Natural Monopoly — Hyunjoo Park

Definition

One firm can supply the relevant market at lower total cost than two or more firms. “Natural” = cost structure, not barriers, government protection or strategy.

Why: large fixed cost

$C(Q) = F + cQ$ → $AC = \frac{F}{Q} + c$ ( $F$ = fixed cost, $c$ = constant MC, AC = ATC) → more output spreads $F$ → AC falls (economies of scale)

MC never reaches AC only because MC is constant. With rising MC, ATC is U-shaped and MC crosses it at its minimum
Cost subadditivity (“less than the sum”): $C(Q) < C(q_1) + C(q_2)$ → the general test
MES (minimum efficient scale) = smallest output where a firm’s AC reaches its minimum. MES large vs market demand → one firm. Efficient firms ≈ demand ÷ MES (demand 10,000: MES 100 → many firms; MES 9,000 → one)
One firm today ≠ natural monopoly: the test is the cost structure

Pricing and policy

Option	Result
Unregulated: $MR = MC$	$P > MC$ → no allocative efficiency, supernormal profit
Force $P = MC$	allocative efficiency, but MC < AC → loss → shuts down unless a subsidy covers AC − MC
Regulate $P = AC$	$\pi = 0$ , still $P > MC$ ; AC still falling → not productively efficient. Two roots → regulator picks the larger q (lower P; the smaller one can be worse than no regulation)
Public ownership	possible, but often inefficient

Exam favourite: is a natural monopoly efficient?

Allocative: no, $P > MC$ → DWL
Productive: no, AC keeps falling over the whole market → its minimum lies beyond market demand → whatever $Q$ it serves, AC is not at its minimum
Policy for allocative efficiency: $P = MC$ + a subsidy covering AC − MC

Electricity

Transmission/distribution = natural monopoly; generation/retail can compete → Unbundling + regulation
Ventosa 2.4: regulated monopoly when (1) strong economies of scale (networks), (2) system too small or too concentrated, (3) authority’s choice. Unregulated → $P > MC$ + LR under-investment.

Links: Monopoly, Market Power, W1.2 Organization of the Electricity Sector