Increasing Returns to Scale

A market is characterized by increasing returns to scale when the cost of producing an additional unit of a product (the marginal cost of the product) goes down as the quantity of the product produced goes up.

Electric power and other public utilities are examples of markets that exhibit increasing returns to scale. Most of the cost of providing electric power comes from setting up the infrastructure of power lines. Once that infrastructure is in place, pumping more and more power over those lines costs little. The presence of increasing returns to scale means that large companies can produce more efficiently than small companies.

A market that has high natural barriers to entry (usually because of increasing returns to scale) is referred to as a natural monopoly because such a market has a tendency to become a monopoly. Indeed, in the presence of increasing returns to scale, a market that consists of a single large producer is the most economically efficient.

Traditionally, governments have dealt with natural monopolies by granting an official monopoly to a business and introducing regulations placing substantial controls on the behaviors in which that business is allowed to engage. (e.g. what pricing schemes are allowable).

Electical power and telecommunications are examples of natural monopolies that have been subject to government regulation. Recently, however, there has been a move in the United States towards deregulation of telecommunications and attempts to restructure markets so that the conditions that produce natural monopolies are eliminated.