Economists have identified four main causes of market failure:The abuse of market power, which can occur whenever a single buyer or seller can exert significant influence over prices or output.Externalities- when the market does not take into account the impact of an economic activity on outsiders. For example, the market may ignore the costs imposed on outsiders by a firm polluting the environment.Public goods such as national defence. How much defence would be provided if it were left to the market? Where there is incomplete or asymmetric information
A monopoly is natural if one firm can produce a given set of goods or services at lower cost than can any other number of firms. A natural monopoly results when costs are decreasing in the scale of a firm (economies of scale). In natural monopoly situations the monopolists will raise his costs and tariffs because he lacks incentives for efficiency and is interested in the maximization of profit.A single firm can meet market demand at a lower cost than two or more competing firms could.
Economies of scale are frequently cited as a reason for natural monopoly. In some industries, the fixed costs of initial entry or set-up are so large relative to operational costs that average cost declines over a substantial volume of output. In extreme cases, a firm may not reach the lowest average cost point in its cost function until the available market demand is exhausted. In markets with these characteristics, a single supplier is actually the most efficient form of organization (unlike other monopolies that arise for legal or other reasons).Public utilities and telecommunications carriers have long been viewed as natural monopolies, but technological change may now be gradually eroding their natural monopoly characteristic. That is because modern technology that relies increasingly on fast computers and software is making plant and equipment more modular and scalable than in the past, and is bringing down the minimum scale that a firm must achieve to operate efficiently.
If there is a natural monopoly, it does not necessarily follow that there is substantial economic inefficiency. First, if entry into the industry is easy, the threat of potential competition may limit the extent to which an incumbent monopolist can restrict output (and raise prices). Second a monopolist may choose to use a pricing policy, involving fixed charges and a low unit price, which can both increase profits and benefits consumers. Third, if there are a number of possible suppliers of a monopoly service, competitive bidding for the right to be the monopolist can be used to lower the supply price and increase economic efficiency. Similarly, an alternative to the regulation of the electric power industry is for communities to own the local distribution system and bargain with power companies for the supply of electricity.
Are there any natural monopolies? And if there are, whether significant economic efficiency or social welfare would be gained by regulation. Economies of scale and scope certainly exist over some sets of goods and services, but these economies can be exhausted at output levels that allow more than one supplier to persist in the market. Empirical studies indicate, for example, that the large electric power plants in the United States have exhausted the achievable economies of scale. A natural monopoly can also result if having more than one supplier would result in an uneconomical duplication of facilities. Local electricity distribution systems within cities may remain a monopoly to avoid duplicate sets of distribution wires. This rationale does not necessarily apply in the telecommunications industry, since cable television and wireless communications systems provide alternatives to the local wire connections.