Natural Monopolies

Natural monopolies, industries in which the conditions of demand and supply are such that production by a single firm minimizes costs, provide one of the oldest justifications for government provision of goods and services. Smith’s invisible hand works well only in competitive markets. In many markets competition does not exist; in others, competition is inefficient. Some production processes enjoy economies of scale; that is, unit costs of production fall as output rises. A common example is the supply of electricity. In densely populated regions, supplying electricity through an integrated network is more efficient than every household having its own generator.

When economies of scale are present, large firms produce more efficiently than small firms and tend to dominate their markets. Eventually they may drive smaller firms into bankruptcy and, in extreme cases, may become monopolies. Monopolies tend to charge too much and produce too little. Whenever natural monopolies arise, government intervention, at least in principle, can lead to more production at a lower price. However, before deciding on some form of government intervention, we need to assess the welfare losses from the exercise of monopoly power and the welfare gains from government intervention. 1

What kind of intervention is appropriate? The first option is to do nothing. This solution might be optimal when the product or service has close substitutes and monopoly power is weak, that is, when the ability to charge prices that result in excess profits is insignificant. In the case of cable television, for example, the presence of close substitutes reduces the monopoly power of cable providers enough to obviate the need for government intervention. A traditional solution is to provide the good or service through a public enterprise. In many countries

Externalities provide another traditional argument for government intervention. Sometimes activities generate benefits and costs that are not reflected in the firm’s benefits and costs. A forest, for example, may lower the level of carbon dioxide in the world, but the owner of the forest—who bears the full cost of planting and maintaining the forest—cannot charge

Public Goods

The strongest argument for public provision is rooted in the nature of the goods and services themselves. All goods provided by the private sector share one important feature: the provider of the good can charge those who wish to consume it and make a profit in the process. Not all goods,

Exclusion Difficult or Costly

Private markets do not produce no excludable public goods because of the impossibility of preventing anyone from consuming them, even if they do not want to pay for them. Consider national defense. If an army succeeds in defending the national territory against an enemy, every citizen benefits, whether he or she paid to sustain the army or not. Similarly, spraying an

area to rid it of malaria-carrying mosquitoes benefits every nearby inhabitant, but charging everyone for the service would be difficult. Those who refuse to pay get a free ride. If a sufficiently large number refuse, spraying may never take place. Because of these difficulties, the private sector will not usually produce no excludable public goods or will produce suboptimal.