Baltic State Technical University

International Business & Communication Institute

Master of Business Administration & Engineering (MBAE)

Economics project work

State regulation of natural monopolies

Executed by Maria Nikolaeva

Scientific chief: Loukitchev P. M.

Saint-Petersburg

2008

Contents:

Аннотация 3

Summary 5

Intoduction 7

Part I: “Natural monopolies” 8

Technical conditions of natural monopoly 9

Barriers to entry 12

Part II: ”State regulation of natural monopolies” 14

The economic basis of regulation 14

Objectives of Government regulation 16

Regulatory responses 22

Deregulation 26

Part III: “How to better regulate natural monopoly” 30

Policy lessons and regulation experience 30

How to better regulate natural monopoly 35

Conclusion 37

References 38

2

Аннотация

Появление концепции естественной монополии часто связывают с именем

Джона Стюарта Мила, который утверждал, что это не экономно иметь

несколько поставщиков коммунальных услуг, хотя он не именовал

ситуацию как "естественная монополия".

Как и во всех монополиях, монополист, который получил преимущество

через естественные монополистические эффекты, может участвовать в

поведении, которое злоупотребляет его позицией на рынке. Эта

неблагоприятная тенденция приводит к просьбам потребителей о

правительственном регулировании. В то же самое время, такое поведение

монополиста, открывает возможности для конкурентов, предложить

клиентам лучший сервис. Правительственное регулирование может также

появиться по требованию бизнеса, надеющегося установить для себя

монополистическую позицию.

Нобелевский экономист Милтон Фридман сказал, что в случае

установленной естественной монополии "есть только выбор среди трех зол:

частная нерегулируемая монополия, частная монополия, регулируемая

государством, и государственная монополия."

Опыт многих развивающихся стран, говорит о том, что конкуренция -

эффективная форма регулирования естесственных монополий. Таким

образом, использование конкуренции на рынке для регулирования должно

быть главной целью государства. Представление конкуренции за рынок

требует осторожного дополнительного регулирования. Прежде всего, это

требует существенных правительственных инвестиций в начальном этапе.

Кроме того, правительству не следует забывать о методах ценового

регулирования.

Не просто найти равновесие для каждой страны и каждого сектора между

ограничительными правилами и принятием более гибкой структуры.

Детализированное априорное регулирование лучше подходит относительно

3

устойчивым, технологически устоявшимся секторам экономики (например,

водоснабжение), чем к секторам, подвергающимся быстрому

технологическому развитию, таких как телекоммуникации.

Данная работа говорит о том, что выбор регулирующего подхода сложен и

нет одного решения для всех проблем.Таким образом, решение о методах,

которые необходимо применять в той или иной ситуации, должно

основываться на экономических реалиях данной страны, учете отрасли

регулирования, а также политических тенденциях.

4

Summary

The original concept of natural monopoly is often attributed to John Stuart Mill,

who argued that it was wasteful to have multiple providers of utility services,

although he did not refer to the situation as a "natural monopoly."

As with all monopolies, a monopolist who has gained his position through natural

monopoly effects may engage in behavior that abuses his market position. This

tends to lead to calls from consumers for government regulation, while at the

same time opening up opportunities for competitors to offer better service.

Government regulation may also come about at the request of a business hoping

to set up a monopoly position for itself.

Nobel economist Milton Friedman, said that in the case of regulation natural

monopoly "there is only a choice among three evils: private unregulated

monopoly, private monopoly regulated by the state, and government operation."

Observing from the experience of many developing countries that competition is

an efficient form of regulation. Where privatization has gone with strong

competition in the market, the outcomes were positive, as is the case with

Argentine electricity. Thus, whenever possible, harnessing competition in the

market for regulation should be the main goal.

Introducing competition for the market requires careful supplementary

regulation. First of all, it requires a substantial government investment in the

initial design of the concession. This also entails government’s

fundamental decision concerning the degree of flexibility of the concession

agreements to be allowed.

Governments still have to deal with the familiar problem of price regulation. At

the time of the concession, the regulator must try to estimate the right price.

It is not easy to find a balance for each country and each sector between

restrictive rules and adoption of a more flexible framework that allows for

evolution of the rule but adds uncertainty. Detailed a priori regulation is better

suited to relatively stable, technologically mature, and monopolistic sectors, such

as water, than to sectors undergoing rapid technological evolution, such as

5

telecommunications. However, in developing countries with weak administrative

and judicial systems or poor track records concerning credibility, the use of

detailed and relatively inflexible concession agreements with fairly precise

upfront regulation may be preferable to more flexible rules subject to more

discretion on the part of the regulator. So the choice of regulatory approach is

complex and there is no best case for all circumstances.

6

Introduction

All industries have costs associated with entering them. Often, a large portion of

these costs is required for investment. Larger industries, like utilities, require

enormous initial investment. This barrier to entry reduces the number of possible

entrants into the industry regardless of the earning of the corporations within.

Natural monopolies arise where the largest supplier in an industry, often the first

supplier in a market, has an overwhelming cost advantage over other actual or

potential competitors; this tends to be the case in industries where fixed costs

predominate, creating economies of scale which are large in relation to the size of

the market - examples include water services and electricity. It is very expensive

to build transmission networks (water/gas pipelines, electricity and telephone

lines), therefore it is unlikely that a potential competitor would be willing to

make the capital investment needed to even enter the monopolists market.

Companies that grow to take advantage of economies of scale often run into

problems of bureaucracy; these factors interact to produce an "ideal" size for a

company, at which the company's average cost of production is minimized. If

that ideal size is large enough to supply the whole market, then that market is a

natural monopoly.

The focus of regulatory policy concerning natural monopoly has clearly shifted

with the evolution of technology and globalization of markets, which led to a

steady breakup of natural monopoly and made more competition technically

feasible. The issue of how to replace regulation with competition, which is

deemed as the best regulator, now occupies a central place on the current agenda

of natural monopoly regulation.

7

Part I: “Natural monopoly “

In economics, the term natural monopoly is used to refer to two different things.

This has been a source of some ambiguity in discussions of "natural monopoly".

The two definitions follow:

An industry is said to be a natural monopoly if one firm can produce a

desired output at a lower social cost than two or more firms—that is, there

are economies of scale in social costs. Unlike in the ordinary

understanding of a monopoly, a natural monopoly situation does not mean

that only one firm is providing a particular kind of good or service. Rather

it is the assertion about an industry, that multiple firms providing a good or

service is less efficient (more costly to a nation or economy) than would be

the case if a single firm provided a good or service. There may, or may not

be, a single supplier in such an industry. This is a normative claim which is

used to justify the creation of statutory monopolies, where government

prohibits competition by law. Examples of claimed natural monopolies

include railways, telecommunications, water services, electricity, mail

delivery and computer software. Some claim that the theory is a flawed

rationale for state prohibition of competition.

An industry is said to be a natural monopoly (also called technical

monopoly) if only one firm is able to survive in the long run, even in the

absence of legal regulations or "predatory" measures by the monopolist. It

is said that this is the result of high fixed costs of entering an industry

which causes long run average costs to decline as output expands (i.e.

economies of scale in private costs). 1

The original concept of natural monopoly is often attributed to John Stuart Mill,

who argued that it was wasteful to have multiple providers of utility services,

although he did not refer to the situation as a "natural monopoly."

1 http://en.wikipedia.org/wiki/Natural_monopoly

8

One example of a claimed natural monopoly would be the subway industry. It is

said that there would be greater social costs to have two competing subway

systems running in parallel, given the costs of digging pathways that go to the

same place. The average cost per trip would be less if there is only one subway

system. So, a legal prohibition against competition is often advocated and rates

are not left to the market but are regulated by the government.

Though a claim that an industry is a natural monopoly does not mean that there is

only one provider, it is often argued that in a natural monopoly industry only a

single firm will be able to survive.

Utilities (electricity, telecommunication, water, gas, and oil) are also often natural

monopolies. In industries with a standardized product and economies of scale, a

natural monopoly will often arise. In the case of electricity, all companies provide

the same product, the infrastructure required is immense, and the cost of adding

one more customer is negligible (up to a point.) Adding one more customer may

increase the company's revenue and lowers the average cost of providing for the

company's customer base.

Technical conditions of natural monopoly

The most common basis for a long-term natural monopoly is a firm's economies

of scale. A natural monopoly will arise when a firm's most efficient scale of

operation supplies all the output required to meet market demand. Economies of

scale exist when the long-run average cost (LRAC) of the firm declines as output

expands. For example, LRAC curve could decline continuously, as in Figure

4(a), so that the greater its scale of operation (output), the lower its average costs

will be. In this case, because its average cost of production is lower, a larger firm

can always drive smaller competitors out of business. Competition is unlikely to

persist, because the firm with the largest output can afford to undercut

competitors without incurring economic losses, taking away their sales and

driving them out of business.

9

A natural monopoly is a monopoly that arises naturally as a result of

technological conditions. In such cases, the market can support only one

producer.

For example, there are two firms in a market and that their combined output of Q

exactly meets market demand at point A. The larger firm produces q^ and its

smaller competitor q0, so Q =q0+q1. If the company sells ql it can charge P1 and

still not sustain a loss, because at point B for output qi on its LRAC curve, price

pi covers LRAC. In contrast, the smaller firm is at point C for output q0 on its

LRAC curve. It would need to charge a high price, P0, to avoid a loss. However,

the small firm can't sell its output at P0 because, from the market demand curve,

the market can only absorb the Q units at the lower price, p1. A small firm can't

survive. Roboserve retains its monopoly through its ability to drive potential

competitors out of business, because of its economies of scale.

The LRAC curve does not necessarily have to decline continuously for a natural

monopoly to persist. The LRAC curve can be U-shaped, as illustrated in Figure

4(b), as long as its lowest point occurs at a level of output sufficiently large for

one firm to accommodate market demand.

Some forms of public utilities are natural monopolies arising from economies of

scale. A large electric power plant generally has a lower LRAC of production

than a smaller plant.

Even without economies of scale, natural monopolies can arise and persist in the

short run if an entrepreneur markets a new product that no one can immediately

duplicate at similar costs. The company will stay a natural monopolist until other

firms develop the know-how to copy the invention and produce humanoid robots

at similar costs. As soon as this happens, in the absence of a commanding scale

economy advantage, the company will lose its natural monopoly as the

competitors enter the industry.

IBM, Apple, and Coca-Cola, for example, enjoyed temporary natural monopolies

during the early years of certain product lines, but then faced stiff competition

from entrants.

10

If a firm has a monopoly in one market, it may also try to naturally extend that

monopoly to other markets. Telecommunication services may be a natural

monopoly based on economies of scale, but production of telephones is not.

However, by virtue of its monopoly in telecommunications, through tying its

services to purchase of phones, the company makes itself a monopolist in the

phone market. That is, links to telephone networks will only be provided if cus-

tomers buy the phones produced by that company, thereby giving that firm a

monopoly in the phone market also.

Finally, natural monopolies can arise from sole ownership or exclusive access to

a natural resource, such as a mineral for which there is only one known deposit.

During the early 1950s, for example, Canada produced about 70 per cent of the

world's nickel. The International Nickel Company of Canada Ltd. (INCO)

accounted for about 80 percent of that amount. In the nineteenth century, John D.

Rockefeller at one time controlled over 95 percent of U.S. oil reserves, although

they were from more than a single oil deposit.

Today firms that control high percentages of natural resources are often

nationalized, or taken over by their respective governments. One justification for

nationalization is that such resources should be part of a nation's common

property, and that the monopoly's profits should accrue to all citizens. If one

country has virtually all production of a resource (for example, South Africa's

production of certain types of diamonds), a similar type of monopoly based on

natural resources occurs. There may be several deposits and firms within the

country, but the national government will enact policies to ensure that the country

acts as a monopolist in the world market.1

1 J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole W. – D.C.

Health, 1991,Toronto. – p 506.

11

As long as long-run average cost (LRAQ) declines until it intersects the market demand curve, as in (a), a large firm can always produce at a lower average cost than a small firm. Therefore, a large firm can charge lower prices than small firms and still make profits. If one firm produces quantity q, and the other q0, for a total output of Q, Q will sell at point A for price /V At pi, q-, is sold at cost (see point B), but q0 is sold at a loss because P^ falls below the LRAC curve for output q0 at point C To break even, a firm would have to sell q0 at price P0, which it can't do.

Barriers to Entry

A monopoly cannot exist without strong barriers to competition. Obviously, the

traditional factors, such as a high barrier to entry, or lack of close substitutes can

help establish a monopoly, but there are strong natural barriers to competition in

the software industry that are unique and exist only if one company

predominates. The more it predominates, the greater the natural barriers. Thus,

the key to establishing a monopoly is by gaining predominance as quickly as

possible. Once a monopoly is achieved, the natural barriers to competition will

maintain the monopoly.

New technologies evolved that are efficient at much lower levels of output than

12

older methods of production. These have substantially reduced economies of

scale and barriers to entry in many sectors, making at least some degree of

competition for many natural monopolies a real possibility. Development of new

technologies such as wireless telephony and optic-fiber cable has created new

scope for competition even with regard to basic line networks. In electricity, with

combined cycle turbine generators, where is a low-capital-cost source of power,

which cancels out economies of scale in generation and voids any argument that

electricity generation is a natural monopoly. As a result, even in some traditional

natural monopolies such as telecommunications (e.g., long-distance and wireless

telephony networks) and electricity generation, market competition has become

both possible and desirable.1

1 ? J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole W. – D.C.

Health, 1991,Toronto. – p 511.

13

Part II: “State regulation of natural monopolies”

As with all monopolies, a monopolist who has gained his position through natural

monopoly effects may engage in behavior that abuses his market position. This

tends to lead to calls from consumers for government regulation, while at the

same time opening up opportunities for competitors to offer better service.

Government regulation may also come about at the request of a business hoping

to set up a monopoly position for itself (e.g. electricity supply in a city). As a

quid pro quo for accepting government oversight, private suppliers may be

permitted some monopolistic returns, through stable prices or guaranteed through

limited rates of return, and a reduced risk of long-term competition.. For

example, an electric utility may be allowed to sell electricity at price that will

give it a 12% return on its capital investment. If not constrained by the public

utility commission, the company would likely charge a far higher price and earn

an abnormal profit on its capital.1

The Economic Basis of Regulation

Long-run average cost (LRAC) for a natural monopoly tends to decline over the rel-

evant range of demand. This decrease is illustrated in Figure 1. The most commonly

cited examples of natural monopoly are communications, such as telephone service and

broadcasting, and transportation, such as railroads, pipelines, and public utilities. For a

firm in these industries to engage in production typically requires an enormous capital

outlay. Consider the cost, for example, of railroad tracks, power lines, and com-

munications satellites. Furthermore, technology changes over time, creating new natural

monopolies, such as cable television, and eliminating some of the traditional natural

monopolies. For example, as we will see later, the traditional natural monopolies of air

transport and long-distance telephone service have, with technological advances and

growth in consumer demand, become more competitive.

1 http://www.econlib.org/library/Enc/Monopoly.html

14

Why is regulation desirable under natural monopoly? As Figure 1 shows, a natural

monopolist left on its own would produce Qm, the output at which marginal revenue

(MR) equals long-run marginal cost at point B. The output would be sold at a price

Pm, earning the economic profits shown in the colored area, where price is in excess

of long-run average cost. The economically efficient solution is to produce Qc at point

A, where demand just equals the long-run marginal cost of production (LRMC), and

to sell at price Pc. Regulation is one way to move a firm from the monopoly outcome,

Qm and Pm, to the competitive outcome, Qc and Pc. If regulation can feasibly do this at

a reasonable cost, it offers the best outcome.

Regulators seeking this best outcome face two primary problems: one concerns

profits and the other, information.1

The profit problem.

The profit problem is shown in Figure 1. At A, with Qc and Pc, price is less than

LRAC at point C, so the firm faces an economic loss equal to the amount shown in

the gray area. If output and pricing are efficient, firms lose money when the LRAC

curve is declining. To stay in business,

these firms would then need a subsidy

to cover their losses. The government

would be responsible for providing

these subsidies

1 ? J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole W. – D.C.

Health, 1991,Toronto. – p 545.

15

An ordinary monopolist would produce at the point at which MR (marginal revenue) intersects LRMC at B. At this output Qm/ price (on the demand curve at D) is Pm, resulting in a profit (above LRAC) of the colored area. Efficient output occurs at the point at which demand intersects LRMC at A. The output is Qc sold at Pc. However, at this price there is a loss, because LRAC is greater than Pc by the amount of the distance AC.

Objectives of Government regulation

1. Profit limitations.

Left on their own, natural monopolies would restrict output, charge high prices,

and potentially earn high economic profits. Economists want regulators to set

output at efficient levels, where demand equals marginal cost, as shown at point

A in Figure 2. However, at efficient output levels, firms now experience

economic losses, not profits. Losses need to be covered by subsidies for firms to

stay in business. And, as we have seen, subsidizing enormous corporations may

not be politically practical.

For this reason, and perhaps others, the regulatory agency does not attempt to

force Local Electric Company all the way to point A in Figure 2, a point at which

subsidization would be required. However, the regulatory agency wants to force

Local Electric beyond monopoly output and price, where profits might be earned.

So the agency tries to set price so as to eliminate the need for subsidies but to

ensure zero profits. Thus regulators try to find the price at which, for the quantity

demanded, Local Electric's total revenues just cover total costs. This occurs at

point C in Figure 2, the point at which demand intersects the LRAC curve. If the

price is set at Pr and Local Electric is required to meet demand, output will be Qr.

Pr is in some sense a compromise between the unregulated monopoly price Pm

and the socially efficient price of Pc, and their associated outputs. At point C

economic profits are zero.1

The primary formula.

1 ? J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole W. – D.C.

Health, 1991,Toronto. – p 547-549.

16

Regulators have a formula for trying to achieve this goal of setting a price (and

thus output) in such a way that demand intersects the LRAC curve. The specific

formula they use is:

Price = average operating cost + fair rate of return x invested capital per unit of

output

In theory this formula sets price equal to average total cost (ATC). ATC equals

average operating (variable) cost (AVC) plus average fixed cost. Average fixed

cost is here defined as average capital invested times its opportunity cost, which

is the prevailing fair rate of return.

Monopoly output occurs at the point at which MR intersects LRMC at B, with

output Qm and price Pm. Efficient output is at A, where demand intersects

LRMC, with output Qc and price Pc, but at A, Pc is less than LRAC. To make

sure that the firm does not suffer financial losses, regulators aim for point C,

where demand intersects LRAC. Here output is Qr with a price Pr, which equals

LRAC. Note that Pr is a compromise price between the high Pm and low Pc/ just

as Qr is a compromise output.

17

Regulatory lag.

A phenomenon known as regulatory lag may alleviate some of the problems

arising from Local Electric's lack of incentives to be efficient. If profits rise or

fall, there is a lag of perhaps two years before regulators adjust prices to bring

profits back to acceptable levels. So if Local Electric becomes more efficient, it

stands to profit temporarily. That is not the full long-term benefit of increased

efficiency, but it helps the firm in the short run. Correspondingly, if a firm's costs

rise unexpectedly (say, fuel prices rise suddenly), there may be a couple of years

before prices are raised to cover the increase. The company is then forced to

temporarily tighten its belt by cutting costs. Thus regulatory lag may help

promote efficiency.

Regulatory lag is the delay in the time it takes regulators to raise or lower prices

in response to a (new) condition of "too low" or "too high" profits earned by

regulated monopolies.

2. Universal service.

The second goal of regulators is universal service. A service must be priced at a

"reasonable cost" so that all—or almost all—potential customers can afford it.

The principle of universal service has two implications:

1. Services should be priced so that low-income families can afford them.

2. Users in "high-cost" classes of service should be able to receive the service at

"reasonable cost," so they are not priced out of the market.

Local Electric Company has different classes of service with different average

costs of provision. These classes include industrial users, apartments, single-

family homes, and urban versus rural areas. Service to low-density areas or low-

volume users is generally expensive to provide per unit of power received. Rural

residents require long transmitting wires because they are spread out. In addition,

power is lost when it is transmitted over long distances. So rural customers are

more expensive to serve than their urban counterparts. Providing electricity to

single-family users is more expensive than serving industrial users because high-

volume provision is cheaper per unit.

18

Universal service may mean that electricity has to be sold to low-income families

and rural customers below cost. This possibility is not limited to electricity.

Airlines and railroads have often been required to provide service at "reasonable

cost" to small, distant, low-volume towns.

Generally, universal service has a lower priority among regulators today than it

had in the past. It is no longer clear that the public interest is served by providing

expensive services to remote customers at a reasonable cost. Some argue that this

practice only encourages people to locate in less accessible areas, increasing the

need for high-cost services. In some instances, affordable new technology has

changed the situation. For example, today people in remote rural areas can

generate their own electricity at a still high but more affordable price than in the

past. Dish television receivers mean that cables for television reception need not

be laid out in more remote areas.

Cross-subsidization.

However, when public policy demands universal service, how can this objective

be met? Specifically, the firm and the regulator need to answer this question:

How can the firm provide service to high-cost users at a reasonable price without

a financial loss to the provider? One way, called cross-subsidization, is to raise

prices on classes of service that are cheaper to provide, in order to offset the cost

of the more expensive service. Regulated air fares and rail rates were traditionally

set below cost for small towns and above cost for other routes, to balance the

firms' budgets. The postal service generally prices second-class and junk mail

below cost and prices first-class mail above cost of provision. The prices for dif-

ferent classes of service represent the rate structure.

Cross-subsidization is the overpricing of lower-cost classes of service and the un-

derpricing of higher-cost classes.

The rate structure is the set of prices for different classes of services provided by

a firm.

Cross-subsidization is widely used in the regulatory process. Unfortunately,

cross-subsidization in cases where universal service is not an issue can become a

19

"political football." Electricity pricing is an example. In America, most people

can afford electricity at cost, and the very poorest can qualify for relief if they

can't. However, consumer-advocate groups are represented through the courts in

the regulatory process. Not surprisingly, they demand lower prices, relative to

cost, for all residential users and higher prices, relative to cost, for industrial

users. And they have a record of some success. You may ask, So what if

businesses pay more than they "should" and residents less?

We can look at the efficiency aspects of cross-subsidization. In the 1920s a

British economist named Frank Ramsey showed that a rate structure should be

designed to minimize the misallocation of resources.3 Here that means we want

demands to be minimally affected by the juggling of the rate structure (to min-

imize losses of consumer surplus). If demands are minimally affected, the

allocation of resources is minimally affected. So, if we are going to cross-

subsidize, we want individual and overall consumption to change as little as

possible relative to the unsubsidized situation.

Recall that if we raise prices when demand is inelastic, the quantity demanded

falls only a little, whereas if we raise prices when demand is elastic, the quantity

demanded falls a lot. The key, then, to ensuring that the fall in overall demand is

as small as possible is to raise prices in classes of service for which demand is

inelastic, relative to those where demand is elastic. This rule is more generally

called Ramsey pricing. In practice, however, cross-subsidization of electricity

does not follow Ramsey's rule. We believe big business has considerably more

elastic demands for power than residents. Then, overpricing electricity to cor-

porate users relative to residential ones violates Ram-sey's rule and therefore

reduces overall economic efficiency.

3. Self-destructive competition.

The final objective of government regulation is to prevent self-destructive

competition. Economists now consider this a less serious issue than they once

did, but self-destructive competition is a traditional concept that policy makers

still consider relevant in some situations. Let's illustrate the argument: A railroad

20

is competing with a trucking company for freight service from the town of

Highgood. The railroad has low marginal costs but high fixed (track) and average

costs. This means it can compete in the short run by cutting prices below average

costs. However, in the long run, if it does so, it will fail to earn enough to cover

average costs and replace its tracks, locomotives, and other capital equipment.

That is self-destructive, because if its track falls apart and cannot be replaced,

bankruptcy is inevitable. To prevent self-destruction, regulators set a price floor

below which the railway firm cannot lower transportation, the theory goes, but

both the trucking firm and the railroad stay in business. Another way to limit self-

destructive competition is to license the number of competitors. In this case, for

example, regulators could restrict the number of trucking firms allowed to service

Highgood.

Many economists do not find the argument in favor of a price floor very

persuasive. They argue that the railway company knows better than regulators the

risks of lowering prices too far and the potential for self-destruction. The

company, not the regulatory agency, also more directly faces the consequences of

self-destruction. The argument for intervention, however, is that management

lacks the competency to see the coming destruction, as regulators do. In the

United States, we tend to think it unlikely that public regu lators have greater

foresight than managers of private firms.

Even if regulators do have greater foresight, it is not clear that a price floor

could save an embattled firm. With a price floor, railroads cannot lower their

prices to compete with the trucking industry, so they may go bankrupt anyway

from loss of business. Price floors have a bad reputation for other reasons, too—

reasons that are worth investigating.1

1 ? J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole W. – D.C.

Health, 1991,Toronto. – p 564-568.

21

Regulatory responses2

doing nothing

setting legal limits on the firm's behaviour, either directly or through a

regulatory agency

setting up competition for the market (franchising)

setting up common carrier type competition

setting up surrogate competition ("yardstick" competition or benchmarking)

requiring companies to be (or remain) quoted on the stock market

public ownership

Doing nothing

Because the existence of a natural monopoly depends on an industry's cost

structure, which can change dramatically through new technology (both physical

and organizational/institutional), the nature or even existence of natural

monopoly may change over time. A classic example is the undermining of the

natural monopoly of the canals in eighteenth century Britain by the emergence in

the nineteenth century of the new technology of railways.

Arguments from public choice suggest that regulatory capture is likely in the case

of a regulated private monopoly. Moreover, in some cases the costs to society of

overzealous regulation may be higher than the costs of permitting an unregulated

private monopoly. (Although the monopolist charges monopoly prices, much of

the price increase is a transfer rather than a loss to society.)

More fundamentally, the theory of contestable markets developed by Baumol and

others argues that monopolists (including natural monopolists) may be forced

over time by the mere possibility of competition at some point in the future to

limit their monopolistic behaviour, in order to deter entry. In the limit, a

monopolist is forced to make the same production decisions as a competitive

market would produce. A common example is that of airline flight schedules,

2 ? http://en.wikipedia.org/wiki/Natural_monopoly

22

where a particular airline may have a monopoly between destinations A and B,

but the relative ease with which in many cases competitors could also serve that

route limits its monopolistic behaviour. The argument even applies somewhat to

government-granted monopolies, as although they are protected from competitors

entering the industry, in a democracy excessively monopolistic behaviour may

lead to the monopoly being revoked, or given to another party.

Nobel economist Milton Friedman, said that in the case of natural monopoly that

"there is only a choice among three evils: private unregulated monopoly, private

monopoly regulated by the state, and government operation." He said "the least

of these evils is private unregulated monopoly where this is tolerable." He

reasons that the other alternatives are "exceedingly difficult to reverse," and that

the dynamics of the market should be allowed the opportunity to have an effect

and are likely to do so. In a Wincott Lecture, he said that if the commodity in

question is "essential" (for example: water or electricity) and the "monopoly

power is sizeable," then "either public regulation or ownership may be a lesser

evil." However, he goes on to say that such action by government should not

consist of forbidding competition by law. Friedman has taken a stronger laissez-

faire stance since, saying that "over time I have gradually come to the conclusion

that antitrust laws do far more harm than good and that we would be better off if

we didn’t have them at all, if we could get rid of them".

Advocates of laissez-faire capitalism, such as libertarians, typically say that

permanent natural monopolies are merely theoretical. Economists from the

Austrian school claim that governments take ownership of the means of

production in certain industries and ban competition under the false pretense that

they are natural monopolies.

Franchising and outsourcing

Although competition within a natural monopoly market is costly, it is possible to

set up competition for the market. This has been, for example, the dominant

organizational method for water services in France, although in this case the

23

resulting degree of competition is limited by contracts often being set for long

periods (30 years), and there only being three major competitors in the market.

Equally, competition may be used for part of the market (eg IT services), through

outsourcing contracts; some water companies outsource a considerable

proportion of their operations. The extreme case is Welsh Water, which

outsources virtually its entire business operations, running just a skeleton staff to

manage these contracts. Franchising different parts of the business on a regional

basis (eg parts of a city) can bring in some features of "yardstick" competition, as

the performance of different contractors can be compared.

Common carriage competition

This involves different firms competing to distribute goods and services via the

same infrastructure - for example different electricity companies competing to

provide services to customers over the same electricity network. For this to work

requires government intervention to break up vertically integrated monopolies, so

that for instance in electricity, generation is separated from distribution and

possibly from other parts of the industry such as sales. The key element is that

access to the network is available to any firm that needs it to supply its service,

with the price the infrastructure owner is permitted to charge being regulated.

(There are several competing models of network access pricing.) In the British

model of electricity liberalization, there is a market for generation capacity,

where electricity can be bought on a minute-to-minute basis or through longer-

term contracts, by companies with insufficient generation capacity (or sometimes

no capacity at all).

Such a system may be considered a form of deregulation, but in fact it requires

active government creation of a new system of competition rather than simply the

removal of existing legal restrictions. The system may also need continuing

government finetuning, for example to prevent the development of long-term

contracts from reducing the liquidity of the generation market too much, or to

ensure the correct incentives for long-term security of supply are present. See

also California electricity crisis. Whether such a system is more efficient than

24

possible alternatives is unclear; the cost of the market mechanisms themselves

are substantial, and the vertical de-integration required introduces additional

risks. This raises the cost of finance - which for a capital intensive industry (as

natural monopolies are) is a key issue. Moreover, such competition also raises

equity and efficiency issues, as large industrial consumers tend to benefit much

more than domestic consumers.

Stock market

One regulatory response is to require that private companies running natural

monopolies be quoted on the stock market. This ensures they are subject to

certain financial transparency requirements, and maintains the possibility of a

takeover if the company is mismanaged. The latter in theory should help ensure

that company is efficiently run.

In practice, the notorious short-termism of the stock market may be antithetical to

appropriate spending on maintenance and investment in industries with long time

horizons, where the failure to do so may only have effects a decade or more

hence (which is typically long after current chief executives have left the

company). By way of example, the UK's water economic regulator, Ofwat, sees

the stock market as an important regulatory instrument for ensuring efficient

management of the water companies.

Public ownership

A traditional solution to the regulation problem, especially in Europe, is public

ownership. This 'cuts out the middle man': instead of government regulating a

firm's behaviour, it simply takes it over (usually by buy-out), and sets itself limits

within which to act.

A final approach to “the natural monopoly problem” has been to rely on public

ownership. Under a public ownership model, the government owns the entity

providingthe services, is responsible for its governance, including the choice of

seniormanagement, and sets prices and other terms and conditions. Public

ownership may beaffected through the creation of a bureau or department of the

municipal or state government that provides the services or creating a separate

25

corporate entity organized as a public benefit corporation with the government as

its sole owner. In the latter case, the state-owned company will typically then be

“regulated” by a municipal or state department which will approve prices,

budgets and external financing decisions. In the U.S. there are been only limited

use of public ownership as a response to the natural monopoly problem. The

primary exceptions are electricity where roughly 20% of the electricity

distributed or generated in the U.S. is accounted for by municipal or state public

utility districts (e.g. Los Angeles Department of Water and Power) or federal

power marketing agencies (e.g. TVA) and the public distribution of water where

stateowned enterprises play a much larger role. Natural gas transmission and

distribution, telephone and related communications, and cable television

networks are almost entirely private in the U.S. This has not been the case in

many other countries in Europe, Latin America, and Asia where public

enterprises dominated these sectors until the last decade or so.

Deregulation

Regulation of some industries appears to have worked moderately well in terms

of meeting the two basic goals: holding down profits and providing universal

service. The electricity, broadcasting, cable television, pipeline, and natural gas

industries are examples. However, regulation of other industries appears to have

failed in recent decades. One reason regulation fails is that either technology

changes or market conditions shift so that the regulated firms are no longer viable

natural monopolists.

The recognition that regulation was failing in certain transport and

communications industries led to a deregulation movement of certain industries,

such as airlines, and loosened regulation of others, such as railroads.

Under deregulation, in some industries, firms became more efficient and some

industries were efficiently restructured. For example, in communications, with

deregulation, more television channels sprang up and satellite broadcasting and

cable television blossomed. The advent of competition in formerly protected

26

industries led to a cut in "fat" in some companies, particularly in airlines. Under

regulation, firms could inflate costs by granting expensive union contracts and

high management salaries. Deregulation made these practices much more

difficult because competition set limits on costs.

However, deregulation has also created the uncertainties of fluidity at the

corporate level, with new companies springing up, many mergers or takeovers,

and bankruptcies. Although we accept fluidity in markets in general, for formerly

stable regulated industries, such as the airlines, it was quite new. Besides the

upheaval in markets, deregulation raised concerns about a loss in product quality

(for example, in late departures of airlines) and loss of universality of service. By

the mid-1980s these concerns led many consumers and policy makers to

conclude that deregulation had gone far enough, perhaps too far.

Airline Deregulation

Until 1978, airlines un USA were regulated by the Civil Aeronautics Board

(CAB), which set fares and determined routes to meet specific objectives.

Overall, fares were set to cover actual, not efficient, costs of production. Cross-

subsidization entailed relatively overpriced long journeys and relatively

underpriced short journeys. The CAB also regulated routes, so airlines were

forced to fly some unprofitable routes (at regulated fares) in return for more

profitable ones. In 1978, the Airline Deregulation Act was passed, phasing in

deregulation of most airline activities other than safety, which is covered by the

Federal Aviation Administration (FAA). Today little regulation remains. The

CAB has been completely disbanded.

The period since 1978 has been one of major readjustment for the industry. Only

now are the principal results becoming clear. On the positive side are the benefits

of fares and routing. Deregulation meant removing price floors and introducing

competition, so real airfares have fallen, benefiting all consumers. Long-distance

fares have fallen relative to short:distance ones, so that they are more in line with

their respective costs. Airline productivity is up by perhaps 15-20 percent, as

measured by millions o'T seats avaliable per employee and per miles flown.

27

Airline routing and production of travel service has changed. The efficient hub

system, which under route regulation was not permitted, has flourished. Hubbing

is a system by which an airline has onty a few major destinations with frequent

service over these long distances. From each major hub, the airline then has a

network of shorter flights connecting to other cities in the region. No longer does

each airline try to provide long-distance service from all major cities to all other

major cities, a practice that sometimes meant half-full and infrequent flights.

Instead, airlines emphasize good connections at hubs (meaning that less time is

needed to switch airlines), lower costs, and shorter overall travel times. Hubbing,

however, does require an airline to operate on a large scale.

With deregulation, airlines offer fewer frills (except perhaps inflight movies).

Flights are often more crowded, and meals plainer or nonexistent. But consumers

appear to have no interest in paying the former high costs for these extras, which

were a way of competing to attract customers when price competition was not

possible. Other elements of service have undergone periods of low quality. For

example, 1987 was a year of unusually high rates of flight delay, cancellations,

and lost luggage. However, new federal legislation now requires airlines to

disclose their on-

informed and can avoid airlines with long delays) and levies penalties for

canceled flights. These measures have helped alleviate the problems. Safety,

which is still regulated, has not been a big issue. The rate of accidents and

fatalities has not risen. Theve's a good deal of discussion of safety problems

caused by aging aircraft and lower maintenance standards, but hard evidence

doesn't indicate an increase in the problem. The public has an ongoing concern,

however, that air travel be kept safe.

Finally, deregulation has restructured the industry. The number of carriers

proliferated from about 35 in 1978 to well over 100 in 1983. A period of

consolidation followed, and the number of carriers has now fallen below 75.

Originally, proliferation meant less concentration, but today, concentration is up.

In 1978, the top four companies controlled 58 percent of revenue passenger miles

28

and the top twelve controlled 91 percent. By 1987, these numbers had risen to 60

percent and 97 percent, respectively. The increased concentration reflects the

mergers of major airlines, and may indicate the large scale of operation needed

for efficiency in the hubbing system.

Increased concentration does not necessarily mean less competition. There are

more airlines today than in 1978, showing the growtt\ of small commuter airlines

that provide service over short distances and to small communities. Since 1983

f,at the height of the proliferation of airlines), the average number of airlines

serving each pair of cities with service in the United States has actually risen.

Therefore, on the average, a consumer flying from point A to point B has more

choices.1

1 D. Begg, S. Fisher, R. Dornbush.Economics/ Begg D., Fisher S., Dornbush R. – British

edit. – McGraw-Hill: London, 1984. – p 443.

29

Part III: “How to better regulate natural

monopolies”

Policy lessons and regulatory experiences

The efficiency and behaviour of a monopolistic enterprise, whether private or

public, depends much on the framework in which it operates, and especially on

the existence of performance eenhancing incentives and penalties.

Which specific approaches and techniques need to be applied? This is the crux of

the matter of designing natural monopoly regulation policy.

Widespread privatization in natural monopoly sectors

In practice, while privatization of traditional natural monopolies has become

widespread in many developing countries over the past 20 years, their policies

towards real sector reform have often been ambivalent. Certainly, there is much

privatization, yet the actual degree of commitment to competitionbased

reform and the measure chosen vary considerably among countries and

industries.

In transition economies, privatization in general has been a tool of transition. It

has been used to establish property rights, to form a private sector and the basis

of a market economy, to enable efficient governance and management of

formerly state-owned enterprises. Yet, privatization of natural monopoly sectors

was usually not featured during the early years of reforms. Instead, reduction of

price subsidies has been a feature of transition in some countries, partly in

preparation for privatization. In particular, increasing energy prices to cover

costs, and increase profits, has been a painful process in many transition

economies. The general trends with regards to energy privatization for transition

economies are to move towards increasing prices; decentralizing

distribution to local authorities; and some privatization, especially production.

Private participation in electricity has been concentrated in the Czech Republic,

30

Hungary, Kazakhstan, and the Russian Federation with some vertical nbundling

of existing firms. Privatization of water in the region has so far been restricted

largely to two countries, the Czech Republic and Hungary, with a couple of cases

in Poland. Restructuring by decentralization has taken place more extensively,

though this decentralization has probably reduced efficiency. In particular, the

problems encountered by competitive restructuring initiatives in Russia point out

the following barriers to reforming natural monopolies that are particularly

important in Russia and, by extension other transition economies: the first is

political opposition from the management of the firms themselves

(e.g.,Gazprom). The second obstacle to reformed natural monopoly regulation

lies with the subnational authorities. The regional authorities’ dual role as owners

of regulated firms and as the principals to which the regional regulatory

commissions are subordinated has not worked well.

Moreover, much of the so-called “privatization” has really been the transfer

of ownership rights from the federal to regional governments. The problem is that

such transfers have introduced additional elements of confusion into corporate

governance, and created conflicting incentives for federal and regional agencies

that function both as owners and as regulators. This confusion and the conflicting

incentives have been a major obstacle to regulatory reform in Russia’s natural

monopoly sectors.1

Importance of ensuring real competition:

Comparative experiences of Chile and Argentina (electric power)

Argentina is the country that has gone furthest in introducing full competition and

vertical disintegration in the electric power industry. Chile is also a path-breaker

of privatization in the developing world—alongside Argentina. Yet in the

electricity sector, the restructuring of enterprises prior to privatization fell short

of what was needed to ensure competition. Despite the comparatively advanced

1S. Ran Kim and A. Horn. Regulation policies concerning natural monopolies in developing and transition economies// Division for Public Economics and Public Administration, United Nations, New York, 2005. – p 13

31

Chilean regulatory framework, it could have paid more attention to the property

structure, to ensure real competition.

Chile: In the case of electricity, Chile was committed to vertical

disintegration, but to a lesser extent to competition. In Chile, there were no

restrictions on cross-ownership of assets in different segments, unlike Argentina

(and Peru), which has prohibited any company or group from controlling more

than one of the market segments (e.g., electricity generation, transmission, and

distribution). One investment group controls most of the system’s generating

capacity, the largest distribution company, and the transmission assets. Cross-

ownership and consequent conflicts of interest have hindered the development of

a more competitive generation market.

Argentina: In Argentina, the power sector was restructured radically in

1992 by unbundling generating, transmission, and distribution activities and

organizing them under separate companies. Joskow (1998) describes Argentina’s

approach to electric power as a “big bang-approach”, in which privatization,

restructuring, and the introduction of competition were all accomplished in one

big step.

Argentina, privatizing much of its power system more than ten years after Chile,

benefited greatly from observing that country’s problems associated in particular

with cross-ownership. Argentina separated monopoly transmission and

distribution segments from the competitive generation segment. It adopted

a mandatory separation principle. No generator is permitted to control more than

10 per cent of the system’s capacity, and restrictions on reintegration and cross-

ownership are enforced. The resulting diversity in ownership ensured a more

competitive environment for generation than in Chile. The

restructuring programme in Argentina created a large number of private

generating companies, and competition at the generation level has been intense.

Transmission and distribution became regulated private monopolies. Retail tariffs

32

are regulated through a price cap mechanism. The Argentine privatization has

been a clear success in electricity industry.1

Designing the initial concession agreements—flexible or inflexible?

(Lessons from Guinea, Ivory Coast, Peru, and Venezuela)

It is not easy to find a balance for each country and each sector between

restrictive rules and adoption of a more flexible framework that allows for

evolution of the rules but adds uncertainty.

Generally speaking, detailed a priori regulation is better suited to relatively

stable, technologically mature, and monopolistic sectors, such as water, than to

sectors undergoing rapid technological evolution, such as telecommunications.

However, in developing countries with weak administrative and judicial systems

or poor track records concerning credibility, the use of detailed and relatively

inflexible concession agreements with fairly precise upfront regulation may be

preferable to more flexible rules subject to more discretion on the part of

the regulator. This may be more likely to reassure investors than the creation of

an autonomous regulatory agency with discretionary rulemaking powers.

Guinea and Ivory Coast both opted for the inflexible approach in

privatizing their water supply andelectric power sectors; the leasing contract and

concession agreement were accompanied by a detailed schedule of obligations

and conditions, leaving few aspects to be decided or agreed upon during

execution of the contract. The results are so far encouraging. It may be desirable

to anchor the regulatory framework securely in a law, which would give it a great

stability, though little flexibility, as Peru did. Peru needed to establish a

reputation for credible

regulatory rules to attract investment to the sector. The terms and conditions of

the initial regulatory contract are enforceable under commercial law, giving the

1 ?S. Ran Kim and A. Horn. Regulation policies concerning natural monopolies in developing and transition economies// Division for Public Economics and Public Administration, United Nations, New York, 2005. – p 15

33

regulator little discretion during the exclusivity period. It has been successful by

and large, exceeding all of its major investment and service improvement goals.

The regulatory framework, including the terms and conditions of concessioning

can be spelled out e.g., as a sector-specific privatization law. This can be

particularly useful for governments with low credibility and an inadequate track

record, which will usually have to offer more guarantees to attract private

investors.

In contrast, the lack of such institutional and legal anchoring probably

remains one of the major weaknesses of Venezuela’s telecommunication

franchising. In 1994 relations between CANTV telephone company holding a 35-

year concession, on the one hand, and the regulator and government, on the other,

became very tense. For political reasons, the regulator blocked the rebalancing of

rates anddid not meet deadlines to authorize some rate increases provided for in

the privatization agreements; one of the quarterly increases was even denied.

Even if the short-term effect is not clear, it is likely that this interference will be

detrimental to continued private investment.1

Using yardstick competition as a “complementary” measure

Argentina used this technique in several sectors. In addition to introducing

competition in the market where it was deemed feasible, Argentines decided also

to break up existing monopolies on a geographic basis to create benchmark (or

“yardstick”) competition in most infrastructure sectors. In the

telecommunications

sector, for instance, it was decided that direct competition should not be

introduced immediately for basic telephone services previously provided by

ENTEL. ENTEL was split between two geographic areas (north and south, with

1 ?S. Ran Kim and A. Horn. Regulation policies concerning natural monopolies in developing and transition economies// Division for Public Economics and Public Administration, United Nations, New York, 2005. – p 20

34

Buenos Aires divided into two zones), served by two separate privatized

companies.

Although direct competition is (initially) not authorized for basic services, this

geographic division allows the regulator and the public to compare the

performance of the two companies and exert pressure on the less efficient

operator. The same principle was applied to power and gas distribution

companies.

How to better regulate natural monopolies

Observing from the experience of many developing countries that competition is

an efficient form of regulation. Where privatization has gone with strong

competition in the market, the outcomes were positive, as is the case with

Argentine electricity. Thus, whenever possible, harnessing competition in the

market for regulation should be the main goal.

Try alternatively “competition for the market”

If competition in the market is not possible, as e.g., in the water industry, one

should at least organize the sector so that it can take advantage of opportunities

for competitive bidding. In the water industry, network-related costs are a higher

proportion of total costs than in gas, electricity, or telecommunications, and the

gains to be made from introducing competition by splitting up ownership of the

system are relatively small. Thus, most water will be supplied monopolistically at

least for the time being, and franchising appears as a way of encouraging

efficiency despite the monopoly.1

Argentina’s positive experience with an international competitive bidding process

for Buenos Aires water concession in 1993 is a case in point. In Argentina, water

and sanitation competition has been introduced through a bidding process.

1 ?S. Ran Kim and A. Horn. Regulation policies concerning natural monopolies in developing and transition economies// Division for Public Economics and Public Administration, United Nations, New York, 2005. – p 23

35

In the railway industry, franchising is also a preferred practice. The success of the

early concessions and the lack of credible alternatives have caused a snowballing

of such franchisebased reforms in Latin America, spreading also to other regions.

So far the experiences in Argentina, Brazil, Chile, Mexico, and Ivory Coast-

Burkina Faso are encouraging. Yet franchising is no panacea.

Introducing competition for the market requires careful supplementary

regulation. First of all, it requires a substantial government investment in the

initial design of the concession. This also entails government’s

fundamental decision concerning the degree of flexibility of the concession

agreements to be allowed.

Governments still have to deal with the familiar problem of price regulation. At

the time of the concession, the regulator must try to estimate the right price e.g.,

for water. In addition, over the course of the concession, it inherently requires

continuing government involvement in regulating safety, monopolistic behaviour,

and compliance with the pricing and service requirements of the concession. It

cannot simply walk away from its concessions once they are completed.

36

Conclusion

Regulation is a continuing process, whichever model is used. Harnessing

competition for regulation should be the goal, but even the alternative measures

of introducing competition require substantial supplementary regulation efforts of

government. Embracing the competition principle as much as possible is

important.

Countries must find which segments of an industry have competitive

characteristics and determine the most suitable ways of introducing more

competition. This entails that governments still need to deal with the thorny

problem of monopoly pricing. In practice, the difference becomes often diluted.

Countries now also have to grapple more explicitly with distributional impacts,

so as to increase the chance of success of competition reform. Certain

distributional inequities are better dealt with by means of subsidies from the

government budget.

In addition to introducing greater competition, it is also equally important that

one gets the privatization process right. In many countries, privatization seems an

unavoidable outcome of constraints, particularly financial ones. Once decided for

privatization, proper sequencing of the privatization and its coordination with the

regulatory reforms are important.

It is not easy to find a balance for each country and each sector between

restrictive rules and adoption of a more flexible framework that allows for

evolution of the rule but adds uncertainty. Detailed a priori regulation is better

suited to relatively stable, technologically mature, and monopolistic sectors, such

as water, than to sectors undergoing rapid technological evolution, such as

telecommunications. However, in developing countries with weak administrative

and judicial systems or poor track records concerning credibility, the use of

detailed and relatively inflexible concession agreements with fairly precise

upfront regulation may be preferable to more flexible rules subject to more

discretion on the part of the regulator. So the choice of regulatory approach is

complex and there is no best case for all circumstances.

37

References:

1. D. Begg, S. Fisher, R. Dornbush.Economics/ Begg D., Fisher S., Dornbush

R. – British edit. – McGraw-Hill: London, 1984. – pp.808.

2. J. V. Henderson, W.Poole. Principles of economics./. Henderson J. V, Poole

W. – D.C. Health, 1991,Toronto. – pp. 1235.

3. Gérard Mondello. REGULATING NATURAL MONOPOLIES: THE CASE

OF DRINKING WATER IN FRANCE// Gérard Mondello. - 2003. – pp.72-78.

4. Paul L. Joskow. Regulation of Natural Monopolies/ Joskow P. L. – CEEPR:

New York, 2005. – pp. 221.

5. S. Ran Kim and A. Horn. Regulation policies concerning natural monopolies

in developing and transition economies// Division for Public Economics and

Public Administration, United Nations, New York, 2005. – pp 25.

6. L. Williams. Should Windows Be Declared A Natural Monopoly? // URL:

http://findarticles.com/p/articles/mi_m0CGN/is_n3419?pnum=2&opg=20641843

7. P. Wonnacot, R. Wonnakot. Economics/ Wonnacot P., Wonnakot R. – 4th edit.

– John Wiley &Sons: New York, 1990. – pp 804.

8. http://en.wikipedia.org/wiki/Natural_monopoly

9. http://thismatter.com/

10 . http://www.econlib.org/library/Enc/Monopoly.html

11. http://knownote.info/link_9200_2.html

12. http://www.bellevuelinux.org/natural_monopoly.html

38