This is “Natural Monopoly”, section 8.5 from the book Managerial Economics Principles (v. 1.0).
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In industries where the minimum efficient scale is very high, it may be that the lowest average cost is achieved if there is only one seller providing all the goods or services. Examples of such a service might be transmission and distribution of electric power or telephone service. This situation often occurs when total costs are very high but marginal costs are low. Economists call such markets natural monopoliesA situation that occurs when total costs are very high but marginal costs are low such that the lowest average cost can be achieved only by one seller..
Unfortunately, if just one firm is allowed to serve the entire market, the firm will be tempted to exploit the monopoly position rather than pass its lower cost in the form of lower prices. One response to this situation is to conclude that the service should be provided by a public agency rather than a private company. In the case of telephone service, European countries often run the telephone system rather than a corporation like AT&T.
Another response is to go ahead and allow the private firm to be the sole seller but require regulatory approval for the prices to be charged. These regulated monopolies are often called public utilitiesA regulated monopoly in which a private firm is the sole seller of a good or service at a price approved by a regulatory agency and that passes the benefits of low average costs to buyers., even though the operator may be a private corporation. In principle, this regulated monopoly could achieve the best of both worlds, letting a private company serve the market, while making sure the buyer is enjoying the benefits of the low average cost. In fact, this notion of a regulated monopoly was first proposed by AT&T when it feared that its near monopoly would be usurped by the government. Governments create agencies like state public utility commissions to review cost information with the public utility corporation in deciding on the prices or service rates that will be approved.
A potential concern when a single provider is allowed to operate as a regulated monopoly is that, without competition, the provider has little incentive for innovation or cost cutting. This could be the case whether the provider operated as a government agency or a public utility corporation. When a public utility corporation understands that it will be reimbursed for its costs plus an amount to cover the opportunity costs of assets or capital contributed by the corporation’s owners, the challenge is to be able to justify the costs rather than seek to trim its costs. Some regulatory agencies try to motivate regulated monopolies to be innovative or cut costs by allowing them to keep some of the surplus created in exchange for lower rates in the future. However, regulation is a game where the regulatory agency and the public utility corporation are both competing and cooperating. And the transaction costs of outside oversight of the regulatory monopoly are substantial. So, as noted earlier, there is no free lunch.