Natural Monopoly:

A natural monopoly  is  referred  to a market structure, where a single firm  is the only supplier of a  particular kind  of  product  or  service due  to  the fundamental cost structure of the  industry  that precludes another entry.

Natural monopolies are often contrasted with  coercive monopolies, in which competition  would  be  economically viable  if  allowed  but  potential competitors are barred from entering the market by  law or by force. Natural monopolies arise where the largest supplier of an  industry, or the first supplier to a local area, has an overwhelming cost advantage over other actual or potential competitors. This tends to be  the case  in  industries where capital costs predominate creating economies  of  scale, which can  be  reaped  at an output level large enough in  relation to  the size of  the market.  Such high costs create barriers to entry. Examples of  these types of industries include water services and electricity. It may also depend on control of a particular natural resource. Companies that grow to take advantage of economies of scale often run  into problems of bureaucracy; these factors interact to produce an "ideal" size for a  firm at which its average cost of production is minimised. If  that ideal size is  large enough to  supply the whole market, then  that market  is a natural monopoly.

A  natural monopoly occurs  in  a  market where  the  average  cost  curve  is decreasing over the entire relevant range of outputs. In Figure, a typical "U"  shaped  long-run  average  cost curve  (LRAC) is  shown.  It  reflects the common tendency for average costs to first fall then  rise as output increases. In  the case of a natural monopoly, the entire relevant part of the LRAC curve (that  is,  the  range of  outputs  where  demand  for  the product  exists)  is downward sloping. If  a single company  supplies the  entire market, the output  it  produces will correspond approximately to  the amount Q.  If  two  firms supply the market, each  firm will produce approximately Q/2,  and  if  there are three firms, each will  produce  Q/3.  The more  firms  in  the industry,  the  less each  firm  will produce, and the greater will be the cost structure for each firm.

If a natural monopolist were free to set prices or output levels, it would tend to produce approximately Ql units  of output and  charge a  price  of about P_I. This price and quantity combination  is considered sub optimal by most economists:  as the diagram suggests,  it creates windfall profits for  the monopolist and also generates less than socially optimal quantities of the good (that is, less product  than would  be demanded  if the price was  lower). It also creates  what  economists  calk  a "dead-weight  loss"  to  society.  For  these reasons, governments tend  to restrict the prices that a natural monopolist can charge. Typically, governments  set the price  at P₂  (determined  by the largest quantity  of  output  that  the  market  demands  and  that  can  be  produced profitably)