AP® Microeconomics · Unit 4 · Topic 4.2
Natural Monopoly
A natural monopoly exists when one firm's average total cost keeps falling across the entire market, so one producer can serve everyone more cheaply than several competitors ever could.
Think about water pipes under a street. Laying them costs a fortune before a single drop flows, but once they're in, serving one more house costs almost nothing. That huge fixed cost spread over more and more customers drags average total cost down and down. If two companies each dug their own trenches and laid their own pipes, each would serve fewer customers and spread that fixed cost over less output, so each one's average cost would be higher than if a single firm served everyone. One firm ends up the cheapest way to supply the whole market.
This is a cost-structure story, not a legal one. Because fixed cost dominates and gets divided across more and more units, marginal cost stays low and sits below average total cost across the relevant range. Adding one more customer costs the firm less than its average cost so far, so average cost keeps getting pulled down as output rises. That gap between a low marginal cost and a falling average cost is the signature of a natural monopoly.
This matters for regulation. If a government forces the firm to price at marginal cost, the efficient-looking rule from competitive markets, price falls below average total cost and the firm loses money on every unit, since average total cost is still falling and sits above marginal cost. Regulators instead often allow average-cost pricing, letting the firm break even, which connects this topic to the next question: how to regulate a monopoly without recreating the deadweight loss from Unit 4's earlier look at monopoly pricing.
Key terms
- Natural monopoly
- A market where one firm's falling average total cost lets it supply the whole market more cheaply than multiple firms could.
- Average total cost (ATC)
- Total cost divided by quantity produced, including both fixed and variable cost per unit.
- Marginal cost (MC)
- The additional cost of producing one more unit of output.
- Cost-structure barrier
- An entry barrier arising from how costs behave, not from any legal restriction on competitors.
- Average-cost pricing
- A regulatory rule setting price equal to average total cost so a natural monopoly breaks even rather than losing money.
Watch it explained
- How it worksHow does average total cost falling across the whole market make one firm the cheapest?
- How it worksWalk me through why marginal cost sits below average total cost for a natural monopoly.
- Going furtherWhat happens when a regulator forces a natural monopoly to price at marginal cost?
- Common mistakeWhy isn't a natural monopoly created by the same kind of barrier as a patent monopoly?
Check yourself
End of topic.