Natural monopoly is a monopoly that exists as a result of a market situation in which a single monopolistic firm can supply a particular product or service to the entire market at a lower unit cost than what could be achieved by a number of competing firms. Natural monopolies typically exist when production of a product or service requires large and extremely costly infrastructure. Pure cases of natural monopoly are rare in real world but they do exit in markets of public utilities such as power, water, telephone, railways etc.
In naturally monopolistic markets, competition is uneconomical because multiple producers are unable to completely utilize economies of scale and this results in unit costs above the lowest possible values and thus higher prices. In other words, a natural monopoly uses the economy's limited resources more productively than multiple competing firms. By this logic, it is preferable for a government to allow monopolization of the market.
However monopolies have the negative feature that they tend to unfairly exploit their monopolistic power if allowed to. Monopolies tend to restrict supply thus inflating prices. In such a situation the government may adopt one of the following two alternative approaches in order to retain the possibility of unit cost advantage of a natural monopoly as well as avoid the negatives of a monopoly:
- Public ownership
- Public regulation
Public ownership typically involves direct governemt control of the natural monopoly producing a specific public good or service. For example a railroad company, owned and managed by government, which is the sole owner of railways infrastructure in the country is a publically owned natural monopoly. By directly operating the monopoly, government bars unfair exploitation of monopoly power by the firm.
Public regulation may involve government control of the price at which a specific utility must be sold by the monopolistic firm. Public regulation is used in naturally monopolistic markets where public ownership is not a feasible option.