Average total cost of a firm's production is the total cost divided by the number of units produced. If we graph average total cost (ATC) on the y axis and the level of output on the x axis then for most firms we get a U shaped graph. Gains from scale reduce average total cost over some range, but eventually problems with increasing scale lead to ATC that increases with higher levels of output. In a competitive industry prices are driven down by entry of new firms until the marginal firm (highest cost firm) is operating at the minimum of the ATC curve. If all firms have roughly the same cost curves then the number of firms in the industry is the total number of units demanded in the industry divided by the quantity at which the minimum of the ATC curve is reached. If total demand for fish is 1 million pounds and boats have lowest ATC at 8,000 pounds then in the long run there are 125 boats in the industry.

But what happens if there is no minimum to the ATC curve? That is, the average cost just keeps falling no matter how much is produced. In that case a natural monopoly esists. This is true of many utility providers such as water companies and electricity distributors. Fixed costs are everything. The more consumers that are connected to the network, the lower are the costs per household. Firms with continuously decreasing average total costs are called natural monopolies because the monopoly does not arise from barriers to entry but instead arises from the cost structure.