Natural Monopoly Theory

Natural monopoly theory analyses the circumstances in which a single firm can supply a market at lower cost than multiple firms, making competition inefficient. The theory provides a rationale for the regulation of industries such as utilities and for the design of the regulatory framework.

Concept

A natural monopoly arises when the cost structure of an industry is such that a single firm can produce the total output at lower average cost than two or more firms. The condition is that the average cost declines over the relevant range of output, which requires large fixed costs relative to the size of the market.

The classic examples are utilities, including the distribution of electricity and water, and the provision of telecommunications and rail services. These industries have high fixed costs, in the form of networks, and relatively low marginal costs.

Subadditivity

The formal condition for a natural monopoly is that the cost function is subadditive, meaning that it is cheaper to produce the total output in a single firm than to divide it among several. Subadditivity is a stronger condition than the presence of economies of scale, since it can hold even when the average cost is rising.

The analysis of subadditivity is used to determine whether an industry is a natural monopoly and to design the appropriate regulatory framework. The measurement requires estimates of the cost function of the industry.

Regulation

The regulation of natural monopolies addresses the problem that a single firm has the power to set prices above cost. The instruments include price caps, which limit the prices that the firm may charge, and rate-of-return regulation, which limits the return that the firm may earn.

The design of regulation must balance the objectives of efficiency and of cost recovery. A price equal to marginal cost would be efficient but would not allow the firm to recover its fixed costs, so that the firm would make losses. The efficient pricing of a natural monopoly therefore requires the use of two-part tariffs or of other mechanisms that allow cost recovery.

Challenges

The regulation of natural monopolies faces several challenges. The regulator has less information than the firm about its costs and its technology, and the firm has an incentive to overstate its costs. The design of regulation must address this asymmetry of information.

Technological change can also alter the nature of the industry. Improvements in technology may reduce the fixed costs and make competition feasible, as has occurred in telecommunications. The regulatory framework must adapt to these changes.

The regulation must also address the quality of service, since a firm that is subject to a price cap may reduce costs by lowering quality. The framework must include provisions to ensure that the quality is maintained.

Contestable Markets

The theory of contestable markets, developed by William Baumol and others, holds that the behaviour of firms in a market depends on the ease of entry and exit, not only on the number of firms. A market is contestable if entry and exit are costless, so that a potential entrant can enter, take the profits, and exit if the incumbent responds.

In a perfectly contestable market, even a single firm will price at the competitive level, since any attempt to raise the price would attract entry. The threat of entry disciplines the incumbent, and the outcome is efficient.

The theory has implications for the analysis of natural monopoly. It suggests that the regulation of a natural monopoly may not be necessary if the market is contestable, since the threat of entry would discipline the firm. In practice, however, markets are rarely perfectly contestable, since entry and exit involve costs.

Franchise Bidding

Franchise bidding is a mechanism for the provision of a natural monopoly in which the right to serve the market is auctioned. Firms compete for the franchise, and the winner is the firm that offers the best terms, typically the lowest price or the highest payment.

The mechanism can introduce competition for the market, even when competition in the market is not feasible. The design of the auction determines the outcome, and the terms of the franchise contract determine the behaviour of the winner.

The mechanism has been used for the provision of services including broadcasting, transport, and utilities. Its success depends on the design of the contract, on the enforcement of the terms, and on the ability of the authority to specify the service and to monitor the performance.

The Regulation of Quality

The regulation of natural monopolies must address the quality of service, since a firm that is subject to a price cap may reduce costs by lowering quality. The framework must include provisions to ensure that the quality is maintained.

The measures include the specification of the standards of service, the monitoring of performance, and the imposition of penalties for failure to meet the standards. The design of the measures must balance the objective of quality against the cost of providing it.

The regulation of quality is particularly important for services that are essential to the users, including the supply of water and of electricity. The framework must ensure that the services are provided reliably and at a reasonable cost.

Summary

Natural monopoly theory analyses the circumstances in which a single firm can supply a market at lower cost, and it provides a rationale for regulation. The theory of contestable markets, the use of franchise bidding, and the regulation of quality are central to the design of the framework for the provision of the services.

See also

• Market Failure
• Industrial Organization
• Competition Policy