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
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 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

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