- What is a Natural Monopoly?
- How Does a Natural Monopoly Work?
- What are the Characteristics of Natural Monopoly?
- Natural Monopoly vs. Monopoly: What is the Difference?
- What Causes a Natural Monopoly in Economics?
- What are Examples of Natural Monopolies?
- Governmental Intervention in Natural Monopolies (Antitrust Regulation)
- Social Media, Search Engine and eCommerce Markets
- Natural Monopoly Example: Public Utilities Industry
What is a Natural Monopoly?
A Natural Monopoly occurs when a single company can produce and offer to sell a product or service at a lower cost than its competitors can, resulting in practically no competition in the market.
The emergence of a natural monopoly is rarely from ownership of proprietary technology, patents, intellectual property, and related assets, nor is it from unfair business practices or unethical corporate behavior prone to anti-trust regulations.
Instead, the company – deemed a “natural monopolist” – possesses a long-term competitive advantage, i.e. economic moat, that exists due to the market’s high fixed costs of distribution for production and a greater need for scale for its business model to be sustainable over the long run.
How Does a Natural Monopoly Work?
In economics, a market characterized as a “natural monopoly” will be characterized by a single company that can operate more efficiently than the rest of the entire market.
Efficiency in this particular context is in reference to a significant cost advantage in which a particular company is capable of producing a product or service for much less, enabling it to benefit from higher profit margins than its competitors.
In order for any new entrant to become profitable, production must be done on a large enough scale, i.e. the minimum consumer demand in the market is set much higher.
Practically all natural monopolies will share one common trait, which is a high fixed cost structure.
In effect, it is impractical for the industry to have more competitors attempt to sell the same product or service, which is the reason for the lack of competition.
More specifically, the market is unfavorable to enter from an economic standpoint because it’ll likely take decades and a large monetary investment for the new entrant to develop a noticeable presence in the market.
What are the Characteristics of Natural Monopoly?
The most common characteristics of a natural monopoly are the following:
- High Fixed Costs
- High Minimum Efficient Scale (MES)
- High Barriers to Entry
- No Competition (or Very Limited)
Simply put, the natural monopolist can meet the demand of the entire market at a lower cost than multiple firms, i.e. more cost efficiency.
If multiple companies were to enter the market, due to the high cost of entry, their average prices would actually exceed current pricing levels and not be competitive with that of the natural monopolist.
Learn More → Natural Monopoly Glossary Term (OECD)
Natural Monopoly vs. Monopoly: What is the Difference?
The formation of other types of monopolies, such as a pure or artificial monopoly – in contrast to a natural monopoly – is attributable to an “unfair” advantage.
The aforementioned advantage could be the possession of proprietary technology, patents and intellectual property (IP) that fend off competitors and enables the market leader to provide substantially more value to the end markets served while restricting market competition, i.e. the target customers, while its competitors are left trailing far behind.
News regarding the existence of a monopoly tends to spread quickly and receive unwanted attention from consumers and regulatory bodies. Because the company with significant market share can set prices based on their own discretion as opposed to letting prices be determined by the natural supply and demand market forces (and a “healthy” amount of competition in the market), the government and relevant regulators may view the company as a threat to society.
The issue here, however, is that a company labeled as a monopoly can be unfairly targeted and receive negative press without performing any unfair business practices or acts that warrant anti-trust regulations or widespread criticism from the public.
The negative perception of a monopoly stems from the fact that a single company with majority control of an entire industry (or sector) in terms of market share creates the risk of predatory pricing.
In markets considered a monopoly, there is centralized control by either one or a handful of companies (i.e. there is a threat of collusion), while consumers possess less choice and are forced to accept market prices due to the lack of competition.
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Enroll TodayWhat Causes a Natural Monopoly in Economics?
The most common type of natural monopoly is a byproduct of high initial costs to enter the market.
Certain markets can be viewed as prone to disruption with numerous issues that could be “fixed” from the perspective of startups. Yet the existing incumbents continue to operate with significant share with minimal risk of disruption because early-stage companies lack the funds to even enter the market – let alone, compete with the market leader(s) and take their market share.
In general, the formation of natural monopolies is from economies of scale, economies of scope, or a blend of the two.
- Economies of Scale → Economies of scale describes the concept wherein the average costs per unit of output decline with the production and sale of each incremental unit, i.e. more output = more profits.
- Economies of Scope → On the other hand, economies of scope refers to the scenario where the unit cost of production declines from more variety in the products offered. The production of different yet still adjacent goods can cause the total cost to decline.
As production output increases, the average cost of supply declines in tandem from the expanded scale, benefiting the profitability of the natural monopolist and contributing to its competitive advantage.
There is a high risk of failure when attempting to disrupt a traditional market with a decent amount of competition.
Thus, attempting to disrupt a market categorized as a natural monopoly is even riskier with an even greater probability of failure. Not to mention, there is a significant upfront cash outlay to even have a chance. While fundraising in the private markets can be quite cyclical, a startup raising sufficient capital here even in a bull market with inflated valuations can struggle to obtain adequate funds to meaningfully enter the market.
What are Examples of Natural Monopolies?
Some examples of industries considered to be natural monopolies include:
- Telecommunications (Telecoms)
- Utilities and Energy Sector (Electric Power Supply and Grids)
- Oil and Gas (O&G)
- Railway and Subway Transportation
- Waste Sewers and Waste Management
- Aircraft Manufacturing (Aviation)
The pattern evident in all the industries listed above is that most of them offer a product or service necessary to society as a whole and would all be considered capital intensive.
The current position of these companies is the result of decades of work, making it an even more challenging problem for the government to tackle.
But note that while the formal definition of a natural monopoly according to academic economics textbooks states that a market is controlled by a single firm with no competition – in reality, there are a handful of other, albeit much smaller, rival competitors in the market.
Governmental Intervention in Natural Monopolies (Antitrust Regulation)
While not all natural monopolies have a net negative impact on a market, the government still tends to step in and intervene to some extent.
Of course, the intervention is rarely as aggressive as with other types of monopolies where companies such as Meta Platforms have historically been fined billions in total by foreign governments for unfair business practices as part of anti-trust regulations.
For natural monopolies, it would be unfair to immediately assume the company is taking advantage of consumers.
The fact of the matter, however, is that natural monopolists have the option to pursue predatory practices, which represents a risk to the government.
But regulatory bodies must be careful because the absence of competition means there is widespread reliance by consumers on the monopoly, so unfairly penalizing them could worsen the problem (or create a problem for consumers that wasn’t apparent in the first place until the government decided to intervene).
As a result of these market dynamics, the government must work with these natural monopolists to ensure they are kept in check and the companies do not exploit their favorable market position.
Meta Platforms GDPR Fine (Source: EDPB)
Social Media, Search Engine and eCommerce Markets
Technically, companies like Meta (formerly Facebook), Google and Amazon grew to prominence as natural monopolies in their respective markets, or at least in their initial days.
- Facebook (Meta) → Social Media
- Google → Search Engine
- Amazon → eCommerce
The treatment received from regulatory bodies tends to be much harsher because of the fact that there are other issues, namely with data collection, and since these services are not necessarily “required,” per se.
Therefore, any sort of action that resembles anti-competitive behavior such as an acquisition would immediately be met with regulatory scrutiny, particularly for Facebook, which most would agree did engage in predatory behavior such as M&A and copying competitors’ product features to intentionally reduce the level of competition.
While certain economists argue the treatment was unfair, others can counter such claims by stating that these leading technology companies like Facebook, Amazon, and Google are artificial monopolies, instead.
Regardless, it is undeniable that these companies grew to become the most valuable companies in the world because they offered a product or service that was unmatched by the rest of the market, especially in the case of Google and Amazon.
In fact, Amazon (AMZN) led the global shift towards eCommerce and by far remains the most dominant company in the space today, and established offerings such as two-day shipping as the norm for consumer expectations.
Irrespective of the value provided to consumers, consumers and the government – e.g. politicians in particular – appeared to have taken aim at Amazon as a whole and seek areas of its business to publicly criticize, as demonstrated by the stories about the company’s working conditions and criticism of the company’s use of tax incentives.
Amazon’s planned move to NY received such scrutiny that the eCommerce company even decided to move in a different direction.
Regardless if one agrees that the tax incentives offered to Amazon were justified, one could argue that the trade-off was worthwhile considering the number of jobs it would have created in New York, the long-term benefits to the state’s economy, and allowing the state to reestablish its reputation as an innovative “tech hub”.
Amazon NYC HQ Retreat (Source: Bloomberg)
Natural Monopoly Example: Public Utilities Industry
Natural monopolies tend to be common in markets offering “essential” goods and services, such as with public utilities.
The infrastructure to deliver electricity, gas, water and related goods is not only costly to build initially, but the maintenance is also expensive.
Contrary to a common misconception, a natural monopoly can be unprofitable. In fact, most of these companies exhibit low profit margins because of how capital intensive their operations are.
If a utility company is on cusp of collapse, the government will likely intervene and help it continue to function, reflecting how natural monopolies can often provide an essential service and have the required infrastructure to deliver a good or service critical to society that others cannot.
