What Is a Natural Monopoly? (Plus Several Examples)

By Indeed Editorial Team

Published 26 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Companies thrive on competition in the free market, which creates sustainable prices, innovation and other benefits. Some businesses, though, find little to no competition in certain niches, creating a natural monopoly. If you're planning to pursue a career in business, it's important to understand natural monopolies. In this article, we explain what a natural monopoly is in business, discuss how it occurs, list some of its characteristics and provide a few examples.

What is a natural monopoly?

A natural monopoly is a kind of monopoly that arises usually because of the high start-up cost or powerful economies of scale of doing a business in a particular industry, which can result in significant barriers to entry for competitors. A business with a natural monopoly may be the only provider of a service or product in a geographic location or industry. Natural monopolies often occur in industries that require technology, raw materials or similar factors to operate.

Related: What Is Marketing Communication? Definition and Career Paths

How do natural monopolies arise?

Natural monopolies can form in two ways. First, when a business takes advantage of an industry's high barriers to entry to build a moat, or protective wall, around its business operations. This high barrier to entry is usually due to the significant amount of cash or capital necessary to purchase fixed assets, which are physical assets necessary for a business to operate.

The second way is where producing at a large scale is so much more efficient compared to small scale production. This makes a single large producer sufficient to meet market demand. Since their costs are higher, a small-scale producer can simply never compete with a larger, lower-cost producer. Here, the natural monopoly of the single producer can also be the most economically efficient method to produce the good or service in question. This type of natural monopoly isn't due to large-scale fixed investment or assets, but can be the result of the simple first-mover advantage.

Related: Business Development Defined (With Answers to FAQs)

What are the characteristics of natural monopolies?

Here are the characteristics of natural monopolies:

Naturally occurring

As the term implies, natural monopoly is natural, which simply means that through the free market, other companies are unwilling or unable to compete. This means that there's no external force, such as a government policy, that prevents competition. In addition, a natural monopoly is naturally occurring as there's an economic force that prevents more than one business from entering the market. This natural element primarily surrounds two factors: long economies of scale and large fixed costs. Both are occurring naturally in specific markets, such as water supply, sewerage systems and energy grid.

Related: 11 Essential Business Skills to Help Grow Your Career

Long economies of scale

Economies of scale is an important aspect of natural monopolies. This is because only one company can enjoy the benefits of economies of scale in a market that's a natural monopoly. In economics, this is called long-tail economies of scale.

Basically, long-run average costs continue to decrease until the company services the large majority of the market. Thus, a company can't fully achieve economies of scale until it completely meets the demand. This means that when the company services 80% of the market, it can cost $5 to produce a particular good. At 100% of the market, though, it may only cost around $4 to produce it. At the same time, there's only demand for the service or product when the company produces or sells it at a lower value.

Large fixed costs

Natural monopolies often have extraordinarily large fixed costs. For example, a sewerage system has a significant initial fixed cost, but also requires regular maintenance. If that initial fixed cost was $15 billion, it means that it's necessary to make that much money back to make it economically viable. If two corporations enter, there may be a total of $30 billion in initial fixed cost to build two sewer systems. This means that it's important for the two companies to recoup double the investment to make it economically viable.

Related: What Is Business Operations? (With Components and Tips)

Competition is undesirable

In natural monopolies, the point at which a business benefits from economies of scale is close to the entire demand in the market. Hence, before this point, economic production isn't efficient. This is because the average cost of creating the service or product is higher than it might be otherwise.

For instance, suppose you have two aeroplanes, each can carry 200 passengers. This means there are a total of 400 seats. Both are flying from Hong Kong to the Philippines, but only 200 people want to go. If you split the people across two aeroplanes, you're left at 50% capacity. Thus, the cost is much higher than if there was only one provider. This means that it's more economically desirable and efficient to have one provider.

Related: Tips From a Recruiter: How to Stand Out When Changing Careers

Low marginal costs

Natural monopolies often have high fixed costs, but low marginal costs. This means that it costs very little to service one extra client, which means economies of scale are vital to such companies. If you look at airlines, for example, there are instances whereby only one airline can service a particular route. This may be because it's remote or there's a low demand for that destination.

To service that route, the airline company has high fixed costs in terms of the plane, staff and maintenance. The cost to fly one client versus 200, though, is almost zero. Thus, the more people the airline company has on the aeroplane, the more economically viable that route is.

Government-regulated

To ensure that natural monopolies don't take advantage of clients or consumers, governments often regulate them. This is usually the case of utility companies, such as water and electricity. Without competitors to offer choices, the government is the only option to make sure that a company delivers a quality product or service at a reasonable price.

Examples of natural monopolies

Here are a few examples of natural monopolies:

Rail network

To travel from one station to another, a rail line is necessary. It's important for that rail line to be constructed and maintained in the years after. If two companies were to enter the market, they might duplicate those costs.

Now you might ask, "What's different from other industries?" The difference is that fact that not only are the fixed costs high, but thousands of customers may pay for the service for it to be economically viable. If there were two corporations with a similar market share, the average cost to them might be double that of a single company. This is due to the low marginal cost, which means there's little cost to serve an extra customer.

Utility company

Utility companies often run sewer systems, water pipes and power lines. Cities can't let multiple companies run all these things for each household in their district. The logistics rarely work. Instead, one company gets permission to have control over its own utility system. For example, suppose Max Company is a government-regulated water company in Kowloon, Hong Kong. To ensure the provision of water to the residents in Kowloon, the company builds a water pipeline across town.

Two or more companies can't compete in offering this service as they can't get their own water supply or create the piping network necessary to run this service. This means that Max Company operates in the market by itself and faces a lower material cost because of the lack of competition while serving the entire district.

Local bus routes

A small town may have a bus route that only serves perhaps 100 people a day. Any company servicing that market often has the fixed costs of a bus, fuel and driver. Due to the small size of demand, the bus may never be full at any point in time.

It may not be economically efficient for two buses to go around at the same time to pick up one passenger each. Because of this very factor, a natural monopoly occurs. It's not economically viable unless the company charged customers prices in excess of $100 a trip. No customers, though, want to pay that amount, which is why one single company is desirable.

Online services

Online retailing, search engines and social media platforms are modern examples of natural monopolies. Technology companies have built natural monopolies for a variety of online services due in large part to first-move advantages, natural economies of scale and network effects involved with handling or storing large quantities of information and data. Unlike traditional utilities, these types of natural monopolies so far have gone almost unregulated in most countries.

Explore more articles