Chapter 12.1 Natural Monopoly

At polar opposite to the perfectly competitive market we have monopoly. A firm operates in a monopoly when it’s the only seller of a product in that market. It’s actually somewhat difficult to identify a pure monopoly as well. The best example of a market with a single firm operating might be utilities like water, power, and gas, but these actually behave differently from a standard monopoly for an important reason. I’ll defer the explanation to later in this section but the quick version is that utilities are considered to be natural monopolies—a particular cost structure with a really large fixed cost of operating in the first place but near zero marginal cost of adding an additional consumer—and under these circumstances competition is actually bad for everyone!

Despite the fact that it’s difficult to identify pure monopolies and the fact that the best examples of pure monopolies have different features from what we normally consider a monopoly to have, it’s useful to study this market structure because we can extend our reasoning to cases where markets operate as if run by a monopoly. An example would be a small town with only a single restaurant, a McDonald’s. Typically we don’t think of McDonald’s as a monopoly because there’s so many other options for fast food. But in a small town the next closest town and next closest restaurant could be miles away—so far that in reality people aren’t going to travel that distance just to avoid the local monopoly. That’s a larger problem in small towns with only one grocery or convenience store.

Geographical barriers are not the only ways we can set aside a single firm as a monopoly. Take for example a person’s internet or data plan. Maybe your options in a given area include internet providers like Xfinity and AT&T as well as cellular based internet options like T-Mobile. If you’re lucky maybe you also have Google Fiber or Verizon Fios or maybe there’s some other fiber optics/high speed options. In any case if you’ve built a new house or moved to a new location you have a choice to make—and the market is often not a monopoly. In the hypothetical arrangement of firms I’ve just suggested we’d probably consider the market to be an oligopoly. That’s where there’s a collection of firms, each of which could have been a monopoly in its own right. Now suppose you’ve already signed a contract and set up your internet service: At this point the firm you’ve selected has some degree of monopoly power over you. Sure, yes, there’s still all the other options—but you’d initially judged them as worse than the one you went with—and there’s a massive time cost associated with switching service. As a result despite the presence of rivals, the firm you’re currently with has at least some monopoly power.

Next we consider monopoly prices. A monopoly wants to produce the output that brings its marginal cost equal to the marginal revenue, MR=MC.

Natural monopoly:

It’s best to think of natural monopoly as a specific cost structure. This is a circumstance where the market is more efficient when served by a single firm. Counterintuitively, competition leads to inefficiency! That’s because:

1.) A large fixed cost of operating

2.) A near zero marginal cost of adding an additional consumer

This is generally industries with:

1.) Economics of scale: this means that the average cost falls as output rises

2.) Increasing returns to scale: this means that if you increase the amount of inputs, the level of output produced will more than proportionally increase (‘double the inputs yields more than

double the output’)

Basically the inefficiency is due to:

1.) Inefficient duplication of infrastructure

2.) Competing firms siphon off the demand necessary to recoup that large fixed cost of operating

Examples:

Utilities like power, gas, and water

U.S. Postal Service (1st class letter delivery)??