Industry with a Natural Monopoly

Historical example

Such a process happened in the water industry in nineteenth century Britain. Up until the mid-nineteenth century, Parliament discouraged municipal involvement in water supply; in 1851, private companies had 60% of the market. Competition amongst the companies in larger industrial towns lowered profit margins, as companies were less able to charge a sufficient price for installation of networks in new areas. In areas with direct competition (with two sets of mains), usually at the edge of companies' territories, profit margins were lowest of all.

Such situations resulted in higher costs and lower efficiency, as two networks, neither used to capacity, were used. With a limited number of households that could afford their services, expansion of networks slowed, and many companies were barely profitable. With a lack of water and sanitation claiming thousands of lives in periodic epidemics, municipalisation proceeded rapidly after 1860, and it was municipalities which were able to raise the finance for investment which private companies in many cases could not. A few well-run private companies which worked together with their local towns and cities (gaining legal monopolies and thereby the financial security to invest as required) did survive, providing around 20% of the population with water even today. The rest of the water industry in England and Wales was reprivatised in the form of 10 regional monopolies in 1989.

Regulation

As with all monopolists, a monopolist who has gained his position through natural monopoly effects may engage in behavior that abuses his market position. This tends to lead to calls from consumers for government regulation, while at the same time opening up opportunities for competitors to offer better service. Government regulation may also come about at the request of a business hoping to set up a monopoly position for itself (e.g. electricity supply in a city). Having a monopoly greatly reduces risk and makes it easier to obtain the finance needed for investment.

As a quid pro quo for accepting government oversight, private suppliers may be permitted some monopolistic returns, through stable prices or guaranteed through limited rates of return, and a reduced risk of long-term competition. (See also rate of return pricing). For example, an electric utility may be allowed to sell electricity at price that will give it an 12% return on its capital investment. If not constrained by the public utility commision, the company would likely charge a far higher price and earn an abnormal profit on its capital.

Regulatory responses

    * doing nothing

    * setting legal limits on the firm's behaviour, either directly or through a regulatory agency

    * setting up competition for the market (franchising)

    * setting up common carrier type competition

    * setting up surrogate competition ("yardstick" competition or benchmarking)

    * requiring companies to be (or remain) quoted on the stock market

    * public ownership

Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecommunications industry is a leading example globally.

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