Natural monopoly

Overview

What makes a market a natural monopoly, the cost conditions that produce one, and why competition would raise total cost.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a natural monopoly?

   Model answer

   A natural monopoly exists where a single firm can supply the whole market at a lower total cost than two or more firms could. It arises when fixed costs are very large relative to the size of the market and marginal costs are low, so average cost falls continuously over the entire range of output that buyers demand. Because the cost advantage grows with scale, whichever firm gets largest first can undercut the others, and the market tends towards a single supplier without any deliberate barrier being erected.

2. 2

   Why do very large fixed costs combined with low marginal costs produce a natural monopoly?

   Model answer

   The fixed cost must be spread over output, so average fixed cost falls continuously as output rises. If marginal cost is low and roughly constant, it does nothing to pull average cost back up, so average total cost keeps falling for as long as demand allows. There is no minimum efficient scale within the market, meaning the biggest producer always has the lowest unit cost. Splitting the output between firms means paying the huge fixed cost twice while each firm operates at a higher point on its average cost curve, which is why duplication raises total cost.

3. 3

   A firm supplying a network has total costs of TC = 60 + 10Q, in pounds. Show why it is cheaper for one firm to supply 15 units than for two firms to supply 7.5 units each.

   Model answer

   One firm producing 15 units incurs 60 + 150 = £210, an average cost of 210 ÷ 15 = £14 per unit. Two firms each producing 7.5 units incur 60 + 75 = £135 each, so total industry cost is £270 and average cost is 270 ÷ 15 = £18 per unit. Duplication therefore raises the cost of the same 15 units by £60, which is exactly the second firm's fixed cost, and raises the unit cost by £4. Since the two firms together produce nothing extra, that £60 is pure waste, which is the essence of a natural monopoly.

4. 4

   For a firm with total costs TC = 60 + 10Q, calculate average cost at 10, 15, 20 and 30 units and explain what the pattern shows.

   Model answer

   Average cost is 60 ÷ Q + 10. At 10 units it is 6 + 10 = £16; at 15 units, 4 + 10 = £14; at 20 units, 3 + 10 = £13; at 30 units, 2 + 10 = £12. Average cost falls continuously and never turns upward, because the £60 fixed cost is spread ever more thinly while marginal cost stays at a constant £10. Since there is no output at which average cost is minimised within the market, no efficient scale exists that several firms could each reach, and average cost lies above marginal cost at every output.

5. 5

   Describe the shape and position of the cost curves in a natural monopoly diagram.

   Model answer

   With quantity on the horizontal axis and price and cost in pounds on the vertical, the average cost curve slopes downwards continuously across the whole range of market demand, never reaching a minimum within it. The marginal cost curve lies below average cost throughout, because average cost is falling and only a marginal cost below the average can pull it down; where marginal cost is constant it is a horizontal line. The demand and average revenue curve slopes downwards and crosses the falling average cost curve, and marginal revenue lies below average revenue as in any monopoly. The crucial visual feature is that average cost is still falling where it meets demand.

6. 6

   Why does requiring a natural monopoly to price at marginal cost create a loss?

   Model answer

   Because average cost is falling throughout, marginal cost lies below average cost at every output. Setting price equal to marginal cost therefore sets it below average cost, so revenue per unit falls short of cost per unit and the firm makes a loss on every unit sold. The loss equals the gap between average cost and marginal cost multiplied by output; where marginal cost is constant, this is exactly the fixed cost that price is no longer contributing towards. The rule that delivers allocative efficiency is therefore incompatible with the firm covering its costs.

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