2 - Natural monopoly and the justification for regulation

Summary

Because the need for economic regulation is closely linked with the concept of natural monopoly, we must have a precise definition of a natural monopoly. A recent survey by Sharkey (1982b) describes how our conception of natural monopoly has evolved since the time of Cournot. Although various economists have offered different definitions, all agree that pervasive economies of scale are at the center of the issue, with some noting that production technology is not the only source of efficiency for a single supplier. Consider these statements by Kahn (1971) regarding the essence of natural monopolies:

… their costs will be lower if they consist in a single supplier.

(Kahn, 1971, p. 11)

… a natural monopoly is an industry in which the economies of scale – that is, the tendency for average costs to decrease the larger the producing firm – are continuous up to the point that one company supplies the entire demand.

(Kahn, 1971, pp. 123–4)

Although both statements are familiar, they are not equivalent. We can show that the second implies the first, whereas the first does not imply the second. Recently, the definition of a natural monopoly has been developed in a more rigorous way by Baumol (1977). After reviewing the definition for the single-product firm and deriving implications for price and entry regulation, we extend the definition to a multiproduct firm. Then we show how the financial consequences of efficient pricing complicate the task of regulators.