Download The regulation of a natural monopoly

The regulation of a natural monopoly
The ‘Data and Response’ column in the November 2001 issue of
Economic Review referred to the problems that arise in the
regulation of a natural monopoly. This arose in the context of a
discussion of transport policy. Figure 1 illustrates:
Figure 1:
Coping with natural monopoly
£
Pm
LAC
AC*
P*
LMC
AR (=D)
MR
Qm
Q*
Output
Suppose we have an industry in which there are substantial
economies of scale. A railway system is one example of a possible
natural monopoly. There are substantial fixed costs required to
establish a rail network in comparison to the marginal cost of
carrying additional passengers. Clearly it would not make sense to
have perfect competition in such an industry – imagine having
several parallel railway systems competing on the same route!
If average costs continue to fall to the very limit of market demand,
then the largest firm will always be producing at a cost advantage
over potential competitors, and the industry will tend to be a
monopoly.
But we know that a profit maximising monopolist will always
produce less output, at a higher price than is in society’s best
interests. In Figure 1, such a firm would produce where MC = MR,
with output Qm and price P m. At this point, we know there is
allocative inefficiency, because the price of the good is set at a level
above marginal cost.
Historically, such industries were often nationalised – i.e. operated
under state control. Regulation can then be used to ensure that the
industry charges a price equal to marginal cost. However, Figure 1
illustrates that such a policy causes problems. If price is set at P*
(the price that clears the market at marginal cost), the industry
incurs losses, because long-run average cost lies above marginal cost
at this level of output. The shaded area on Figure 1 illustrates the
loss made in this situation.
If the state subsidises the industry to cover this loss, then this will
cause distortions elsewhere in the economy, as the funds for the
subsidy must be raised somehow. Furthermore, if the managers of
the industry know that any losses they make will be covered by a
subsidy, then the incentives to be efficient are low. (This partly
explains the drive towards privatisation of previously nationalised
industries, on the argument that accountability to shareholders will
improve incentives.)
An alternative approach (which has operated in utilities such as
electricity, gas supply, etc.) is to allow the industry to impose a fixed
charge for access to the service, and then a variable charge
reflecting usage. The fixed charge then enables the firm to cover
the loss, and the variable charge reflects marginal cost. This is
known as a two-part tariff pricing system.
Another possibility is to have the industry charge a price equal to
average cost, thus just making normal profits. This produces a
position that is still away from society’s optimum, but is less
inefficient an allocation than the profit-maximising position.
However, the incentive effects for managers are still weak.
Peter Smith