[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

A natural monopoly occurs whenever the average costs of production
for a single firm decline as output increases up to levels beyond
those likely to emerge in the market. When the average costs of production
fall as the scale of production increases, we say there are
economies of scale, a concept first introduced in Chapter 6. In Figure
12.7, the demand curve facing a monopoly intersects the average cost
curve at an output level at which average costs are still declining. At
large enough outputs, average costs might start to increase; but that
level of output is irrelevant to the actual market equilibrium. For
instance, firms in the cement industry have U-shaped average cost
curves, and the level of output at which costs are minimized is quite
high. Accordingly, in smaller, isolated communities, there is a natural
monopoly in cement.
A natural monopolist is protected by the knowledge that it can
undercut its potential rivals. Since entrants typically are smaller and
average costs decline with size, the average costs of new firms are
higher. Therefore, the monopolist feels relatively immune from the
threat of entry. So long as it does not have that worry, it acts like any
other monopolist, setting marginal revenue equal to marginal cost.
In some cases, even when a market is occupied by a natural monopolist,
competition can still exist for the market. Competition to be that
single supplier is so keen that price is bid down to average cost, at p r .
If the firm were to charge a slightly higher price, another firm would
enter the market, steal the entire market with its lower price, and still make a profit.
Markets for which there is such fierce competition are said to be contestable.
Contestability requires that sunk costs be low or zero. If they are significant, a firm
that entered the market could be undercut by the incumbent firm, which might
lower price to its marginal cost (since so long as price exceeds marginal cost, it
makes a profit on the last unit sold). The lower prices that result are sometimes
referred to as a price war, and the result of a price war is that the entrant encounters
a loss—when set equal to marginal cost, price is substantially below average cost. The
entrant knows that even if it leaves at this juncture, it loses its sunk costs, which
are, by definition, the expenditures that are not recovered when the firm shuts down.
But anticipating this outcome, the potential rival does not enter the market. Thus,
despite sustained current profits, other firms may choose not to enter the market.
In fact, sunk costs appear to be sufficiently important that few markets are close to
perfectly contestable. Even in the airline industry, where sunk costs are relatively
low—airlines can fly new planes into markets that seem profitable or out of markets
that seem unprofitable—they act as a sufficiently large barrier to entry that
there are sustained profits in certain routes, especially those out of airline hubs (like
American Airlines’ hub in Dallas–Fort Worth). Just as most markets are not perfectly
competitive, so most natural monopolies are not perfectly contestable, though
the threat of competition (or potential competition) may limit the extent to which an
incumbent monopolist exercises its monopoly power.
Whether a particular industry is a natural monopoly depends on the size of the
output at which average costs are minimized relative to the size of the market.
PRICE (p )
p m
p r
Figure 12.7
Marginal
revenue
curve
Q m
NATURAL MONOPOLY
Q r
QUANTITY (Q )
Marginal
cost curve
Demand
curve
Average
cost curve
In a natural monopoly, average cost curves are downward
sloping in the relevant range of output. A firm can charge
the monopoly price p m . If the market is contestable,
potential competition prevents the firm from charging
a price higher than average costs. The equilibrium price
is p r .
ECONOMIES OF SCALE AND NATURAL MONOPOLIES ∂ 269