Natural Monopoly and How It Is Regulated

Why some industries are cheapest with a single supplier, and how governments regulate prices to protect consumers.

Usually, economists favour competition. But in some industries, one firm can supply the whole market more cheaply than several competing firms. This is called a natural monopoly.

Why it happens

Natural monopolies arise when fixed costs are very high and the cost of serving each extra customer is low. Building water pipes, electricity grids, railway tracks or gas networks costs enormous amounts. Once built, adding one more customer costs little. Two competing water companies laying separate pipes down every street would double the fixed cost without much benefit.

In these cases, average cost keeps falling as output rises across the whole market, so a single firm has the lowest cost.

The problem

A natural monopoly, left unregulated, could charge high prices, since customers have no alternative. It might also provide poor service.

Solutions

Governments use several approaches:

Public ownership: the government runs the service, as with many water and railway systems.
Price regulation: a private firm operates, but a regulator sets or caps prices.
Rate-of-return regulation: prices are set to let the firm cover costs and earn a fair return on investment.
Price-cap regulation: prices can rise by no more than inflation minus an efficiency factor, encouraging the firm to cut costs.
Separating networks from services: the network is run as a regulated monopoly, while services over it are opened to competition, as with electricity retailers or train operators using shared tracks.

In India, electricity tariffs are set by state electricity regulatory commissions, and telecom and airport charges have their own regulators.

The water utility

A city's water utility has built pipes, treatment plants and reservoirs. A second company offering competing pipes would need to rebuild everything, making water more expensive for everyone. So the city keeps one utility but has a regulator review its costs and approve its prices, aiming to cover costs fairly while preventing excessive charges.

Challenges

Regulators may lack information about true costs, and regulated firms may have weak incentives to be efficient. Technology can also change whether a natural monopoly exists; for example, mobile phones brought competition to telephone services once dominated by fixed-line monopolies.

Thinking all monopolies should be broken up

Breaking up a natural monopoly can raise costs by duplicating expensive networks. Regulation is often a better solution than forcing competition where one supplier is cheapest.

Key takeaways

A natural monopoly occurs when one firm can serve a market more cheaply than several.
High fixed costs and low costs per extra customer create natural monopolies.
Governments use public ownership or price regulation to protect consumers.
Technology can end natural monopolies, as mobile phones did for telephones.