 'Of Profits', para. 9
  8. Principles of Political Economy , Book II, Chapter XVI, "Of Rent", para. 2 and 16
  9. Principles of Political Economy , Book V, 'Of the Grounds and Limits of the Laisser-faire or Non-Interference Principle'
  10. On subways, see also, McEachern, Willam A. (2005). Economics: A Contemporary Introduction. Thomson South-Western. p. 319.
  11. Mosca, Manuela (2008). "On the origins of the concept of natural monopoly: Economies of scale and competition". The European Journal of the History of Economic Thought. 15 (2): 317–353. doi:10.1080/09672560802037623. S2CID   154480729.
  12. Saidu, Balkisu (8 May 2009). "Regulating the Abuse of the Natural Monopoly of Pipelines in the Gas Industry vis-à-vis the Provision of Third Party Access". The Journal of Structured Finance. 13 (4): 105–112. doi:10.3905/jsf.13.4.105. S2CID   153866300.
  13. Natural Monopoly [ dead link ]
  14. Olivera, Oscar (2004). Cochabamba! : water war in Bolivia. Cambridge, Mass.: South End Press. ISBN   978-0-896-08702-6.
  15. Body of Knowledge on Infrastructure Regulation "General Concepts: Introduction."
  16. Water, Electricity, and the Poor: Who Benefits from Utility Subsidies?. Washington, DC: World Bank. 2005. ISBN   978-0-8213-6342-3.
  17. "Archived copy". Archived from the original on 2016-02-05. Retrieved 2016-01-30.{{cite web}}: CS1 maint: archived copy as title (link)
  18. "What might a Coop Uber look like? (or should we be thinking bigger)? - Hello Ideas".

Further reading