Absence of economic competition is the chief characteristic of a monopolistic situation. Natural monopoly is one of the various such market situations. It is an economic condition in which the largest supplier in a particular industry, often the first one to enter the market, has a gigantic cost advantage over other actual and potential competitors. This situation can occur when it is most efficient for the entire production to be concentrated in a single organization. Let's take a detailed look at this phenomenon and its underlying microeconomic mechanisms.
There are a couple of cost factors that are responsible for the rise of a natural monopoly. The initial cost of setting up a business varies in magnitude from industry to industry. In case of a prospect venturing into a business involving a public utility, the initial investment is gigantic. This acts as an entry barrier despite the scope of tremendous earnings, and that is the reason why we see very few entrants in the utilities sector. Talking about cost advantages, we need to take into consideration the fixed costs, marginal costs, and their interactions during the course of a business life cycle. In case of natural monopolies, the tremendous cost advantage that the supplier holds over its actual or potential competitors comes from this interaction between fixed and marginal costs, which differ in case of utility suppliers as compared to suppliers of conventional products and services.
In conventional output-based industries, as a supplier ramps up his operations, the marginal costs (cost of catering to one additional customer unit) decline due to economies of scale. The business breaks even after some time and proceeds on an upward trend as various cost-efficiencies set in. The fixed costs remain stable throughout this entire business cycle. However, in case of naturally monopolistic industries, they are not output based and the fixed costs are huge. A decent return on investment is only possible if the business is able to cater to a large customer base. The marginal costs are more or less constant throughout. In such a cost structure, the fixed cost gains economies of scale as the customer base grows, because the same cost gets divided among a larger number of consumers.
This ultimately leads to the average total cost declining, as the level of such an increase takes place across a larger base as compared to output-based industries. Therefore, any supplier who is capable of transcending the initial entry barrier, reaps enormous economies of scale owing to this quantum fixed cost advantage. An excellent example of this type of monopoly would be an electric power company. The set up costs are huge, the marginal cost of gaining an additional consumer unit is insignificant, and the revenue generated by adding one more unit will only serve to increase the supplier's revenue and lower the average cost.
As in the case of any monopoly, natural monopolies are also not free from regulations. This is necessary for preventing market exploitation and price rise. It could be a reason why most countries still insist on having public utility services such as electric power, railroads, water supply, etc. under state control, and these utilities function under strict government regulations.