a natural monopoly is a situation where a single firm can supply the entire Market at a lower cost than two or more firms you tend to see large firms in Industries with decreasing costs or increasing returns to scale returns to scale refers to how output changes as you scale your business up or down increasing returns to scale means that as we scale up and produce larger quantities of a product we're able to take advantage of cost cutting measures only available at large scales which drives our average costs down the most extreme version of this is when those average costs keep falling forever which means the larger a firm gets the cheaper it produces each unit for we see this with Public Utilities electric companies gas companies internet companies and so on a single firm is able to provide the product cheaper than two or more firms could a natural monopoly is likely to occur in Industries with low and constant marginal costs marginal costs like this mean the cost of producing each unit isn't changing no matter how many we produce but to prevent the entry of more firms there need to be very high fixed costs High fixed costs mean average cost starts high and then Falls towards marginal cost average cost won't start Rising until marginal costs rise and with a natural monopoly that may not happen so how much will a natural monopoly charge for its product for that we need to charge demand which will likely be inelastic in a market with a natural monopoly since there will be few substitutes we also need marginal revenue a profit maximizing firm will choose where marginal revenue crosses with marginal cost when we follow that quantity up to the demand curve we can find the price consumers are willing to pay for this limited quantity of the good which of course leaves us with deadweight loss if this is the power company we would expect them to severely limit how much energy they produce and sell since that would allow them to charge a very high price for it but this is not what we see energy is actually pretty cheap that's because governments tend to regulate natural monopolies to prevent them from charging a high price by setting a price ceiling so where should we set the price ceiling in a competitive market we know that the price is competed down to marginal cost so perhaps that's where we should set it the price ceiling rewrites the marginal revenue The Firm earns since they cannot charge more than the price ceiling the marginal revenue they will earn is essentially set by that price ceiling at the same time the lower price increases the quantity demanded up to the point where demand crosses with that price ceiling which is also at marginal cost if the Monopoly provides this quantity then we'll have reached the efficient market outcome and eliminated all deadweight loss but will the Monopoly Supply this quantity not for very long this price ceiling is set below average cost which means that this firm is earning negative economic profits they will end up shutting down in order for the monopolist to break even the lowest we can set the price ceiling is where demand crosses with average cost at this point the monopolist breaks even earning zero economic profit the downside is that this point still comes with a little deadweight loss but far less than there would be without a price ceiling this is essentially how governments regulate utility companies they identify the average cost for the power company or gas company or water company or what have you and they set a price ceiling which gives them a normal accounting profit beyond that amount where the goal is to reach zero economic profits we'll also see in the next chapter that the deadweight loss still present can be eliminated by subsidizing consumers a little but we also know that price discrimination can be an effective strategy here and indeed many utility companies employ second and third degree price discrimination to reduce this deadweight loss