Natural monopoly
Based on Wikipedia: Natural monopoly
In the year 2000, the people of Cochabamba, Bolivia, took to the streets. Their target was a single company that had recently acquired the exclusive right to supply their city's water. The firm had dramatically hiked rates to fund a dam project, and suddenly many residents couldn't afford to turn on their taps. Water—the most basic necessity of human life—had become a luxury. The protests turned violent. People died. The government eventually reversed course and expelled the company.
This is what happens when a natural monopoly goes wrong.
But here's the strange thing: the monopoly itself wasn't the problem. The problem was what the monopoly chose to do with its power. Natural monopolies aren't created by greedy corporations or corrupt politicians. They emerge from the basic physics and economics of certain industries. Understanding why they form—and why they're sometimes inevitable—is essential to understanding modern infrastructure, from your electric bill to your internet connection to the water coming out of your faucet.
The Economics of Inevitability
Imagine you want to start a company that delivers electricity to homes. First, you need to build power plants. Then you need to string wires across hundreds of miles of territory, erecting poles, negotiating rights-of-way, and connecting every single house and apartment building to your grid. This will cost you billions of dollars before you sell a single kilowatt-hour.
Now imagine your neighbor decides to compete with you. They need to do the exact same thing—build their own power plants, string their own wires, erect their own poles right next to yours. They also spend billions.
The result? Two companies, each with enormous fixed costs, fighting over the same customers. Neither can charge low enough prices to cover their investments. Both eventually go bankrupt, or one drives the other out of business and becomes the sole supplier anyway.
This is a natural monopoly in its purest form. It's "natural" because no law creates it and no conspiracy brings it about. It simply emerges from the cost structure of the industry.
The key concept is fixed costs versus marginal costs. Fixed costs are what you pay regardless of how many customers you serve—the power plants, the wires, the infrastructure. Marginal cost is what it takes to serve one additional customer—essentially just a bit more electricity flowing through wires that already exist.
In a natural monopoly, fixed costs are enormous and marginal costs are tiny. Once you've built the electrical grid, sending power to one more house costs almost nothing. But building that grid in the first place costs everything.
Why Competition Makes Things Worse
In most industries, competition is wonderful. Multiple restaurants compete for your dinner dollars, which keeps prices reasonable and quality high. If one restaurant starts serving mediocre food at outrageous prices, you simply eat somewhere else.
But natural monopolies flip this logic on its head.
Consider what happens when a second company tries to enter a market dominated by a natural monopoly. The incumbent has already paid off most of its infrastructure costs over years or decades. Its average cost per customer is low because those massive fixed costs are spread across millions of users. The newcomer, by contrast, has to build everything from scratch. Its average costs are astronomical because it has the same fixed costs spread across zero customers (at first) or very few.
The result is that competition doesn't lower prices—it raises them. Society ends up paying for two sets of infrastructure instead of one. Resources are wasted duplicating facilities that only need to exist once.
This seems counterintuitive because we're trained to think competition is always good. But the math is clear: if one company can supply the entire market at a lower average cost than two or more companies, then having multiple competitors is economically inefficient. You're better off with just one supplier.
Of course, this creates an obvious problem. If one company is the only game in town, what stops it from gouging customers? The answer, as the people of Cochabamba learned, is nothing—unless someone intervenes.
John Stuart Mill Saw This Coming
The English philosopher and economist John Stuart Mill was writing about natural monopolies in the mid-1800s, well before electricity grids or telecommunications networks existed. His examples were the professionals of his day: jewelers, physicians, and lawyers.
Mill noticed something peculiar about their wages. These skilled workers earned far more than their labor alone seemed to warrant. The gap between a physician's income and a laborer's income wasn't just compensation for years of education—it was something extra, something that looked suspiciously like monopoly profits.
The "monopoly," Mill realized, wasn't created by law. It arose naturally from the scarcity of skills. Most people simply couldn't become physicians, no matter how much they might want to, because they lacked the ability, the education, or the opportunity. The skilled workers had what Mill called "a natural monopoly in favour of skilled labourers against the unskilled."
Mill then extended this insight to capital. If a business requires enormous initial investment, the number of people who can possibly enter that business is tiny. Only the wealthy can afford to build a gas works or a water utility. This small class of potential competitors can coordinate to keep prices high—not through explicit conspiracy, but simply because there are so few of them that tacit agreement is easy.
"If a business can only be advantageously carried on by a large capital, this in most countries limits so narrowly the class of persons who can enter into the employment, that they are enabled to keep their rate of profit above the general level."
Mill didn't stop at diagnosis. He prescribed a remedy. For what he called "practical monopolies"—network industries like electricity, water, roads, rail, and canals—he argued that government must either regulate the business or operate it directly. The profits of such monopolies, he believed, should benefit the public rather than enriching a small class of owners.
Economies of Scale and Scope
Two related economic concepts explain why natural monopolies tend to form and persist.
Economies of scale occur when the cost per unit falls as production increases. Think of a factory that makes cars. Building the factory costs billions, but once it exists, each additional car costs relatively little to produce. The more cars you make, the more that initial investment is spread out, and the cheaper each car becomes. This is economies of scale in action.
For natural monopolies, economies of scale operate with unusual intensity. The fixed costs are so large relative to the market that even a dominant player serving millions of customers can still have lower average costs than a newcomer serving thousands. The incumbent's cost advantage isn't just significant—it's insurmountable.
Economies of scope are different but complementary. They occur when producing multiple products together is cheaper than producing them separately. A telecommunications company might offer phone service, internet access, and television through the same network of cables. Running all three services through one set of wires costs less than running three separate networks.
The American economists Paul Samuelson and William Nordhaus pointed out that economies of scope can create natural monopolies all by themselves. If a company producing multiple products has lower costs than several single-product competitors combined, those competitors will either fail or be absorbed into the diversified firm. The result is monopoly—not through predatory behavior, but through the basic economics of joint production.
The Formal Mathematics
In 1977, the economist William Baumol provided a rigorous mathematical definition of natural monopoly. He defined it as "an industry in which multi-firm production is more costly than production by a monopoly."
The technical term Baumol used was "subadditivity." A cost function is subadditive if the cost of producing everything in one firm is less than the cost of splitting production across multiple firms. In mathematical notation, if you add up the costs of having several companies produce portions of the total output, that sum exceeds the cost of having a single company produce everything.
Baumol's key insight was subtle but important: economies of scale are sufficient to create a natural monopoly when a company produces a single product, but they're neither necessary nor sufficient when companies produce multiple products. The relationship between scale economies and natural monopoly is more complicated than it first appears.
This matters for policy. You can't simply look at whether an industry has economies of scale and conclude it must be a natural monopoly. The actual test is whether total costs would rise or fall if the market were served by multiple competitors rather than one. Sometimes the answer is obvious (electricity grids), and sometimes it requires careful analysis.
Classic Examples
Railroads are perhaps the quintessential natural monopoly. Building a rail network requires purchasing rights-of-way, laying thousands of miles of track, constructing stations, and buying or leasing locomotives and cars. These costs are staggering, and they must be paid before a single passenger buys a ticket.
Once the network exists, running an additional train is relatively cheap—just fuel, crew, and maintenance. This combination of massive fixed costs and low marginal costs creates overwhelming advantages for the incumbent. A would-be competitor must somehow convince customers to switch while simultaneously recovering billions in infrastructure investment.
Railroads also demonstrate another property of natural monopolies: significant long-run economies of scale. The bigger the network, the more valuable it becomes. A railroad connecting New York to Chicago is useful. One connecting New York, Chicago, Los Angeles, and dozens of cities in between is transformative. This network effect compounds the first-mover advantage that natural monopolies typically enjoy.
Utilities follow the same pattern. Electricity requires generators, transmission lines, substations, and distribution networks. Water requires reservoirs, treatment plants, and pipelines. Natural gas requires wells, processing facilities, and pipeline networks. In each case, the infrastructure costs are immense, the marginal costs of serving additional customers are minimal, and the result is natural monopoly.
Telecommunications historically fit this model as well. Stringing telephone wires or laying fiber-optic cables requires enormous investment. Once the network exists, adding calls costs almost nothing. For decades, telephone service in most countries was provided either by regulated private monopolies or by state-owned enterprises.
The interesting thing about telecommunications is how technology has partially disrupted the natural monopoly. Wireless networks can compete with wired ones. Internet-based calling can bypass traditional phone systems entirely. Natural monopolies, it turns out, aren't necessarily permanent—they depend on the technological context of their time.
What Governments Do About It
Natural monopolies present policymakers with an uncomfortable choice. You can allow the monopoly to exist unregulated, accepting that it will likely exploit consumers. You can regulate it, accepting the complexity and potential for regulatory capture that entails. Or you can have the government operate the utility directly, accepting the inefficiencies and political interference that often accompany state ownership.
Each approach has been tried. Each has failed in various ways. None is perfect.
Regulation typically works by limiting what prices the monopoly can charge. A regulatory body examines the company's costs, determines what a "fair" return on investment would be, and sets rates accordingly. This prevents the most egregious gouging but creates perverse incentives. If your profits are capped at a percentage of your costs, why bother cutting costs? Inefficiency becomes profitable.
Government ownership was the dominant approach in Europe after World War Two. Railways, utilities, telecommunications, and postal services were nationalized across the continent. State-owned enterprises could theoretically operate in the public interest, providing universal service at reasonable prices.
In practice, state ownership often meant bloated workforces, political interference, and chronic underinvestment. Some governments treated their utilities as cash cows, extracting revenue to fund other programs rather than reinvesting in infrastructure. Others used them for patronage, hiring politically connected workers regardless of qualification.
A third approach, increasingly popular since the 1980s, involves privatization with regulation. The government sells off the state-owned utility but maintains regulatory oversight. This theoretically combines private-sector efficiency with public-interest protection. In practice, it often creates powerful private monopolies that spend heavily on lobbying to weaken the regulations meant to constrain them.
When Monopolies Behave Badly
The danger of natural monopoly isn't the monopoly itself—it's the behavior the monopoly enables.
A company with no competitors faces no market discipline. If customers have nowhere else to go, the monopolist can raise prices, cut quality, or simply stop investing in improvements. Why spend money on better service when your customers have no alternative?
The Cochabamba water crisis illustrates the extreme version of this problem. The water company needed to fund a dam, so it raised rates. Customers couldn't switch to a competitor—there was none—and they couldn't simply stop using water. The company's monopoly position gave it the power to impose costs that many residents simply couldn't bear.
Less dramatic versions of this dynamic play out constantly. Cable companies notorious for poor customer service face few consequences because many customers have no other broadband option. Electric utilities can delay investments in renewable energy because customers can't choose cleaner alternatives. Natural monopolies, unless restrained, tend toward complacency at best and exploitation at worst.
This is why Mill and every major economist since has argued for some form of intervention. The question isn't whether to regulate natural monopolies but how. The challenge is designing regulations that prevent abuse without creating worse problems of their own.
The Connection to Modern Debates
Understanding natural monopoly helps clarify contemporary arguments about internet service, cable television, and telecommunications more broadly.
When critics argue that Comcast or other cable companies behave like monopolists, they're usually pointing to the natural monopoly characteristics of cable infrastructure. Running coaxial cables to every home in a city requires massive investment. Once one company has made that investment, it's extremely difficult for a second company to justify duplicating it. The incumbent has all the advantages that natural monopolies typically enjoy.
But technology complicates this picture. Fiber-optic networks can compete with cable. Cellular networks can compete with both. Satellite internet has improved dramatically. The natural monopoly that once seemed ironclad has become contested terrain.
This is actually the hopeful lesson of natural monopoly economics. These monopolies arise from specific technological and cost conditions. When those conditions change—when new technologies emerge that alter the cost structure—natural monopolies can weaken or disappear entirely. The telephone monopolies of the twentieth century have given way to fierce competition among wired, wireless, and internet-based alternatives.
Yet the basic dynamics persist. Any industry with very high fixed costs and very low marginal costs will tend toward monopoly or oligopoly. Any company in such an industry will face temptations to exploit its position. And any society will need some mechanism—regulation, public ownership, or technological disruption—to prevent that exploitation from becoming intolerable.
The people of Cochabamba learned this the hard way. The rest of us can learn it from their example.