Sample Page: Natural Monopoly
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- Define the monopoly market structure
- Describe two of the processes by which monopolies are created
- List three identifying features of a monopoly market structure
- Specify the role that governments play in creating some monopolies
- Draw two key curves that describe a monopoly's cost versus quantity
- Describe the key features of a natural monopoly
- List three examples of a natural monopoly
- Describe why the cost structure in a natural monopoly makes it "natural" for a single firm to dominate
Jodi Beggs explains the economic conditions that leads to a natural monopoly. Companies that have high fixed cost but low marginal cost have the advantage that as they produce more units, their average total cost declines rapidly. Companies like this can be so efficient that they become natural monopolies.
NATURAL MONOPOLY - KEY FEATURES
Monopolies may arise in some markets simply because it is more efficient to have one large producer than it is to have several smaller producers in a market. Companies in these types of markets are referred to as natural monopolies. Their cost structures are usually such that their fixed costs of production are large compared to the variable cost of serving one more customer. Therefore, large companies can undercut smaller competitors on price and push the smaller companies out of the market leaving a large company as the only firm in the market.
Some common examples of natural monopolies are electric utilities, phone and cable companies, since it is clearly inefficient in these industries to have several companies laying the infrastructure necessary to serve customers.
The key feature of a natural monopoly is that average cost continuously declines as the firm produces larger quantities of output. This happens because the marginal cost of production (simply the cost of each additional unit) is very low when compared to the upfront fixed costs of production. As the company produces more output, its costs get spread out over more units, resulting in this decrease in average cost.
This phenomenon is very important because it means that larger companies can produce at lower costs than smaller companies. Therefore, the larger companies can undercut the smaller competitors on price, causing the smaller competitors to exit the market and leave only one large competitor in the market as a monopoly.
Sometimes monopolies exist because of government legislation or a patent. A natural monopoly is different. In a natural monopoly, a firm dominates a competitive market often because they were first to market and gained an overwhelming cost advantage over competitors. Utilities, like electrical companies, are often natural monopolies.
NATURAL MONOPOLY: GOOGLE VERSUS UTILITIES
Dr. Ruebeck explores natural monopolies using electric utilities and Google as examples. Natural monopolies have high fixed costs and low marginal costs. At low units of production, the firm experiences very high unit costs. As production quantity increases, unit costs drop dramatically. If there were two firms competing in such situations, the average total cost for a competing firm increases dramatically because the market demand is shared by two firms. Natural monopolies are not imposed by government.
What is a natural monopoly? Does it mean that the government must provide a service? Does it mean that the government must do things to allow the service to be produced? Actually, what is key about a natural monopoly is the word "natural". It is natural for a monopoly to arise in a natural monopoly market structure.
In this video, we look at a few examples, including Google as a modern example, and an electricity company as a traditional example.There are two key features of a natural monopoly:
- High fixed cost
- Low marginal cost
The high fixed cost, such as a power generation plant or Google's computer server farm, means that at low units of production there is a very high cost per unit. The low marginal cost means that the average cost is falling for a very long time as quantity produced increases.
If we look at where the demand curve crosses the average total cost curve, we see that this very low average cost for one firm will become very high if two firms are producing instead of one. If we move that same demand curve for a single firm back halfway toward the price axis (now that two firms are producing half as much as one firm), the economic cost of each firm's production would be very inefficient. We can also see that it is natural for a single firm, that gains a foothold and is first-to-market, to have a huge advantage over any potential entrant.
Demand for one company in a monopoly results in a low average total cost.
So now let's review our examples. The first example was the electricity company that has a high fixed cost of setting up a power generation plant and distribution network to deliver electricity to each neighborhood, but a very low marginal cost of providing it to each house. It would be very hard for another firm to compete with the first electricity company. It would also be a very poor use of our resources to have those two firms competing.
Now let's think about our modern example of Google, with its very large cost of server farms, patents and other intellectual property, and the engineers, computer scientists and mathematicians who are working there. It is very expensive to start up a Google. Each additional customer and each additional search carries a very small cost. Therefore, it is very difficult for another firm to compete with Google, and we can see that it has been difficult for other search firms to compete with Google.
A key feature of a natural monopoly is that the firm's average cost continues to decline as the firm produces larger quantities. This happens because the marginal cost, or cost of producing each additional unit, is very low when compared to the firm's fixed costs of production. As the firm produces more, the fixed cost is spread out over more units causing the decrease in average cost. This permits a large company to offer lower prices than smaller competitors, thus creating, then protecting the natural monopoly.