A monopoly exists when a single provider serves the entire market demand. Even though there are several concepts of natural monopoly, they possess a common thread, namely, that rivalry in a particular market cannot be sustained and perhaps is even inefficient.
One idea of natural monopoly is that in some situations competition self-destructs, resulting in a single firm supplying the entire market demand. This idea led to the cost-based definition of natural monopoly, which states that a firm is a natural monopoly if it is able to serve the entire market demand at a lower cost than any combination of two or more smaller, more specialized firms. If the monopoly firm serves a single market, then economies of scale are sufficient for the firm to be a natural monopoly, although other cost characteristics may also result in a single-product firm being considered a natural monopoly. Economies of scale imply that the firm’s average cost declines as the firm increases output. If the firm is a monopoly in several markets, more complex cost concepts, such as economies of scope and cost subadditivity come into play. Economies of scope exist when it is less costly for a single firm to provide two or more products jointly than for multiple firms to provide the products separately. Cost subadditivity exists when a single firm is able to satisfy the entire market demand(s) for its product(s) at a lower cost than two or more smaller, more specialized firms.2 The most recent definition of natural monopoly states that a firm is a natural monopoly in a market if no more than one firm can serve the market and receive non-negative profits.
Operators providing utility services have certain cost characteristics that sometimes make some portion of their service a natural monopoly or at least make competition difficult to sustain at any appreciable level.3 For example, operators tend to have high capital costs relative to firms in other sectors. Sometimes capital costs constitute a sunk cost, which means the cost is unrecoverable if the operator decides to exit the market. Sunk costs are a barrier to entry, which means that they make it less likely for firms to enter the market. Some portion of the utility operations may also have high fixed costs, which are costs that do not vary with the output of the firm. High fixed costs can lead to economies of scale, which may lead to natural monopoly.
If an operator in a market is a natural monopoly – in the sense that a single firm can serve the entire market demand at a lower cost than two or more smaller firms – then the operator cannot recover all of its costs if its prices are set at incremental cost. Left unregulated and without a threat of government intervention, a profit maximizing monopoly operator would limit output to receive monopoly profits, which results in what economists call a deadweight loss. If the natural monopoly operator were regulated, the regulator would need to allow prices to exceed incremental cost for the operator to be commercially viable.
If a firm has economies of scale, economies of scope, or both, it may be difficult to develop prices that encourage allocative efficiency. Allocative efficiency means that the optimal mix of outputs is provided. This form of economic efficiency is said to exist when the price that customers pay for each product is equal to that product’s marginal cost. Marginal cost is the cost of increasing output by one unit. Setting prices equal to marginal cost is difficult when there are economies of scale because such prices would not result in sufficient revenue to cover the firm’s total cost.
Likewise, with economies of scope, if prices for each product cover only the incremental cost of producing that product, the firm would not receive sufficient revenue to cover its common costs. Incremental cost in this context is the additional cost of producing the entire amount of a product, given that the firm is already producing all of his other products. Common costs in this context are the costs that are necessary for the firm to produce its n products, but that are unaffected by the dropping up to n – 1 of its products.4 Tariff Design examines possible solutions to this pricing problem.
Even if the operator is not a monopoly, it may not be subject to significant competitive pressure. In this situation, the firm is said to have market power or significant market power because the firm is able to receive profits above its cost of capital by limiting output. Profits in this context refer to the income left after all input suppliers and taxes have been paid. The cost of capital includes both the cost of equity, which is the rate of return that shareholders must be paid for them to continue to supply equity capital for the firm, and the cost of long term debt. The profit left over after the operator has paid interest on its long term debt is called the return on equity. The difference between the return on equity and the cost of equity is called economic profit. A firm with market power can receive economic profits because the firm can limit output below a competitive level, which causes prices to rise.
Regulators have several tools available for detecting market power, such as the Herfindahl-Hirschman Index (HHI), the Lerner Index, watching for collusive activities, and assessing barriers to entry. The HHI is an index of the number of firms in the market and their market shares. The Lerner Index measures the degree to which prices exceed marginal cost. Collusive activities include fixing prices and dividing markets. Barriers to entry include sunk costs, switching costs, restricted access to essential facilities, and anticompetitive practices. Switching costs exist when it costs more for a customer to change to a competitive supplier than it does to stay with the customer’s existing supplier. Essential facilities are elements of the utility system, such as electricity distribution lines that are needed to provide the utility service and that are uneconomical for a rival to supply for itself. Anticompetitive practices are activities that a dominant firm may engage in to drive rivals from the market.5
- Monopoly and Market Power provides references for this topic.
- Although technically complex, cost subadditivity is the key to identifying natural monopolies under the cost-based view.
- A utility network is a distribution system over which the utility service is provided. In the case of water, electricity and gas, the service includes a commodity that is supplied over the network. The network is the system of pipes that carry the water or natural gas, or the system of wires that transmit the electricity. In the case of telecommunications, the service is primarily the use of the network, which may consist of switches, routers, wires, and radio transmitters and receivers. The cost structure of a utility service provider generally consists of fixed costs, capacity costs, and usage costs. Fixed costs are often high. There may also be externalities. Environmental pollution from power production is an example of a negative externality. When a person or business subscribes to telecommunications service, the new subscriber provides a positive externality to the other subscribers who can now call this person or business.
- Other definitions for incremental cost and common cost exist, so the reader needs to always be aware of the context and use of the terms to ensure that the reader understands how they are being used.
- Regulation of Marker Structure vs. Regulation of Conduct of Foundations of Regulation and the reference sections on Institutional Design Issues and Stakeholder Relations examine the regulator’s relationships with other government authorities, including the competition authority.