Natural Monopolies Regulation

A free market requires no outside control. But so-called "natural monopolies need some supervision. Saul Estrin outlines the economic case for this assertion and examines various techniques for regulation.

In the past 15 years, the role played by regulators in UK industry has increased enormously, largely as a consequence of the Conservative government's privatisation strategy. Regulators' impact on industry is very much at the centre of the policy debate. In this section, I will explain why some industries are regulated and others are not, what regulators try to achieve and the way that they carry out their role.

To understand the fundamental economic problem posed by the so-called "natural monopolies, one needs first to grasp why economists place such faith in free markets.

 

In certain industries, two key conditions hold. First, economies of scale are modest. This means that long-run average costs, i.e. the unit costs of production allowing choice of technique to vary, begin to rise quite sharply as output increases while the company is still supplying a relatively small share of the market. There are many production processes of this form "� much of food processing, textiles, garments, wood and furniture making fall into this category.

Second, it is relatively easy to enter the market as a supplier "� for example capital requirements are very low, as in window cleaning. More significantly, sunk costs, i.e. costs that can not be recouped if entry fails, are low. Many service industries, such as car hire companies fall into this category.

One of the most important results in economics is that, with just these two conditions, markets will offer consumers the maximum attainable satisfaction, i.e. the highest possible output at the lowest possible prices without companies making losses. The threat of entry ensures that prices never exceed long-run average cost (for example, marginal companies in the industry cannot persistently earn above average profits). Moreover, competition also ensures that price equals long-run marginal cost. Hence the price of a good accurately reflects the opportunity cost of manufacturing it.

Problems arise from leaving everything to the market, however, if these two pivotal assumptions are not satisfied.

An important example of where the two assumptions do not hold is the case of natural monopoly, a market structure in which unit costs fall as production increases until it is economic for a single company to satisfy the entire market; in other words, one company can supply the whole market at a lower cost than two. In economists' jargon, there remain economies of scale to be exploited when one company meets market demand. There are typically also major barriers to entry in such industries.

Most public utilities "� electricity generation, water supply, gas supply and perhaps national telecommunications systems - have technologies of this sort. There are several special problems for these industries.

First, their size and capital intensity often puts particular strain on private capital markets in satisfying their investment needs. In the UK in the 1960s and 1970s, the strain was felt instead on the public coffers, and this was a major factor behind privatisation. Note also that these companies are usually in the non-traded sector. The problem for the domestic economy caused by rampant economies of scale is usually resolved in practice by trade, which acts to expand demand and therefore market size.

Hence, while for example automobile or chemicals manufacture are also characterised by huge scale economies, governments have rarely seen it as their role to regulate companies in these industries. Such companies may be very large players in their domestic markets because of scale economies but still face severe competition on global markets.

The question for policy makers is what to do about natural monopolies. Left to themselves, they will charge monopoly prices and restrict output. The absence of any competitive threat will also probably leave such organisations wasteful, inefficient and sluggish. Since all costs can be passed on to the consumers, there will be little incentive for managers to keep them under control. Experience from, for example, the coalmines or the railways suggests that it will not be long before workers realise that they, too, can share in the economic rents by raising wages, improving working conditions and reducing hours relative to the norm in the private sector. Perhaps most seriously, the absence of competitive pressures may damage the motives for innovation and change, so crucial in such capital-intensive sectors.

If this outcome is bad, many of the alternatives are worse. If the government decides to break the company up, but there really are significant scale economies, long-run average costs in two or more companies will be much higher than if the company runs as a monopoly. In this perverse world, consumers could end up paying higher prices for more competition.

If the government decides instead to nationalise the companies and run them as if they were in competitive markets, the outcome may be even worse. The appropriate role, we saw above, would be for the government to tell public sector managers to set output levels where price equals long-run marginal cost. This would avoid the problem of low output levels (and high prices) characteristic of monopoly.

However, when average costs are falling, marginal costs lie below average costs. This is because, when unit costs fall as production increases, it must be true that each increment to cost with rising output is successively less than the last. Hence "marginal cost pricing, as such a rule is called, leads to loss-making because the price set must be less than average cost.

In following such a rule, the Exchequer must implicitly agree to bear the resulting losses. The incentive problem for managers who have in effect been ordered to make losses will exacerbate the natural tendencies to inefficiency in monopoly noted above.

If, though, fixed costs are high and sunk costs are low, one way out is for the government to franchise the natural monopoly. Operators bid a price to operate the monopoly for a fixed period. In this case, entry does not dissipate economies of scale because only one company ever supplies the market, but the threat of entry is meant to keep the monopolists honest in the interim.

In the UK, franchising is used to regulate commercial television and is planned for railways. However, franchising creates serious incentive problems for investment by companies at the end of the franchise period as they may be unwilling to reinvest earnings if they are not certain that their franchise will be renewed.

The only other way is to nominate a regulator who must fix the natural monopolist's price. In the UK, privatisation has been accompanied by the formation of a regulator's office for all markets where it is felt that competitive pressures alone would not be sufficient to prevent the natural monopolies from exploiting consumers. Hence there are regulators for telecommunications, gas, electricity and water, but not for coal, oil, or aero engines (where Rolls Royce is the only major manufacturer).

How should regulators fix prices? As we have seen recently, this is a very sensitive decision because it affects profits, investment and the value of the utility companies as well as consumer welfare.

The traditional approach in the US was to regulate in such a way as to give companies a pre-determined rate of return, i.e. rate of return regulation. The problem with this was that it gave the utilities an incentive to raise their capital base.

In the UK, there is a pioneering price cap regulation using a rate known as RPI-X. This means that the regulator caps prices at a level equal to the retail price index minus some value to reflect the expected rate of fall of average costs. In effect, the regulator looks at the change in the average price charged by the monopoly, requiring it to fall in real terms by some pre-determined amount related to expectations about the rate of technical advance. But this is a very hard figure to determine.

So the UK's privatised utilities will probably always need regulators, at least until scale economies are exhausted in these sectors. But the current rules do not seem to be working quite right yet. More thought is needed better to balance the conflicting needs of current consumers, future consumers and shareholders.