Natural Monopoly

What Causes a Natural Monopoly in Economics?

The most common type of natural monopoly is a byproduct of high initial costs to enter the market.

Certain markets can be viewed as prone to disruption with numerous issues that could be “fixed” from the perspective of startups. Yet the existing incumbents continue to operate with significant share with minimal risk of disruption because early-stage companies lack the funds to even enter the market – let alone, compete with the market leader(s) and take their market share.

In general, the formation of natural monopolies is from economies of scale, economies of scope, or a blend of the two.

• Economies of Scale → Economies of scale describes the concept wherein the average costs per unit of output decline with the production and sale of each incremental unit, i.e. more output = more profits.
• Economies of Scope → On the other hand, economies of scope refers to the scenario where the unit cost of production declines from more variety in the products offered. The production of different yet still adjacent goods can cause the total cost to decline.

As production output increases, the average cost of supply declines in tandem from the expanded scale, benefiting the profitability of the natural monopolist and contributing to its competitive advantage.

There is a high risk of failure when attempting to disrupt a traditional market with a decent amount of competition.

Thus, attempting to disrupt a market categorized as a natural monopoly is even riskier with an even greater probability of failure. Not to mention, there is a significant upfront cash outlay to even have a chance. While fundraising in the private markets can be quite cyclical, a startup raising sufficient capital here even in a bull market with inflated valuations can struggle to obtain adequate funds to meaningfully enter the market.

What are Examples of Natural Monopolies?

Some examples of industries considered to be natural monopolies include:

• Telecommunications (Telecoms)
• Utilities and Energy Sector (Electric Power Supply and Grids)
• Oil and Gas (O&G)
• Railway and Subway Transportation
• Waste Sewers and Waste Management
• Aircraft Manufacturing (Aviation)

The pattern evident in all the industries listed above is that most of them offer a product or service necessary to society as a whole and would all be considered capital intensive.

The current position of these companies is the result of decades of work, making it an even more challenging problem for the government to tackle.

But note that while the formal definition of a natural monopoly according to academic economics textbooks states that a market is controlled by a single firm with no competition – in reality, there are a handful of other, albeit much smaller, rival competitors in the market.

Governmental Intervention in Natural Monopolies (Antitrust Regulation)

While not all natural monopolies have a net negative impact on a market, the government still tends to step in and intervene to some extent.

Of course, the intervention is rarely as aggressive as with other types of monopolies where companies such as Meta Platforms have historically been fined billions in total by foreign governments for unfair business practices as part of anti-trust regulations.

For natural monopolies, it would be unfair to immediately assume the company is taking advantage of consumers.

The fact of the matter, however, is that natural monopolists have the option to pursue predatory practices, which represents a risk to the government.

But regulatory bodies must be careful because the absence of competition means there is widespread reliance by consumers on the monopoly, so unfairly penalizing them could worsen the problem (or create a problem for consumers that wasn’t apparent in the first place until the government decided to intervene).

As a result of these market dynamics, the government must work with these natural monopolists to ensure they are kept in check and the companies do not exploit their favorable market position.

Social Media, Search Engine and eCommerce Markets Analysis

Technically, companies like Meta (formerly Facebook), Google and Amazon grew to prominence as natural monopolies in their respective markets, or at least in their initial days.

• Facebook (Meta) → Social Media
• Google → Search Engine
• Amazon → eCommerce

The treatment received from regulatory bodies tends to be much harsher because of the fact that there are other issues, namely with data collection, and since these services are not necessarily “required,” per se.

Therefore, any sort of action that resembles anti-competitive behavior such as an acquisition would immediately be met with regulatory scrutiny, particularly for Facebook, which most would agree did engage in predatory behavior such as M&A and copying competitors’ product features to intentionally reduce the level of competition.

While certain economists argue the treatment was unfair, others can counter such claims by stating that these leading technology companies like Facebook, Amazon, and Google are artificial monopolies, instead.

Regardless, it is undeniable that these companies grew to become the most valuable companies in the world because they offered a product or service that was unmatched by the rest of the market, especially in the case of Google and Amazon.

In fact, Amazon (AMZN) led the global shift towards eCommerce and by far remains the most dominant company in the space today, and established offerings such as two-day shipping as the norm for consumer expectations.

Irrespective of the value provided to consumers, consumers and the government – e.g. politicians in particular – appeared to have taken aim at Amazon as a whole and seek areas of its business to publicly criticize, as demonstrated by the stories about the company’s working conditions and criticism of the company’s use of tax incentives.

Amazon’s planned move to NY received such scrutiny that the eCommerce company even decided to move in a different direction.

Regardless if one agrees that the tax incentives offered to Amazon were justified, one could argue that the trade-off was worthwhile considering the number of jobs it would have created in New York, the long-term benefits to the state’s economy, and allowing the state to reestablish its reputation as an innovative “tech hub”.

Natural Monopoly Example: Public Utilities Industry

Natural monopolies tend to be common in markets offering “essential” goods and services, such as with public utilities.

The infrastructure to deliver electricity, gas, water and related goods is not only costly to build initially, but the maintenance is also expensive.

Contrary to a common misconception, a natural monopoly can be unprofitable. In fact, most of these companies exhibit low profit margins because of how capital intensive their operations are.

If a utility company is on cusp of collapse, the government will likely intervene and help it continue to function, reflecting how natural monopolies can often provide an essential service and have the required infrastructure to deliver a good or service critical to society that others cannot.