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On the origins of the concept of natural

monopoly: Economies of scale and


competition*
Manuela Mosca
[T]here is reason to think that in concerns of such magnitude as railways the
relatively short period is absolutely long. (Edgeworth 1912: 215)
1. Introduction
In microeconomics, industrial organization, and public economics
textbooks,
1
the theory of natural monopoly describes a market in which,
for structural reasons, only one rm nds it protable to produce; the
diagrams used look like that in Figure 1.
In the rst edition of Samuelsons textbook (Samuelson 1948), and until
the end of the 1970s, natural monopoly was considered to occur in cases
where economies of scale exist over the entire range of market demand.
2
In
this literature, scale economies are attributed to high xed costs and low or
* A rst draft of this paper was presented at the III annual meeting of Storep
(Associazione Italiana per la Storia dellEconomia Politica) in Lecce, Italy in
June 2006; at the 2006 annual meeting of the History of Economics Society in
Grinnell, USA in June 2006; at the Department of Economics, University of
Lecce, Italy in July 2006; and at the meeting of the Association for Public
Economic Theory (PET06) in Hanoi, Vietnam in August 2006. An earlier version
was published as Working Paper No. 92/45 by the Department of Economics,
University of Salento, Lecce, Italy.
1 For microeconomics see Kreps (1990: 302), for industrial organization see
Cabral (2000: 75), and for public economics see Stiglitz (2000: 291).
2 Some of the basic factors responsible for monopoly are inherent in the
economies of large-scale production (Samuelson 1948: 40).
Address for correspondence
Dipartimento di scienze economiche e matematicostatistiche Via per Monteroni
73100 Lecce, Italy; e-mail: manumosca@economia.unile.it
Euro. J. History of Economic Thought 15:2 317 353 June 2008
The European Journal of the History of Economic Thought
ISSN 0967-2567 print/ISSN 1469-5936 online 2008 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/09672560802037623
zero variable costs.
3
Excess capacity is a characteristic of the natural
monopoly here described, because the rm produces below its minimum
efcient scale. If the market demand can absorb more output, the rm will
increase its variable, not its xed inputs, so in this case the distinction
between long-run and short-run average cost curves is negligible.
4
Scale
economies are also considered a barrier to entry: due to the monopoly
power derived from them, natural monopoly is seen as a market failure,
and government intervention is required (in the forms of nationalization,
regulation, or antitrust). Natural monopoly is more likely to occur where
the market is small: a growth of market demand can shift the demand
function to the right, and this could eliminate the monopoly. Moreover, as
natural monopoly depends upon the technology employed, technological
innovations can open it to competition and, again, eliminate it.
This theory has been criticized. The most inuential criticism came from
a number of articles published after 1977 dealing with natural monopoly
in multiple output production
5
and from the theory of contestable
markets.
6
They caused a radical change in the denition of natural
Figure 1. Natural Monopoly.
3 See the interesting contribution on the history of the treatment of natural
monopoly in introductory textbooks by Ulbrich (1991).
4 A typical example of this kind of technology is given by a single, high xed cost,
indivisible facility that can realize continuous decreasing unit costs, supplying
the entire foreseeable market demand more efciently than multiple rms
(OmniTRAX 2000: 2).
5 The question of multiproduct natural monopoly was dealt with from 1977 by
Baumol, Bayley, Panzar, and Willig.
6 The idea of contestability was dealt with in a series of articles from 1980 by
Baumol, Bayley, Panzar, and Willig. See for all Baumol et al. (1982).
Manuela Mosca
318
monopoly. After them, natural monopoly is described as characterized by
the sub-additivity of cost functions (production costs less if it is done by one
rm only), and by sustainability (entry is not protable). Sub-additivity of
single output cost functions can be generated by economies of scale, which
in turn imply decreasing average costs. But economies of scale are only a
sufcient, not a necessary, condition for sub-additivity; so while a
decreasing average cost function is always sub-additive, the reverse is not
the case. Moreover, for multi-product rms, scale economies are not even a
sufcient condition. In their own words: scale economies [are] neither
necessary nor sufcient for monopoly to be the least costly form of
productive organization (Baumol et al. 1982: xvi). Not only does this theory
demonstrate that scale economies do not help to dene natural monopoly
properly, but also that they alone may not constitute a barrier to entry: to
deter entry, economies of scale must be associated with sunk costs.
7
The policy implication of the theory of contestable markets is that even in
the absence of anything resembling pure competition, market forces are
potentially a guardian of the general welfare far more powerful and
effective than is commonly supposed (Baumol et al. 1982: 347). In other
words, monopoly has no damaging effects in contestable markets, and
there is no need for government intervention. The systematization of this
viewpoint on natural monopoly was carried out by Sharkey (1982).
The theory of contestable markets is not the only source of criticism of
the notion of natural monopoly. Over the years funeral bells have
repeatedly been tolled for it. The followers of the Austrian school, for
example, do not nd anything wrong in monopolies,
8
while for the Chicago
school market power is only temporary.
9
Some recent research suggests
denitions for natural monopoly still more restrictive than the one
proposed by the contestability theory;
10
other studies deny the empirical
7 As Bailey writes: sunk costs, not economies of scale, constitute the entry barrier
that confers monopoly power (Baumol et al. 1982: xxii). There are actually two
denitions of entry barriers in the literature, one proposed by Bain, the other by
Stigler. As Schmalensee points out An updated Bain denition would not rule
out scale economies as an antitrust barrier to entry when sunk costs are
important, while the Stigler denition would (Schmalensee 2004: 471).
8 Austrians do not contrast monopolistic markets with competitive markets: for
them, markets are competitive by denition. See among others Kirzner (1991:
1467).
9 In 1969 Posner wrote: In the long run, there may be few natural monopolies,
perhaps none (Posner [1969] 1999: 115). Thirty years later he observed:
Natural monopolies have crumbled (Posner 1999: viii).
10 For example, Amir (2003: 4) proposes: to dene natural (unregulated)
monopoly as an industry where the socially optimal number of rms is one.
Origins of the concept of natural monopoly
319
relevance of the concept.
11
Still other works narrow the limits of its use as a
rationale for public intervention, like those that indicate even in the
infrastructure segments of utility industries, where the characteristic of
natural monopoly is not eliminable, competition could improve social
welfare;
12
or like those that claim the monopoly created by strong network
economies is very fragile because of the particularly innovative character of
that industry,
13
and so on.
But apparently the story does not end here. There have been strong
criticisms of the new theories as well. Shepherd, for example, radically
claims that the theory of contestable markets is a kind of fantasy
(Shepherd 1984: 576), and he adds: The theory is internally inconsistent,
difcult to relate to reality, and hazardous for policy treatments of market
power (Shepherd 1995: 300). More recently, the game theoretical
approach to industrial organization shows that monopoly power might
persist under free entry, even in a contestable market;
14
this result implies
that market mechanisms might not prevent a monopolist from exercising
market power.
We do not know whether the concept of natural monopoly will really be
expelled from economic theory or not. What we do know is that its
elaboration had required a great effort from the best of the economists of
the past, and we think that before its alleged disappearance it is worthwhile
to reconstruct its history. Therefore, the purpose of this article is to
contribute to the history of the concept of natural monopoly, and of its
policy implications, focusing on the reconstruction of its origins, long
11 See for example Grossman and Cole: the production of a particular good . . .
would be a natural monopoly only if as output were expanded to meet the entire
market demand, one machine or one plant or, . . . one dispersed rm would
have to be able to achieve reduced average long term costs. That is, costs would
have to be lower per unit at higher and higher levels of output (2003: 19); but in
their view, as transaction costs are important, average cost curves for any rm are
likely to be U-shaped (Grossman and Cole 2003: 28).
12 For Shy, the introduction of competition into these industries is welfare
improving . . . on the consumer side, [without worsening] anything on the
production side because the introduction of access pricing . . . preserved
the efcient large-scale use of existing infrastructure by letting all rms use
the existing infrastructure while paying access charges to the rm that owns and
maintains the infrastructure (Shy 2001: 8). It is also claimed that competition,
by forcing rms to operate at the cost frontier, may be less costly despite
sacricing some scale economies (Kwoka 2006: 127).
13 See for example Schmalensee (1995).
14 Market forces alone are unlikely to reduce market power in a number of cases
(if sunk costs are important, if consumers have switching costs, if there are
network externalities, and if a monopolist can engage in anti-competitive
practices) (Motta 2004: 71).
Manuela Mosca
320
before Samuelsons rst edition, and ending with the formulation of the
concept of natural monopoly as it was before 1977. We repeat that,
according to this formulation, natural monopoly is a market structure in
which there are barriers to entry created by a technology characterized by
economies of scale (i.e. declining average costs) over the whole range of
market demand. Such scale economies, due to the presence of high xed
start-up costs and low or zero variable costs, are considered to be the source
of a market failure that requires government intervention.
Very few studies have been devoted to this topic. We have found some
synthetic reconstruction of the initial history of natural monopoly in
Sharkey (1982: chapter 2),
15
Hazlett (1985), and DiLorenzo (1996); there
are hints in Ekelund and Hebert (1981), ODriscoll (1982) and Stigler
(1982); we can also cite Crain and Ekelund (1976), who deal with the
principle of competition for the eld, while Ekelund and Hebert (2003)
are mainly concerned with the theory of Dupuit, and Beraud (2004) is
focused on Walras; we nally mention Tynan (2007), who deals with J. S.
Mill and Senior on Londons water supply.
16
The secondary literature is
therefore rather scarce.
While examining the origins of the theory of natural monopoly, we want
to eliminate a source of confusion, which derives from the fact that the
concept of natural monopoly is composed of different elements. The
present paper identies the following features, which go to make up that
notion: the expression itself; the singling out of the concrete situations to
which it is applied; the inquiry into economies of scale; the consideration of
their incompatibility with perfect competition; the drawing of the diagram;
and the need for government intervention. As shown in this article, every
feature has its own history, and requires a separate analysis. In other words,
we think that an accurate historical reconstruction of the notion of natural
monopoly, because of its complexity, cannot be written without breaking it
down into all its component parts and analyzing the particular paths
followed by them separately. If each of these elements is not considered
individually, it is hard to correctly identify original contributions, and to
properly reconstruct the inuence of ideas. Hence, in Sections 27 of the
paper, each of the above features is separately examined from a historical
perspective, highlighting the originality of economic theories in that
specic respect, as well as the way they inuenced one another. After an
overview (Section 8), and after having found priorities and inuences
(Section 9), in the conclusions we suggest some interpretation and
contextualization.
15 Sharkey (1982: 15) also cites Lowry (1973).
16 All these works will be recalled later in the paper.
Origins of the concept of natural monopoly
321
The primary approach in this paper is known as rational reconstruction:
we extract from the whole of the economists thought those parts
concerning the different elements composing the notion of natural
monopoly. We are aware of the limits of this perspective, but our main
purpose here is to take only a rst step, clarifying the confusion we
mentioned above, and thus providing a sound basis for a further historical
reconstruction, which will be our task in future research.
2. The expression natural monopoly
Aristotle was the rst to talk about monopoly (De Roover 1951: 492,
Langholm 2006: 397), but who was the rst to talk about natural monopoly?
When did this expression start being applied to the monopolies resulting
from the production process itself? And why was the word natural used for
this kind of monopolies? This is what we look in this section. We limit our
analysis here to the meaning attributed by economists to the expression
natural monopoly and to its denition; the identication of its distinctive
features, the recognition of economies of scale, and the designation of
them as the source of natural monopoly are separate questions that will be
discussed in the next sections. In other words, it is possible for the
economists under analysis to have perfectly understood that a monopoly
could be generated by something inherent in the production process,
without seeing any relation to scale economies.
Smith never uses the expression natural monopoly, but he gives a
detailed description of the characteristics of what this was to be called
immediately after him: Some natural productions require such a singularity
of soil and situation, that all the land in a great country . . . may not be
sufcient to supply the effectual demand; the consequent enhancements
of the market price are evidently the effect of natural causes which may
hinder the effectual demand from being fully supplied, and which may
continue, therefore, to operate forever (Smith 1776: I.7.24).
The earliest explicit use of the term that we have found in the literature is
in the essay The Nature of Rent by Malthus, where natural monopoly is
distinguished from articial monopoly. For Malthus there are peculiar
products of the earth . . . which may be called natural and necessary
monopolies (Malthus [1815] 1969: 13). As an example of natural
monopolies, he takes certain vineyards in France, which, from the
peculiarity of their soil and situation, exclusively yield wine of a certain
avour (Malthus [1815] 1969: 1314).
17
The expression turns up again in
17 Note that Malthus uses the same phrase as Smith: soil and situation.
Manuela Mosca
322
Bastiat, who wrote: People who class together articial monopoly and what
they call natural monopoly . . . are quite blind or quite supercial (Bastiat
[1850] 1864: 180). In general, we can say that the expression was used to
indicate those cases of monopoly deriving from natural agents supplied in
xed quantity, also including talent and location (Cairnes [1861] 1888).
Economists always regarded them favorably. Hence we think that the
reason for the use of the adjective was to aim at distinguishing natural
monopoly (created by nature) from an articial one (created by law).
While the former was seen with favor, classical economists were strongly
against the latter, considering it unnatural.
So far, we have seen that classical economists did use the expression
natural monopoly, but we have not yet found a denition of the concept.
This is supplied by J. S. Mill, who explains that natural monopolies are
those which are created by circumstances, and not by law (Mill 1848:
II.15.9). His denition is rather broad; and actually his examples of natural
monopoly are mixed up with others that today we would say do not qualify,
such as industries in which the entry barriers are due to capital
requirements or to the action of combinations. But he does include
examples where the monopoly is due to technology, such as the supply of
gas and water (Mill 1848: II.15.9).
18
Therefore we can state that Mill was the
rst to apply the expression to monopolies resulting from the production
process itself.
19
In France we nd the term natural monopoly employed
with more precision by Walras, who writes that transport networks such as
18 J. S. Mill writes: All the natural monopolies (meaning thereby those which are
created by circumstances, and not by law) which produce or aggravate the
disparities in the remuneration of different kinds of labour, operate similarly
between different employments of capital. If a business can only be
advantageously carried on by a large capital, this in most countries limits so
narrowly the class of persons who can enter into the employment, that they are
enabled to keep their rate of prot above the general level. A trade may also,
from the nature of the case, be conned to so few hands, that prots may admit
of being kept up by a combination among the dealers. It is well known that even
among so numerous a body as the London booksellers, this sort of combination
exists; though individual interest is often too strong for its rules, nor, indeed,
does the combination itself include the whole trade. I have already mentioned
the case of the gas and water companies (Mill 1848: II.15.9).
19 Sharkey writes: John Stuart Mill . . . was the rst economist of note to speak of
natural monopoly (Sharkey 1982: 14). We think that he was absolutely the rst,
if we limit our concern to the meaning of monopoly due to technology. Also,
Hazlett states that it was J. S. Mill who introduced . . . the term natural monopoly
(Hazlett 1985: 2; emphasis added); again, he should have added: in the meaning
of monopoly due to technology.
Origins of the concept of natural monopoly
323
railways, roads, and canals make up a natural monopoly (Walras [1875]
1936: 232).
20
Then there was a period in which the expression natural monopoly was
used both in the meaning of monopoly due to natural resources in xed
supply, and in the meaning of monopoly due to the characteristic of the
production process, even in the same text.
21
Thereafter, the meaning
referring to production technology became consolidated, thanks particu-
larly to the numerous important contributions by Ely (1886, 1889, 1894). In
effect, in his 1894 article, where the expression even appears in the title,
22
Ely denes natural monopoly as those undertakings which are monopolies
by virtue of their inherent properties (1894: 294), and lists the following
cases: railways, telegraphs, telephones, canals, irrigation works, harbors,
gasworks, street-car lines, and the like (1894: 294). It is interesting that
Marshall proposed a different denition for that class of industries, which
are often called monopolies, but which are perhaps better described as
indivisible industries (Marshall [1890b] 1964: 106; original emphasis).
Leaving Marshall aside, we can see here that there has been a gradual shift
from the meaning of monopoly deriving from xed-supply natural agents
to one deriving from the production process, with a period of overlapping
of the two; we can also see that the latter sense crowded out the former in a
period in which it was generally thought that the natural monopolies due to
technology were much more important than the others.
23
3. Singling out of the concrete situations to which it is applied
Natural monopolies typically occur in two kinds of production: the rst is
characterized by the need for a large infrastructure to start the operation,
as in transport networks and some public utilities;
24
the second is due to the
20 According to Ekelund and Hebert: Walras may have been the earliest writer to
employ the actual term in its modern sense (Ekelund and Hebert 2003: 665;
emphasis in original). But, as we have seen, we think it was Mill.
21 As in the case of Hadley (1886), who used natural monopoly both for highways
and for land ownership.
22 The title of the article is Natural monopolies and the workingman.
23 See for instance Hadley: This monopoly, due to the advantages of large
organizations of capital, is characteristic of the present day. . . . Natural
monopolies, like that of land ownership, are still important; but they are not
the matter of supreme importance in productive industry any more than in
transportation (Hadley 1886: 40).
24 In these industries, high start-up costs and low marginal costs give rise to
economies of scale; as much of the cost for the infrastructure is sunk, it is
considered a barrier to entry also by the contestable market theory.
Manuela Mosca
324
presence of network effects.
25
Over the years economists have identied
some industries in which monopoly is spontaneously generated for reasons
linked to the production process itself. In this section we analyze the
writings of the economists who identied new situations in which natural
monopolies occur. We will show here that the singling out of these kinds of
industry by economists has not necessarily to do with the development of
the theory of natural monopoly. In actual fact, their justications for
monopoly that we consider in this section are not related to economies of
scale. It should also be remembered that the expression natural monopoly
was not necessarily used to describe these situations.
Adam Smith, discussing the subject of joint stock companies, explains
that businesses cannot expand without running into problems of
mismanagement. However, he believes there are domains where large size
rms can work better than small ones, and he mentions: rst, the banking
trade; secondly, the trade of insurance from re, and from sea risk and
capture in time of war; thirdly, the trade of making and maintaining a
navigable cut or canal; and, fourthly, the similar trade of bringing water for
the supply of a great city (Smith 1776: V.1.121). According to Smith, three
circumstances have to concur for production on a large scale to be
successful: it must be reducible to strict rule and method; be of greater
and more general utility than the greater part of common trades; and
require a greater capital than can easily be collected into a private
copartnery (Smith 1776; V.1.125).
26
Although Smith mentions here
industries where natural monopolies typically occur, he speaks only of
large size rms, not of monopolies.
27
After him, it is J. S. Mill who explains
in which sectors production on a large scale is preferable to production on
a small scale, giving the example of the postal service, and the supply of
25 Positive network effects [. . .] have impacts that are very similar to conventional
rm-level economies of scale. [. . .] If larger networks have a forever widening
advantage over smaller networks, we have entered the realm of natural
monopoly [. . .]. It is critical to note, however, that network effects are not in
general sufcient for natural-monopoly-type results (Liebowitz and Margolis
1998: 672; emphasis in original).
26 These three circumstances are also identied by Tynan (2007: 512).
27 Elsewhere, talking about wages, Smith claims that where there are few agents,
competition cannot work: The masters, being fewer in number, can combine
much more easily (Smith 1776: I.8.12); the same reasoning could be applied
also to the case of large size rms, and we could push his argument to the
statement that when rms are large, they are few, and when they are few,
competition cannot work; but this would be forcing Smiths meaning. This is
actually what Stigler claims: Smiths . . . view was that nothing could be done
about the instances of monopoly and collusion of small numbers of rivals
(Stigler 1982: 1).
Origins of the concept of natural monopoly
325
water and gas (Mill 1848: I.9.1), which are commonly considered as natural
monopolies. And Mill goes further than Smith, when he argues that the
possible disadvantages of a change from a small to a large scale are not
applicable to the change from a large to a still larger (Mill 1848: I.9.24);
this reasoning leads him to conclude that rms belonging to these sectors
are in general destined to become monopolies: Where competitors are so
few, they always end by agreeing not to compete (Mill 1848: I.9.24). As we
shall see later, this is not the only, nor the most interesting reason Mill gives
to explain why monopolies are spontaneously generated in these sectors.
A French contemporary of J. S. Mill, the engineer-economist Jules Dupuit
(185253a, 185253b), identies another situation of natural monopoly, i.e.
transport networks, which he calls a de facto monopoly. The reasons he
found for this phenomenon are quite different from those given by the
economists already examined. In his opinion, it is impossible for a new rm
to enter the market of transport networks because: the huge size of capital
requirement cannot be available to more than a very limited number of
entrepreneurs; the new rm takes customers away from the monopolist and
the prot will not be enough to cover the xed costs of both; and the rst
business uses the best conditions, leaving the less favorable ones to the new
one; in short: instead of one good business, there will be two bad ones
(Dupuit 185253a: 340). We have seen in the previous section that also for
Walras monopoly is inevitable in transport networks; but the reasons he
gives are different from Dupuits. According to Walras, competition cannot
work because the expropriation of the land needed to build the
communication networks can be decided only by the government. The
same occurs, he says, to public utilities, due to the impossibility of laying
pipes under public roads without authorization; as such permission can be
granted only to very few rms, a monopoly is necessarily created, because
Competition between a limited number of entrepreneurs is rationally
nothing but a passing phase after which there is the denitive creation of a
sole monopoly based on the ruin of the others, or a monopoly of all of
them or of some of them in coalition (Walras [1875] 1936: 202). We shall
see later that Walras also provides other much more interesting
technological reasons for natural monopolies.
Another important and original voice on this issue comes from Italy. It is
that of the public economist De Viti de Marco (1890), who states that the
telephone industry always tends to become a monopoly,
28
and gives
different reasons for this: one is linked to the network effects of the
telephone. It seems to be the earliest recognition of network effects in
28 De Viti de Marcos article on the telephone industry is examined in Mosca
(2007).
Manuela Mosca
326
economic literature: The consumers he says enjoy a utility that is
greater, the greater the number of subscribers with whom they can
communicate when necessary (De Viti de Marco [1890] 2001: 521). Some
other, very inventive reasons given by the Italian economist will be
discussed later because they are related to technology. We stop here,
because all of the concrete situations in which natural monopolies occur
have already been pointed out, and nothing original was added in this
respect by later economists.
4. Inquiry into economies of scale
29
Natural monopoly is due to technological reasons; it is some specic
technologically determined production process that generates it. We have
seen in the introduction that in the pre-1977 view of natural monopoly, the
fundamental characteristic of technology responsible for its emergence was
considered to be economies of scale, due to the presence of high xed costs
and law marginal costs. Obviously, the economies of scale we are interested
in are internal to the rm: the rms average costs decline as production
increases, because the cost of the xed inputs is spread over a greater
number of output units. Scale economies are a more general category than
increasing returns to scale:
30
increasing returns to scale occur with the
same proportional change in all the inputs, while for scale economies
inputs increase by some amount, and such an increase leads to a reduction
in the average costs of production; for example, productions with high
xed costs and low variable costs give rise to economies of scale, without
exhibiting increasing returns to scale. It is worthwhile recalling that, until
the 1920s, the expression increasing returns was used as it implied
changes in input proportions.
31
In this section we shall see that economists
of the past followed three different paths to identify economies of scale.
32
29 While for the aspects examined in the previous sections there is only the
secondary literature focused on the specic issue of natural monopoly, the
topics dealt with from now on have been widely studied from many historical
points of view; the literature cited here only shows a small part of this abundance
of references.
30 This is true if the price of inputs does not change.
31 For the meaning of increasing returns in Marshall, see Loasby (1989: 62), while
on the terminology concerning the laws of returns used in the cost controversy
see Aslanbeigui (1996: 27880).
32 We limit our inquiry here to scholars, and we do not mention all those who
applied the decreasing average cost concept to their businesses like, for
example, Gottfried Hartel, a German music publisher who, around 1800, plotted
the data on average costs for printing sheet music (see Scherer 2001).
Origins of the concept of natural monopoly
327
The rst concerns those who focused on rm-level increasing returns,
considering at the same time (more or less explicitly or approximately) the
fact that they imply decreasing average costs.
33
The second is related to
those who singled out scale economies by the distinction between xed and
variable costs. The third includes those who identied a diminishing rms
cost function. Again, we would like to point out that economists ideas on
economies of scale do not necessarily have to do with their ideas about the
other elements composing the notion of natural monopoly: for example,
not all of them used the expression, or even considered economies of scale
related to monopoly. We will see in the next section whether the decrease
in average costs was considered to lead necessarily to monopoly.
We start with the laconic statement of the Italian mercantilist Antonio
Serra that, unlike in agriculture, in manufacturing it is possible to multiply
inputs even two hundred fold, and with proportionately less expense
(Serra 1613: 155); this is all he says about scale economies, and we will
never know the reason for this decrease in expense.
34
We then proceed to
the celebrated rigorous analysis of non-proportional returns by Turgot, and
particularly to his description of the increasing returns that occur initially
when a given piece of land is tilled: tilling [a soil] a second, a third time,
might not merely double and triple, but quadruple or decuple the produce,
which will thus augment in a much larger proportion than the advances
increase, and that up to a certain point (Turgot [1767] 1844: 421).
35
As
this certain point takes place when only a very small portion of the market
demand is satised, we can say that the occurrence of a natural monopoly
in agriculture can be excluded. The economies of specialization associated
with the division of labor are not involved in the problem of natural
monopoly.
36
Nevertheless, we briey recall with Schumpeter ([1954] 1986:
585) that, from Smith onwards, every classical economist assumes the
existence of a law of increasing returns in manufacturing (just due to the
division of labor), in contrast to that of decreasing returns in agriculture.
37
33 Again, this is true if the price of inputs does not change.
34 We think Schumpeter exaggerates Serras insight when he writes: a general law
of increasing returns in manufacturing industry, also in the form of a law of
decreasing unit cost, had been stated explicitly and in full awareness of its
importance by Antonio Serra (Schumpeter [1954] 1986: 258).
35 The translation from French is by Edwin Cannan (1892: 55).
36 The literature shows that if the economies of specialization generated by the
division of labor are at rm level, they create a trade-off with the costs of
coordination, communication, transaction, and so on, which are specically
associated with the division of labor; therefore they do not lead to monopoly.
37 Schumpeter writes: Senior or West and Senior must be held responsible for
the tradition, which took such time in dying, that agriculture was the domain of
the latter [decreasing returns] and industry the domain of the former
Manuela Mosca
328
Its known that the advantages of the division of labor are well expressed by
Babbage (1832), who was to be the fundamental reference point for later
economists on this issue (Loasby 1996: 3078).
Senior had a very clear understanding of scale economies when xed
costs occur; referring to the spinning of cotton in a mill, he writes: As the
quantity produced is increased, the relative cost of production is
diminished (Senior 1836: 4.53). A few years later, Cournot used the total
cost function and its derivative; that is, marginal cost. Concerning marginal
cost, he believed that this function was usually diminishing for manufac-
tured articles, because of a better organization of the work, . . . and . . . [the]
reduction [of] general expenses (Cournot [1838] 1960: 59; emphasis in
original).
38
It is to Babbage that J. S. Mill (1848: I.9) refers in the discussion on
increasing returns; but he goes further, explicitly stating that a large scale of
production (like the post ofce) gives rise to savings in xed costs: as a
general rule he writes the expenses of a business do not increase by any
means proportionally to the quantity of business (Mill 1848: I.9.3). Dupuit,
in his entry Voies de communication, is much more precise: he uses a
numerical example to describe the case of a canal in which, due to the
presence of xed costs, the cost per unit transported decreases as the
quantity increases (Dupuit 185253b: 848). In examining the distribution
of water and gas, and citing Mill and especially Dupuit, Walras recognizes
that average costs decrease, because the expenses of the initial set-up, and
up to a certain point in its utilization, can be spread over a varying number
of products (Walras [1875] 1936: 210).
We decided not to mention all those railway engineers like Ellet, Jullien,
Belpaire, Lardner and others whose interest in railway costs easily led them
to distinguish between xed and variable costs, and to write an equation of
total cost, with a decreasing average cost function; their brilliant studies
were mainly empirical, and they only represent a prelude to theory
(Ekelund and Hebert 1999: 124).
39
But we do mention the Austrian
railroad engineer Wilhelm von Nordling (1886), who is acknowledged
40
to
be the rst scholar to identify the relationships between total, average and
[increasing returns]. This quite misleading arrangement was not set right until
the next period (Schumpeter [1954] 1986: 585).
38 As for the shape of this function, he adds that: it may happen however . . . that
when the exploitation is carried beyond certain limits . . . [the function] . . . again
begins to increase (Cournot [1838] 1960: 60), thus indicating the possibility
that the marginal cost curve might be U-shaped.
39 On the mentioned railway engineers see also Locklin (1933).
40 See Staehle (1942).
Origins of the concept of natural monopoly
329
marginal costs, by plotting a total costs function increasing and concave
toward the x axis.
41
His work is quoted by E

mile Cheysson (1887): in a very


innovative work, the French engineer-economist, perhaps for the rst time
in the economic literature, plots a decreasing average cost function.
42
He
also provides the important hint that the average costs curve may have
different shapes according to the type of industry: it will be different, he
writes, for large industry, for small industry or for agriculture (Cheysson
1887: 13). After him, it is H. C. Adams who clearly classies industries into
three classes, according to their returns to scale: These may be termed
industries of constant returns, industries of diminishing returns, and
industries of increasing returns (Adams [1887] 1969: 105).
43
A similar
classication, but seen from the costs side, is made by the Italian marginalist
Pantaleoni when he writes: we may . . . divide all products into various
classes: [1] commodities of which a greater quantity than that available . . .
may be obtained by a simply proportionate increase of cost; [2] products which
can be increased at a less than proportionate cost; [3 other products require] a
more than proportionately increased cost (Pantaleoni [1889] 1957: 187;
emphasis in original). As he believes that an increase of the quantity
produced is, within certain limits, accompanied by a diminution of cost
but . . . beyond those limits, it involves increased cost (Pantaleoni [1889]
1957: 193), there is no possibility for a natural monopoly to be generated.
44
In Pantaleonis Pure economics scale, economies derive from different
sources;
45
however, it is worth mentioning here his famous later work on
economic dynamics, where decreasing average costs are due to the fact that
41 In his words: the average cost, y/x, of each ton actually transported is
represented by the trigonometric tangent of the angle XOAOAA
0
[the slope of
the radius vector], and the marginal cost, dy/dx, is represented by the
trigonometric tangent of the angle CADBAA
0
[the slope of the tangent] . . .
since the angle OAA
0
4BAA
0
, marginal cost is always lower than average costs
(Nordling [1886] 1960: 69).
42 The data used by Cheysson are an elaboration on Nordlings data, and concern
an Austrian railway; therefore they are internal to the rm.
43 We know that, in considering the class of increasing returns industries, H. C.
Adams is referring to rm-level economies of scale, because he writes: The
railroad business may be cited as a good illustration of this third class of
industries; and he adds: The cost of plant is necessarily great in proportion to
the business that may be immediately expected (Adams [1887] 1969: 114).
44 Pantaleoni seems to believe that the minimum efcient scale can only be a small
proportion of the market demand.
45 The sources of economies that he mentions are: the stage of civilisation
attained, . . . every advance in the technical arts and in the organisation of
labour, the facilities of communication (Pantaleoni [1889] 1957: 187).
Manuela Mosca
330
average overhead (xed) costs decrease, while direct (variable) costs
remain constant (Pantaleoni [1909] 1955: 4151).
46
Another of the Italian marginalists, De Viti de Marco (1890), makes an
important contribution to a much more detailed description of the cost
features related to natural monopoly: he identies industries with high
xed costs (some of which are described as sunk) and low marginal costs
(transport networks, telegraph and telephone industries), or zero marginal
costs (the production of non-rival goods, like theaters) and on this basis he
explains the reason why average costs decline as the scale of production
increases. The importance attributed by Marshall to the law of increasing
return is well known. On the one hand, he identies cost features as a
cause of scale economies, when he writes supplementary costs are, as a
rule, larger relatively to prime costs for things that obey the law of
increasing return than for other things (Marshall 1890a: V.XII.11). On the
other hand, he does not include them among the sources of internal
economies, which in his words depends on the resources of the individual
houses of business engaged in [the industry], on their organization and the
efciency of their management (Marshall 1890a: IV.IX.25).
47
Paretos assertion that for each type of production, there is a certain size
of enterprise which corresponds to the minimum cost of production
(Pareto [1906] 1971: 243), is expressed with perfect clarity by Barone. As a
matter of fact, Barone gives a precise, complete description of the U-shape
of the average cost curve: if the [total cost] curve [. . .] were transformed
into a diagram with the unit costs of production on the y-axis, it would slope
downward until a certain point, and then upward (Barone [1908] 1936: 23;
emphasis in original). We shall see in the next section where that certain
point lies in relation to the market demand. Incidentally, we would like to
point out here that this is the rst time in the history of economics that a
diagram with the U-shaped average cost curve is verbally described.
48
46 Sylos Labini points out that: Pantaleoni is perhaps the rst of the few
economists who have dedicated a systematic, albeit brief, reection on the
question of overhead costs (Sylos Labini [1995] 1997: 197).
47 Internal economies are very much considered by Marshall, not only in his
Economics of Industry but also in his Principles, despite the growing importance of
the concept of external economies: he devotes chapters IX and XI of book IV of
his Principles to them. See Stigler (1941: 7683) and Marchionatti (1992: 55961)
among others.
48 In an interesting article by Keppler and Lallement (2006) the authors, while
giving Barone a well-deserved place in the history of the origins of the U-shaped
average cost curve, write that this history would have been quickly over, if
Barone had not decided to display total cost and total revenue on the vertical
axis rather than per-unit cost and price (Keppler and Lallement 2006: 748). It is
true, Barone did not draw a diagram with the average cost on the vertical axis,
Origins of the concept of natural monopoly
331
Historians of economic thought like Stigler and Schumpeter (who quotes
Stigler on this) agree that Edgeworths analysis of the law of returns is one
of his most important contributions to economic theory (Stigler 1941:
112). In fact, in 1911 he examined the increasing returns of a rm in
relation to marginal and average costs, separately considered (Edgeworth
1911a, 1911b).
49
As his article is focused on the railway industry,
Edgeworths main concern is scale economies due to input indivisibility.
We turn now to the consideration of economies of scale over the entire
range of market demand, and to the problem of monopoly that they could
imply.
5. Incompatibility of scale economies with competition
The decisive step in identifying a situation of natural monopoly is to
recognize that, when technology causes average total cost to decline as
output increases for the relevant range of demand, a single rm will survive
in the market. The question under examination in this section is what
economists thought would happen to the market structure as the average
cost decreased over the full range of market demand.
Despite the role that the division of labor within the rm plays in his
analysis, Smith does not take into the slightest consideration the possibility
that increasing returns may be at the origin of monopolies.
50
It is well
known that Senior divided monopolies into four kinds; he did consider
scale economies in two of the four kinds, but he never stated that they
but he did actually say: la curva della g. 12a, se si riducesse ad un diagramma di
cui le ordinate fossero i costi di produzione unitari, sarebbe decrescente no ad
un certo punto e poi crescente. This quotation is not only a verbal illustration of
the U-shaped average cost function, it is the very description of a graph. In our
opinion, this quotation should have a crucial role in Keppler and Lallements
historical reconstruction.
49 Moreover, his 1913 article has probably the rst diagram of U-shaped average
and marginal cost curves, and the demonstration that the marginal costs curve
intersects a U-shaped average costs curve at its minimum (Edgeworth 1913: 214,
g. 3). This is conrmed by Keppler and Lallement (2006), whose article is
entirely devoted to the history of this concept. See also Harrod (1931), Robbins
(1934), and the literature cited in Aslanbeigui and Naples (1997).
50 Adam Smith did not appear himself to be in the least troubled by the thought
that competition and increasing returns might not be able to coexist
(Richardson 1975: 354); see also Stigler (1951) and Groenewegen (1999). In
the light of the successive studies on economies of specialization, we can say that
he was right.
Manuela Mosca
332
could lead to monopoly by themselves:
51
in both kinds, in fact, monopoly
was due to other reasons, such as exclusive facilities (Senior 1836: 4.514)
and legal protection (4.56)
52
Cournot was the rst to clearly pose the
problem: if the marginal cost function j (D) is diminishing, he writes,
nothing would limit the production of the article and a monopoly would
occur (Cournot [1838] 1960: 91); and: investments made under the
condition that as D increases j (D) decreases, can only yield a net income
or a rent in the case of a monopoly properly so-called, or of a competition
sufciently limited to allow the effects of a monopoly collectively
maintained to be still perceptible (60; emphasis in original). Although
basing his case on different arguments, Mill reaches the same conclusion:
as we have seen, he identies many causes of cost savings in large-scale
production; in these cases, according to Mill, the presence of numerous
small businesses is a useless waste. All this leads him to conclude that when
competition could bring about only a multiplication of costs, a single rm
will survive (Mill 1848: I.9.7).
53
As we have seen in the previous section, it was Mill and Dupuit who
inspired Walras; he writes: Laying a second system of water or gas pipes in a
city where there is already one that could satisfy all the needs, building a
second network of roads in a country where there is already one that is
enough for all the communications, would be an absurd way of chasing
after economies (Walras [1875] 1936: 211). Ely just briey mentions the
question, but hits the nail on the head: there is great economy and
convenience in the conduct of the transportation . . . by those operating on
a vast scale . . . and this gives to that industry its inherent and irresistible
impulse toward monopoly (Ely 1886: 574). Like many other economists, he
also takes up Mills argument about waste, stating: One telegraph company
can send telegrams all over the country cheaper than two (Ely 1889: 44).
54
Hadley makes an interesting comment on the process toward equilibrium:
since the railroad is not subject to the law of the diminishing return . . .
there is . . . no direct limit to [the] cut-throat competition (Hadley 1886:
51 According to Tynan Senior recognized the existence of partial barriers to entry
due to xed costs, but argued that [. . .] as costs increased with network
expansion, partial barriers were overcome and new rms entered to compete
with incumbents (Tynan 2007: 49).
52 This is perhaps one of the reasons why Stigler writes that Senior was wholly
promiscuous in his use of the concept of monopoly (Stigler 1957: 3).
53 Referring to the case of the London water supply, Tynan conrms that for J.S.
Mill competition was largely illusory and that ultimately it was destructive due to
excessive entry and over-investment (Tynan 2007: 50).
54 We do not understand how DiLorenzo (1996) can include Ely among those
economists who saw economies of scale as a competitive virtue (1996: 44).
Origins of the concept of natural monopoly
333
35); such price competition generates, in his opinion, the survival of only
one rm, and therefore a monopoly. For De Viti de Marco (1890) the
telephone industry tends to be a monopoly not only due to cost features,
but also, as we have seen, due to network effects.
The position taken by Marshall (1890a) in this respect is much more
complex. The literature on this aspect of his thought is massive.
55
We need
only recall here that, in his Principles, Marshall cites Cournots statement on
the contradiction between internal economies and competition, but
afterward he criticizes him for having misapplied mathematics here. He
ignored the conditions which, in real life, prevent the speedy attainment of
monopoly by a single manufacturing rm (Marshall 1898: 49, n. 1).
Marshall, as we know, tries various ways of solving the so-called Cournot
dilemma,
56
without abandoning either internal economies or competi-
tion.
57
Like Marshall, Pareto also disapproves the theory that economies of
scale necessarily lead to monopoly, and concludes that the facts are not in
accord with this theory (Pareto [1906] 1971: 243).
A very precise examination of the incompatibility of scale economies with
competition can be found in Principi di economia politica by Barone, who
explains it in the following terms: If the unit cost of the product were to
diminish indenitely, as the quantity of output increases, it would be
advantageous for the production of every good to be concentrated in a
single rm (Barone [1908] 1936: 201); this can occur he adds when
. . . there is . . . a type of rm such that, while its costs decline toward a limit,
its size is enough to satisfy the entire market demand ([1908] 1936: 289).
58
After him, a truly complete analysis of a typical situation of natural
monopoly can be found in Edgeworth (1911 to 1913): he species that, as
railways exhibit increasing returns, they will tend to become a monopoly.
59
We shall examine Edgeworths analysis in the next section.
55 We just mention Newman (1960), Whitaker (1990, 2003), Hart (1991, 1992,
1996, 2003) Marchionatti (1992), Prendergast (1992), Loasby (1996), Groene-
wegen (1999), Quere (2003), and Niman (2004).
56 While it was Marshall himself who dened the choice between increasing returns
and competition a dilemma, it was named Cournots dilemma after Newman
(1960). In the secondary literature the expression reconciliation problem is
also widely used to indicate the problem of reconciling increasing returns and
competition; it probably comes from Stigler (1951: 186).
57 We also know that Marshall changed his views over the years on this question
(Whitaker 2003).
58 The same concept is found in his Principi di economia nanziaria (Barone 1911
12: 1201). Barones view of market power is examined in Mosca (2005).
59 Before his articles on railway rates (1911 to 1913), Edgeworth had already briey
stated the incompatibility: The law of diminishing costs, as Cournot argues, is
only intelligible on the supposition of monopoly (Edgeworth 1897: 69).
Manuela Mosca
334
We could stop here, with the statement made by Barone, and then by
Edgeworth, that scale economies over the entire range of market demand
lead to monopoly. However, we think it is worthwhile examining the debate
on this issue that followed because, as Schumpeter recalls, this is a striking
instance of the slowness and roundaboutness of analytic advance
(Schumpeter [1954] 1986: 1049). Schumpeter also claims that even
Marshall had already all the clues that are needed for a satisfactory
treatment of decreasing costs in all its meanings and aspects; and he adds:
the only thing to wonder at is that this discussion took so long to burst into
print and to present results to the scientic public at large (Schumpeter
[1954] 1986: 1046). In actual fact, contributions to the issue reappear only
in the 1920s, although without mentioning examples of natural monopolies.
It is well known that the incompatibility of scale economies with perfect
competition was one of the focuses of Sraffas critique of the Marshallian
supply function.
60
His 1925 article opens with Pantaleonis classication of
industries based on three classes of returns, already quoted. Then Sraffa
distinguishes three factors that can make the average cost of a rm decline.
First, the increasing marginal productivity of a variable factor of
production, due to the excessive quantity of an indivisible constant factor
(Sraffa [1925] 1998: 330); second, internal economies coming from
improved methods of production, in particular a greater division of labor
(in this case, for Sraffa all the inputs increase, although not necessarily in
the same proportion) ([1925] 1998: 3434); and third, overheads that
remain constant when output increases ([1925] 1998: 345). According to
Sraffa, the rst two cases give rise to a decrease of the marginal cost and, as
a consequence, to a reduction of the average total cost, while in the third
case the effect is directly a reduction of the average total cost, independent
of the behavior of the marginal cost. Then Sraffa states the incompat-
ibility,
61
and he does the same in his 1926 article.
62
Sraffa used this
argument to demonstrate that the only economies that could in principle
be compatible with perfect competition were the external ones; however, as
is widely known, he showed that also external economies create crucial
60 The literature devoted to Sraffas criticisms of Marshalls theory is also massive;
see the up-to-date references in Rosselli (2005).
61 In his words: it is clear that, if a rm can decrease its costs without limit by
increasing production, it would continue to reduce the selling price until it had
acquired the whole market. We would then have abandoned the hypothesis of
competition (Sraffa [1925] 1998: 3445).
62 He writes: reductions in cost connected with an increase in a rms scale of
production arising from internal economies or from the possibility of
distributing the overhead charges over a larger number of product units,
[are] incompatible with competitive conditions (Sraffa 1926: 540).
Origins of the concept of natural monopoly
335
theoretical difculties for the partial-equilibrium approach in a perfectly
competitive market.
63
In a brief historical reconstruction of Smiths theorem that the division
of labor is limited by the extent of the market, Stigler (1951) does not
mention Sraffa, while he cites Knights criticisms of Marshalls solutions for
the problem of incompatibility between perfect competition and increasing
returns. In fact, in the rst half of the 1920s, Knight dealt with the problem
several times,
64
reafrming that the necessary outcome of decreasing costs
due to large-scale production was monopoly.
65
We can thus ascribe to Sraffa
and Knight the denitive statement on the question of the incompatibility
of scale economies with perfect competition. In the 1920s both of them,
together with many other economists inside and outside Cambridge,
contributed to the well known cost controversy, which was focused exactly
on whether increasing returns and competition could be compatible or
not. It is worth noting again that those participating in this conference did
not mention any concrete example of industries exhibiting economies of
scale over the relevant range of output; moreover, the expression natural
monopoly to identify those industries was never used. Once more, we see
that the history of the different components of the concept of natural
monopoly followed different paths.
6. The diagram
Graphically, natural monopoly is represented by a demand curve that
intersects the downward sloping portion of the average costs curve: in this
case, the market will be served by a single rm. We have seen that Barone
accurately described the shape of average cost curves and the situation in
which natural monopoly occurs, explicitly referring to market demand. He
did this in words, and did not draw the diagram. It was Edgeworth who rst
drew a diagram in which natural monopoly was perfectly represented, with
the two cost curves (average and marginal) and the demand function
intersecting the decreasing portion of the average cost curve (1913: 214,
g. 3). He did this in one of his four famous articles on the theory of railway
rates, written between 1911 and 1913, in the section called Graphical
Representation of Cost.
63 Roncaglia points out that in Sraffas later work no general static functional
relationship can be established connecting unit cost . . . to output levels
(Roncaglia 1991: 393).
64 In particular we recall Knight (1921).
65 See Marchionatti (2003: 60).
Manuela Mosca
336
In his diagram (Figure 2), DD
1
is the demand curve, SS
1
is the average
cost curve, and SS
2
is the marginal cost curve. Edgeworth writes that, while a
decreasing average cost curve is insignicant in a regime of competition . . .
(1913: 213), it is perfectly possible under a monopoly regime.
66
7. Government intervention
We now turn briey to natural monopoly as a rationale for government
intervention. We are aware that a subject of such importance should be
treated in much greater depth; at the same time, we think that a brief
synthesis of the different positions taken by the economists mentioned
above is enough for the scope of this paper. We will briey resume here
whether they where in favor or against government intervention, while
realizing that economic theory is mainly interested in examining which
kind of intervention they thought was required.
We start with J. S. Mill, who states that When . . . a business of real public
importance can only be carried on advantageously upon so large a scale as
to render . . . competition . . . illusory . . . it is much better to treat it at once
as a public function (Mill 1848: I.9.24). As Ekelund and Hebert point out,
Figure 2. Edgeworths diagram.
66 Correctly, Keppler and Lallement interpret this curve as the cost (supply) curve
of an individual monopolist, rather than as the cost curve of a rm under
competition (2006: 753); in fact, Edgeworths article is primarily devoted to the
railway industry, and his main focus is on monopoly rather then on competition.
Consider this passage from another section of the same article: I need not enter
further into particulars which are not characteristic of monopolized industries
like railways (Edgeworth 1911a: 359).
Origins of the concept of natural monopoly
337
he proposes a: decentralized provision of service at the municipal level
under government ownership and locally elected board management
(Ekelund and Hebert 1981: 470). Its well known that J. Dupuit was a very
strong supporter of free markets; nevertheless he was convinced that, as the
transport network is a monopoly, the private monopolist could abuse of his
position; for this reason Dupuit was in favor of public intervention: The
government management of any industry, he writes, is an exception which
must always be justied by exceptional circumstances. Now, here [transport
network, water distribution, lighting, heating] the circumstance is mono-
poly (Dupuit 185253b: 853).
67
The principle of competition for the eld,
68
proposed by the English
reformer Edwin Chadwick (1859), is well known: the government can
regulate entry in a natural monopoly through a system of competitive
bidding; this principle implies that natural monopolies must be nationa-
lized and privately managed, although some regulation is always required.
69
Also Walras (1875) wanted the government to intervene in the railways,
either by directly controlling or by regulating them.
70
The importance of
nationalization for the railways is strongly expressed also by Ely (1886,
1889),
71
while Hadley nds the necessity for government regulation in the
very difcult aim of controlling the abuses of monopolies without
destroying the industries (Hadley 1886: 28), and Adams (1887) sees social
harmony restored by extending the duties of the State in the industries of
increasing returns.
72
It is to these American writers that Marshall refers
when he says: arguments are now used, especially in America (as for
instance by Mr H. C. Adams), in support of the active participation of the
State in industries which conform to the law of increasing return (Marshall
1890a: V.XIII. fn. 129). On the contrary, Marshall suggests that such
67 There are many other occasions, like the monthly meetings of the Societe
deconomie politique between 1853 and 1864, in which Dupuit expressed his
opinion in favor of public management of natural monopolies. See Mosca (1998:
265). Ekelund and Hebert (1999) give an opposite interpretation of Dupuits
opinion on the role of the government in this kind of market failure.
68 For the proto-history of franchise bidding see Ekelund and Hebert (1981).
69 Crain and Ekelund (1976) illustrate which kind of government regulation
Chadwick thought to be necessary; they also show that his principle was not
intended only for natural monopolies, but that it holds for every kind of
monopoly.
70 For a different analysis of Dupuit and Walras on railroads see Ekelund and
Hebert (2003).
71 See the criticisms of Elys belief in government superiority for the regulation of
natural monopolies by ODriscoll, who thinks that: he was in error in almost all
his contentions (ODriscoll 1982: 1979).
72 On Adams opinion of regulation, see Sharkey (1982: 1516).
Manuela Mosca
338
undertakings, though always under public control, and sometimes even in
public ownership, should whenever possible be worked and managed by
private corporations (Marshall [1890b] 1964: 106). It is interesting to note
that long before Demsetz (1968), De Viti de Marco (1890) rediscovered
the principle of competition for the eld: he thought that the government
could award a franchise to the most efcient rm and could refuse to renew
it if the rm behaves as a monopolist. Edgeworth (1911 to 1913) did not
write the promised nal section on the issue of government regulation, but
his article does contain a brief discussion in favor of the intervention of the
state for railway and public utilities in general (Edgeworth 1911a: 346).
8. An overview
See Table 1 for an overview.
9. History of the idea
Now that the analysis of all the elements has been carried out, we can sum
up. According to Stigler, Smith that great manufacturer of traditions
created also in the area of monopoly all the traditions that were faithfully
followed in English economics for almost 100 years (Stigler 1982: 1). Yet, as
far as natural monopoly is concerned, we can say that Smith gave nothing
more than suggestions.
73
In actual fact, we have seen that the idea of scale economies is a very old
one, and that it was Malthus who introduced the expression natural
monopoly. We owe to Cournot the elaboration of the mathematical
apparatus, the analysis of the decreasing marginal cost function, and the
statement of its incompatibility with competition. As we can see from the
above overview (Section 8), J. S. Mill is present in all the columns (with
the exception of Diagram); this shows that he had all the elements to
identify situations of natural monopoly, and he actually did it properly,
even using the expression in its present meaning, but without any analytical
tools. While Dupuit is often remembered for the theory of price
discrimination, his contributions that are worthwhile mentioning here
are that, as early as the 1850s, he identied the transport network as a
situation in which natural monopoly would have occurred, and that he made
73 This is also the opinion of O Driscoll (1982); he thinks that, for Smith, No form
of monopoly, save perhaps that of specialized land, is a natural market
phenomenon (ODriscoll 1982: 195).
Origins of the concept of natural monopoly
339
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Manuela Mosca
342
a rst step in the elaboration of the decreasing average cost function.
Chadwick has to be remembered mainly for his principle of competition for
the eld, while there is no evidence of any other original contribution to the
notion of natural monopoly by him. We have seen that Walras was very much
inuenced by J. S. Mill and Dupuit; for himwe can say the same as we said with
respect to Mill that is, he is present in ve columns: yet, compared with that
of Mill, Walras analysis was much more focused on the issue, as his essay was
specically devoted to the railways; however, he did not use mathematics in
dealing with it. Another important French economist who must be mentioned
here is Cheysson, for having plotted a decreasing average cost curve.
A signicant place is occupied by American economists. Despite his
critical tone, ODriscoll (1982) rightly stresses the importance of the legacy
of Ely; and Hazlett (1985) does the same, critically as well, with H. C.
Adams. From our analysis it emerges that Elys role was mainly that of
consolidating the use of the expression natural monopoly, that Hadley is
important for the focus on the adjustment process that leads to monopoly,
and that Adams is noteworthy for having distinguished three classes of
returns to scale.
74
Italian marginalists are also very important in this
context, although they are completely neglected by the secondary literature
on natural monopoly: the link between network effects and monopoly we
certainly owe to De Viti de Marco (1890), while the consideration of market
demand, which is essential to qualify a natural monopoly, and the
description of the diagram, come from Barone (1908).
However, there is no doubt that the pivotal gure for this reconstruction
is Edgeworth (1911 to 1913). In his long article the various elements that
make up the concept of natural monopoly are all present except the
expression. In fact his analysis is specically devoted to constructing an
abstract theory of railway economics, where railways are considered as the
leading type of a wider class, . . . public works, characterized by monopoly of
such a kind as to justify the intervention of the State (Edgeworth 1911a: 346).
10. Conclusions
The research carried out so far highlights some interesting aspects.
1. We have seen that Cournot, Mill, Walras, the American and Italian
marginalists, and Edgeworth realized that some rms become monopolies
74 Sharkey writes that Adams is one of the rst to suggest direct regulation of
natural monopoly (1982: 15), but actually we have seen that Dupuit and Walras
did this before him.
Origins of the concept of natural monopoly
343
just because in those industries competition cannot work. The idea that
monopoly implies the absence of competition is linked to a specic notion
of competition, that of perfect competition. The history of the theory of
competition has been widely studied in the literature.
75
If we compare the
historical reconstructions of the notion of perfect competition with our
history of the concept of natural monopoly, we can see that there is a
remarkable overlapping between the economists who elaborated that
notion, and those who played a role in identifying natural monopolies.
This suggests that the notion of natural monopoly emerged together with
that of perfect competition. The link between the two is also conrmed if
we consider the criticisms of the concept of natural monopoly, and the
related different notions of competition. The Baumol group, for example,
replaced the notion of perfect competition with that of contestability: as we
have seen, their fundamental idea is that the monopolist would be
compelled by the threat of new entry to behave according to the principles
of the perfect competitive model. We can also mention the Chicago
school: according to their idea of competition, market share does not
imply market power and monopolies are dictated by efciency. We nally
recall the Austrian view of competition as a dynamic process and of market
power as an expression of competitive rivalry. The most recent develop-
ments of microeconomics employ still other notions of competition,
76
which imply different ideas on natural monopoly. For example, according
to Shepherd, mainstream is not static efciency only, perfect competition
only, and total natural monopoly only . . . Instead there is an entirely
satisfactory competitive standard: effective competition, rather than the
pure theorists textbook idea of perfect competition (1995: 3056;
emphasis added). Also Vickers states that the concept of competition as
equilibrium resource allocator is not the only model of a modern micro-
economist (1995: 18); he uses the advances in economics of imperfect
information, imperfect competition, and dynamic processes (Vickers
1995: 7) to discuss incentives, selection and innovation . . . three of the
fronts on which advances are being made (1995: 18). We nally cite Blaug,
who encourage scholars to abandon the concept of perfect competition
(1997: 79), as well as its near-neighbour, the theory of perfectly contes-
table markets (Blaug 1997: 80), to promote the study of every chapter in
every textbook on imperfect or monopolistic competition, on oligopoly,
duopoly and monopoly, in short, . . . industrial organization (1997: 80).
75 In addition to the references cited in Blaug (1997), see DiLorenzo and High
(1988), Groenewegen (1999), Machovec (1995), and Morgan (1993).
76 For a history of the concept of competition up until recent times see Backhouse
(1990).
Manuela Mosca
344
With these complex notions of competition in the background, the new
industrial organization shows that even when entry is in principle free,
reasons to worry about monopolies still exist (Motta 2004: 71).
2. In Section 5 we have seen that Smith, Senior, Pantaleoni, Marshall, and
Pareto did not believe in the incompatibility of scale economies with
competition. Pantaleoni, for example, in his later work on combinations
and associations, did not consider them any actual danger for the
competitive process, because he believed that the threat of entry by new
rms is always at work (Pantaleoni 1903 [2001]: 1645).
77
Moreover, if
we examine all those ideas that, in order to follow our particular path
closely, we have here decided to exclude from our account, it will be
seen that we could reconstruct another, quite different history of the
concept of natural monopoly, by no means less rich. For example, we
might reconstruct the history of the idea that natural monopoly is always
exposed to competition, or that it is itself an expression of competition.
It would be sufcient to follow the historical development of the concept
of potential competition, or that of competition dened only in terms of
free entry, or that focused on the competitiveness of large rms. This is
what Sharkey does, when he points out that before the 1970s many
economists had already noted that the test for economies of scale is an
incomplete test of natural monopoly (Sharkey 1982: 21); and also
Hazlett, highlighting those economists who believed in the universality
of the competitive assumption (Hazlett 1985: 5). DiLorenzo and High
do the same, when noticing that economists at the turn of the century
thought that the advantages of competing in large-scale units increased
output and beneted the consumer (DiLorenzo and High 1988: 426).
These two positions (whether natural monopoly is protected from
competition or not) have always confronted each other, all along the
history of economic thought, and they are still sources of lively debate.
3. ODriscoll writes that: surely few would argue that monopoly is a
concept of any interest independent of policy implications (1982: 209);
in this case we belong to the few, because our analysis shows that the
problem of compatibility of scale economies with competition, which is
crucial in identifying natural monopoly, was mainly a theoretical matter.
However, it is well worth reecting on these implications, too. They are
important also because the critics of the concept of natural monopoly
claim that it was intended precisely for its policy implication,
78
and that
77 Pantaleonis view of market power is examined in Mosca (2007).
78 The fundamental importance of natural monopoly is a legalistic entity that
facilitates the efforts of political coalitions to restrict output in the manner
predicted in the capture view of regulation (Hazlett 1985: 2).
Origins of the concept of natural monopoly
345
it was even developed by economists only as an ex post rationale for
government intervention (DiLorenzo 1996: 43). And there is no lack of
allegations from the symmetrically opposite perspective: the Baumol
group, for example, is in fact accused of proposing the recurrent
arguments favoring a cutback to minimal antitrust policies (Shepherd
1995: 299). In the light of the previous analysis we can say that, as soon as
natural monopoly was considered a market failure, economists,
including those who supported the free market, put forward claims for
antimonopoly policies. This position, again, was adopted by those
economists who (more or less explicitly) accepted perfect competition
as an ideal benchmark.
79
In effect, if monopolistic power depends on
market structure, and if the market is concentrated due to entry barriers,
then competition policies are needed. On the other hand, in the free
market-oriented literature that holds different notions of competition
no interventions are required, such as public ownership or regulation
for utilities, and antitrust policies for networks. We have seen that
nowadays the theory of industrial organization, studying the strategic
contexts in which the potential entrants and the incumbents operate,
concludes that there are a number of reasons why market forces alone
are unlikely to reduce market power (Motta 2004: 71).
4. We are facing a typical case of economic thought shaped by reality. In
fact the spread of the expression natural monopoly in its current
meaning, and the consolidation of the related theory, came about
mainly with the spread of the situation that could be described as natural
monopolies. For instance, when Ely says that various undertakings . . .
are monopolies by virtue of their own inherent properties, he also
species that these undertakings are nearly all of them comparatively
new (1894: 294); also the article by Hadley (1886) clearly shows that,
through numerous examples drawn from the economy of the time, the
problem appeared particularly in those years. The public utilities and
networks determined the theory; it is true that the tools provided by
Cournot already existed, but many economists did not use them for their
explanations.
5. A by-product of having kept the history of the various elements that
contribute to the concept of natural monopoly separate has brought out
the undoubted importance of the work of economists from many
countries, and also of the Italian marginalists. In the secondary literature
79 An interesting point by DiLorenzo and High is that: Perhaps the clearest link
between economists changing views of competition and their support of
antitrust in the post 1920s era is found in the structure-conduct-performance
paradigm of industrial organization theory (1988: 431).
Manuela Mosca
346
one often nds the statement that the debate over costs and competition
is a phenomenon of the 1920s; we have seen here that the beginning of
the debate can certainly be anticipated to the works of the Italian
marginalists, and especially to Barone, who deserves priority over the
others. Their actual inuence on that debate remains to be studied
although, in view of their international fame, it was certainly
considerable.
80
To conclude, we are aware that the concept of natural monopoly still
contains many features it would be well worth while examining more
closely. We hope that with this article we have helped prepare the ground
for further research.
Acknowledgements
Helpful comments from Giampaolo Arachi, Michael Bradley, Gilbert
Faccarello, Francesco Ferrante, Vitantonio Gioia, Marco E. L. Guidi, Russel
Pittman, Marcella Scrimitore, David Teira, and two anonymous referees are
gratefully acknowledged. The usual caveat applies.
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Abstract
The present article contributes to the history of the concept of natural
monopoly, focusing on the reconstruction of its origins. The paper
considers various facets of natural monopoly: the expression itself; the
singling out of the concrete situations to which it is applied; the inquiry into
economies of scale; the consideration of their incompatibility with perfect
competition; the drawing of the diagram; and the need for government
intervention. In this paper each of the above features is separately
examined from a historical perspective. Priorities and inuences are then
traced, and in particular it is found that the pivotal gure in this historical
reconstruction is that of Edgeworth. The relation of the concept of natural
Manuela Mosca
352
monopoly with that of competition is also highlighted, as well as its policy
implications.
Keywords
Natural monopoly, economies of scale, competition, cost curves, network
industries, contestable markets, barriers to entry, market power
Origins of the concept of natural monopoly
353