Natural Monopoly

Updated on April 5, 2024
Article byKhalid Ahmed
Edited byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

Natural Monopoly Definition 

Natural monopoly refers to a market where only one firm/company has complete control over the production of goods or services owing to an excess capital requirement or high entry barrier for another potential competitor. The purpose of this market system is to use the resources efficiently for cost-effectiveness and efficiencies for the firms/companies. 

Natural Monopoly - Overview

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Natural Monopoly (wallstreetmojo.com)

It reduces the overall production cost and wastage of products by involving a single company instead of two or more companies. Most sectors developing natural resources like gas, petroleum, and railways benefit from this system. Hence, the government has to regulate companies under natural monopoly as there is no competition in this sector. 

Key Takeaways

  • A natural monopoly is a company’s monopoly due to large economies of scale and the highest barriers to entry for rivals, with the government acting as a price regulator.
  • The company’s profit, cost-effectiveness, and efficiency under this type of monopoly are due to a single company handling all aspects of the production of products and services. An example includes the power generation sector.
  • The supply-demand curve shows a declining slope for both the demand curve and the long-run average cost curve (LRAC).
  • The monopoly market has space for the existence of only one company, and hence, competitors find it difficult to enter the market. 

Natural Monopoly Explained

A natural monopoly is a form where only one company can efficiently and cost-effectively produce and distribute the products to the market on a large scale. As a result, there is no scope for the other entrants to get started in the market. New entrants will owe high capital costs and excessive barriers to entry like logistics, workforce, the scale of economies, and others. Moreover, monopolistic companies can produce and provide the goods at the most affordable price. Many other companies fail to enter this segment.

So, it is a monopoly where a single company captures the market with its lowest-priced product or service. One or more competing firms could not substitute this good or service. An example includes a tap water-providing company.

A natural monopoly becomes a monopoly because of the prevalent market conditions and not by any unfair practice. It is a rarity these days but is found in sectors dependent on natural resources like rivers, minerals, mountains, geographical locations, and physical locations. Hence, one can find the presence of a natural monopoly in these sectors that depend on the natural resources mentioned previously. Here are its most relevant sectors:

  • Railway transport
  • Highway construction
  • Waterways 
  • Telecom sector
  • Petroleum generation

Moreover, the companies functioning as monopolies must take utmost care in pursuing the most ethical business practices; otherwise, they could be legally sued and pave the way for their rivals to end their monopoly. Furthermore, suppose one makes a comparative study between the natural monopoly vs monopoly; in that case, one finds that a monopoly does not require an extremely large scale of economies, and its profits are not limited to a single firm servicing the major market portion.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Examples of Monopoly Explained in Video

 

Natural Monopoly Factors

Here are some factors of this monopoly:

  • This type of monopoly firm has to create an extremely high entry barrier for new rivals to keep themselves unique and insulated. As a result, its competitors will be stifled of resources and not succeed in entering the market. An example includes the railway sector. They have a first-mover advantage.
  • The second factor for a firm to be a monopoly is to become so large in resources, production of goods, and financially that it starts buying out its smaller competitors to eliminate any competition from the sector and keep the operating cost so low that smaller companies cannot compete in prices. Again, it mostly occurs in the airline sector, where larger airlines do not allow new small carriers to flourish. The firm caters to the whole market, obtains economies of scale, and generates demand for the goods.

In conclusion, one can say that a firm enjoying a monopoly has the best economies of scale where it can provide goods and services to satisfy customers’ needs and demands, operate most efficiently, and produce on a large scale to meet every demand at the lowest market price. As a result, there is no competition in their segment, and it flourishes. Natural monopoly regulation is under government control.

Graph

Here is a natural monopoly graph to understand the concept better:

Natural Monopoly graph

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Natural Monopoly (wallstreetmojo.com)

In the above natural monopoly graph, the firm practicing this monopoly will face a supply-demand sloping curve, and the long-run average cost curve (LRAC) will be the same. The figure above shows that the monopoly firm can enjoy the maximum profits by producing quantities between Q1 and Q2 of the graph. The demand curve slopes downwards from left to right, indicating a negative relationship between the costs and the quantity supplied. Competition would result in a wasteful duplication of resources and non-exploitation of economies of scale. 

Examples 

Here are natural monopoly examples to understand the concept better. 

Example #1

Railways are the best natural monopoly example. Railways require huge investment to start and operate, a large workforce to manage their operations, a great amount of power to run their wagon, and large factories to manufacture their wagons, signal systems, rail tracks, and underground cables. As a result, more than one company can’t get involved in the rail sector and provide the services efficiently and cheaply to the consumers. Therefore, it comes under the natural monopoly of the government sector, as in most countries. However, Amtrack, private railways operating company, exerts a monopoly over the train travel of long-distance journeys.

Example #2

Some latest examples include search engines, digital platforms, social media, and operating systems. Google is a type of natural monopoly as it is the most dominating search engine in the market. It has a market value of more than $1 trillion. 

It would be hard to raise the amount of capital to start a new search engine like Google. Moreover, the functions of this search engine surpass other systems. It collects data to tie and improve its search and ads business. Customers use it for free. It provides them with a wide range of choices. 

Example #3

Hydroelectric power generation is another perfect natural monopoly example. In almost all countries across the globe, electricity generation comes under the control of the government. It is so because the process of generation of electricity from river water requires huge investment, overhead costs, and workforce, both technical and non-technical, including labor, large turbines, long power cables, distribution infrastructure, the building of dams, and resettlement of displaced people affected from the dam for power generation.

All these factors are not possible for two or more companies to collaborate or individually accomplish to produce electricity as it may lead to confusion, loss of resources, and disagreements over project inception delay and execution of the project. Hence, it is mostly undertaken and accomplished by a single large government enterprise with full control over power generation and distribution single-handedly. Hence, the electricity generating company becomes a natural monopoly enterprise that deters other companies from the sector, and the high entry barriers prevent new entrants into this sector. In short, the utility industry is a natural monopoly.

Characteristics 

There are certain natural monopoly characteristics as discussed here. 

  1. They occur naturally in the free market as competitors are willingly or unwillingly unable to compete with them. Economic forces naturally prevent other companies from entering the market.
  2. Usually, this monopoly has the characteristic of a long-run average that is steeply declining. 
  3. They have curves of marginal costs that decline steeply too. 
  4. It is rational for one firm to supply the entire market. Competition is undesirable.
  5. As a result, the market has space only for one company to come forward to exert its monopoly through its completely exploited scale of economies and product supply in the market. 
  6. Economies of scale make the firms have a high fixed cost. They also have higher maintenance charges along with a prime initial fixed cost. As this cost is huge, these firms have to cater to the entire market.
  7. However, they have lower marginal costs to produce an extra unit of goods or services.
  8. Some companies can have a monopoly in a single country or a region and not necessarily on an international level.

Frequently Asked Questions (FAQs)  

What is a natural monopoly in economics?

In economics, a monopoly is naturally described as one arising out of a market situation with extremely high fixed costs or difficult to break entry barriers for startups related to special business or providing customer services. It is applicable for a market where it is beneficial to offer a product or service by a single company instead of multiple companies.

What is natural about a natural monopoly?

A natural monopoly is natural because it is only one most effective firm whose supply meets the demand efficiently in the entire market. Moreover, owing to the lowest priced product it can provide, irreplaceable by any other firm or multiple companies. An example includes the power industry. So even in a free market, competitors cannot compete efficiently.

Which firm is most likely to be a natural monopoly?

Firms with enormous fixed cost rates are natural monopolies because other firms can’t manage a very high cost. The former generates supply at a lower cost than two or more firms. So, the firms most likely to be a natural monopoly are the electricity grid, railway infrastructure, bus routes, gas network, tap/bottled water, and operating systems like Windows and Apple Mac.

Who may regulate a natural monopoly?

Since the market forces cannot regulate natural monopoly, the government regulates the price and the production quantity of the product of the natural monopoly company.

This has been a guide to What Natural Monopoly is and its definition. Here we discuss factors and characteristics of natural monopoly with a graph & examples. You can learn more from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *