Understanding Natural Monopoly Regulation: Protecting User and Consumer Investments, Study notes of Economic Theory

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The rationale for monopoly regulation

Why do we regulate monopolies?^ Darryl BiggarACCC Annual Regulatory Conference^ 24 July 2008

Slide 218 July 2008

Outline

•^

The conventional economic rationale for why we regulate naturalmonopolies is inadequate.^ –

Many policy prescriptions which are soundly based in conventionaleconomic theory are routinely rejected by regulators in practice.

-^

Is this because regulators are economically illiterate? Or that they are notseeking to maximise economic welfare? Or is it that the conventionaleconomic approach to monopoly somehow misses the key point?

•^

I propose an alternative explanation as to how natural monopolyregulation promotes economic welfare.^ –

This alternative explanation is based on protecting the investment in sunkcomplementary assets on the part of users and consumers of the monopolyservice.

-^

In my view this alternative does a better job of explaining how regulatorsactually behave in practice (and how they should behave).

Why regulate?

-^

Avoidance of deadweight loss (= unrealized gainsfrom trade)

-^

But regulation itself has costs– It requires specialists (who may be particularly costly in

developing countries)

• There are probably economies of scale in regulation, so it is

more worthwhile in larger markets

• There may also be economies of scope => multi-sector

regulation

Simon Cowan Presentation ACCC Regulatory Conference July 2007

© Covec Ltd 2007

July 2007

www.covec.co.nz

5

Motivations for regulation •^

Economic motivation:•^

improve allocative efficiency

•^

This creates extra welfare•^

because there is more trade, inthis market

•^

But, there are offsetting costs•^

Direct costs of regulation•^

Mostly fixed, so scale matters

-^

Indirect costs•^

May deter efficient investment

P

M PC

Demand^ Q

M^

Q

C WelfareGain

John Small Presentation ACCC Regulatory Conference July 2007

If the DWL hypothesis was correct... •^ Slide 718 July 2008

If the DWLH is correct, regulators should be enthusiasticabout:^ –

marginal cost pricing

Bonbright (1988): “While most people in the public utility community are aware of and^ Bonbright (1988): “While most people in the public utility community are aware of andwould probably acknowledge the validity of marginal cost pricing many would minimizewould probably acknowledge the validity of marginal cost pricing many would minimizeit in actual ratemaking on grounds of either practicality or of a lack of singlemindedness toit in actual ratemaking on grounds of either practicality or of a lack of singlemindedness toeconomic efficiency … It is no secret that ratemaking in the United States has historicallyeconomic efficiency … It is no secret that ratemaking in the United States has historicallydeviated significantly from the first-best marginal cost ideal”deviated significantly from the first-best marginal cost ideal”

If the DWL hypothesis was correct... •^ Slide 818 July 2008

If the DWLH is correct, regulators should be enthusiasticabout:^ –

marginal cost pricing

perfect price discrimination

If the DWL hypothesis was correct... •^ Slide 1018 July 2008

If the DWLH is correct, regulators should be enthusiasticabout:

marginal cost pricing

perfect price discrimination

• … and

Ramsey pricing

-^

If the DWLH is correct, why are regulators soenthusiastic about:^ – ensuring

stable prices

over time?

If the DWL hypothesis was correct... •^ Slide 1118 July 2008

If the DWLH is correct, regulators should be enthusiasticabout:^ –

marginal cost pricing

perfect price discrimination

• … and

Ramsey pricing

-^

If the DWLH is correct, why are regulators soenthusiastic about:^ – ensuring

stable prices

over time?

• … preventing

adverse movements

in prices?

Slide 1318 July 2008

Regulation is not about reducing DWL

-^

Conclusion: The “deadweight loss hypothesis” does apoor job of explaining the way regulators actually behave.^ – Why? Are regulators bad economists? Are the economists not

shouting loud enough? Are regulators pursuing non-welfaremaximising objectives?

• Or is there something wrong with the economic theory? -^

Is there a better explanation of why we regulate naturalmonopolies?^ – Do we regulate in order to encourage productive efficiency?^ – Do we regulate in order to eliminate the incentive to waste

resources obtaining a monopoly?

• Is regulation primarily about protecting and promoting sunk

investment by the regulated firm?

Slide 1418 July 2008

Sunk investment by the regulated firm

-^

There is a strand of the economics literature which argues that aprimary task of regulation is protecting the sunk investments of theregulated firm:^ –

The story is: Natural monopolies must make substantial sunk investment

-^

Once sunk, this investment is subject to the risk of “expropriation” or“hold-up” through attempts by the government to force lower prices.

-^

Regulation is primarily about preventing this “opportunism” in order topromote sunk investment by the regulated firm. Spiller and Tommasi:

Slide 1618 July 2008

Sunk investment by customers

-^

What are these sunk investments made byusers/consumers?^ – A shipping company deciding whether to locate close to an inter-

state rail terminal, or to build a rail spur to its depot…

• A paper producer deciding whether to locate next to a major gas

transmission pipeline…

• An irrigator deciding whether to plant an annual crop (which only

requires one year’s water) or to plant an orchard which wouldrequire irrigated water for many years in the future…

• A factory deciding whether to invest in equipment which uses

electricity or gas (or both) as a fuel…

• A commuter deciding whether to locate close to a commuter rail

station..

Slide 1718 July 2008

Sunk investment by customers

•^

It is efficient for the customers to make these investments^ –

but the customer will be reluctant to make a substantial sunk investment if themonopolist can raise the price (or lower the quality, or threaten to cut off theservice), in the future.

•^

This problem could be solved by long-term contracts…^ –

This does occur in some industries (such as in the natural gas industry) but formany industries the number of customers is sufficiently large that thetransactions costs of negotiating such contracts makes them infeasible.

-^

The role of the regulator is to re-create that long-term contract which, byensuring the customer a long-term stable path of prices facilitates sunkinvestment by the customer.

•^

Note that this is an

efficiency

argument rather than a fairness or

distribution argument.

Slide 1918 July 2008

The sunk investment hypothesis

-^

The sunk investment hypothesis (“SIH”) makes it clearwhy regulators love:^ – Ensuring

stable prices

• …and

preventing adverse movements

in prices

-^

And why regulators hate:^ –

Price discrimination

and

Ramsey pricing

Slide 2018 July 2008

The sunk investment hypothesis

-^

The sunk investment hypothesis (“SIH”) makes it clearwhy regulators love:^ – Ensuring

stable prices

• …and

preventing adverse movements

in prices

-^

And why regulators hate:^ –

Price discrimination

and

Ramsey pricing

-^

…and why regulators have embraced

incremental cost

as the relevant price floor…