Discusión

Natural monopoly arises because of fixed costs incurred in infrastructure invest-ment. It is inefficient to duplicate the fixed costs. Hence, monopoly is cost-efficient, or “natural.” Electricity supply (although not electricity production) is a natural monopoly. Delivery of water or gas through pipelines is a natu-ral monopoly. Dumping of waste and garbage is a regional natunatu-ral monopoly because of fixed costs incurred in setting up and using a dumping site. Railroad tracks may be a natural monopoly; however, transportation and freight services on the tracks are not a natural monopoly because different suppliers can compet-itively use the tracks.

Natural monopoly can be due to insufficient demand to warrant duplicative competitive supply. On routes where demand is sufficiently low, bus and air trans-portation can be a natural monopoly. Schools can be local natural monopolies. A doctor in a small town can likewise be a natural monopolist.

In a number of cases, technology has ended natural monopoly. When tele-phone communication was exclusively through wires, the teletele-phone company was a natural monopoly that installed the infrastructure, maintained network con-formity, and owned the communications infrastructure that physically connected users to one another. Competition was first introduced into long-distance munication by requiring regional telephone companies to act as conduits for com-peting long-distance companies. Cellular telephones introduced competition into local as well as long-distance communication. The Internet introduced voice com-munication through personal computers. Mail and parcels sent through the post office used to be regarded as a natural monopoly, but mail eventually came to be supplied competitively through private courier and express services. The advent of the facsimile machine provided competition for hand-delivered mail.

E-mail became a substitute for letters written on paper. In many countries, gov-ernment mail service was preserved as a monopoly by law until private-courier and express-service competition made it clear that the government mail service was not a natural monopoly but rather government monopolization.

2 1

3

MR

c = Constant MC of personal supply DEMAND (MB)

AC PM

PB

O PE

QM QB QE Quantity Valuation

and cost

Figure S2.1. Natural monopoly.

Financing solutions for natural monopoly

Figure S2.1 shows the declining average cost that is characteristic of natural monopoly. The source of declining average cost AC is a fixed cost F divided among increasingly greater quantities supplied.²⁷

In addition to average cost, figure S2.1 shows a constant cost c for each unit of output delivered to the buyer: c is the personal marginal cost associated with connection to the infrastructure that has a fixed cost F. Total cost of supply C is the sum of the fixed cost F and the additional per-unit cost c of supplying users.

With the total quantity supplied equal to Q, total cost is:

C= F + cQ. (S2.13)

Average cost is:

AC= F

Q+ c, (S2.14)

which is declining in the quantity supplied Q. The declining AC confirms that there is a natural monopoly. AC is always greater than marginal cost of personal supply c, and AC approaches the constant marginal cost c as the quantity supplied increases. Different public policies result in outcomes at points 1, 2, and 3.

27 The source of natural monopoly can be a sunk cost rather than a fixed cost. A sunk cost is incurred once and for always (for example, communication cables, railway tracks, electricity lines, or natural gas pipelines). A fixed cost is a recurring per-period cost that is independent of the number of users or the extent of use (for example, maintenance of communication cables, railway tracks, electricity lines, or natural gas pipelines).

Efficient supply

Efficiency is achieved by maximizing W= B − C, which results in the outcome point 1, where market demand intersects MC. At point 1:

MB= PE= MC (= c) , (S2.15)

where P_E is price and Q_E is quantity supplied. A privately owned natural monopoly would make losses by charging price PE and providing the efficient output QEbecause at QEaverage cost of supply exceeds price. Profits (or losses) are given by:

π = Q · (P − AC). (S2.16)

The shaded area in figure S2.1 is the loss to a private supplier from efficient sup-ply. The losses need to be covered through subsidies if supply is to take place.

Efficient supply by a privately owned natural monopoly requires govern-ment to provide subsidies.

Maximum profits

Profits are maximized at point 2, where price is P_Mand output is Q_M. The profit-maximizing outcome is inefficient because QM< QE.

The self-financing price

At point 3, price P_B = AC and the quantity QB supplied. The price is self-financing and the natural monopoly does not make a loss. No subsidy is required.

However, supply is inefficiently small because QB< QE.

The case against subsidies

There are a number of arguments against the subsidy solution at point 1.

Choice of effort

The amount in subsidies required for the efficient solution at point 1 depends on AC. Cost, in turn, depends on the effort of the natural monopolist. Because of the subsidies from the government, the natural monopolist faces a “soft budget”

under which losses are automatically covered. There is no incentive, therefore, to exert effort to keep costs low. The task of determining the subsidy at point 1 in general is assigned to a government agency. Because of unobservable effort and the soft budget, the government agency confronts a principal–agent problem. The natural monopolist determines costs through unobservable effort and thereby can increase the magnitude of the subsidy, whereas the government agency – if the faithful agent of taxpayers – wants costs of supply and thereby also the amount of the subsidy to be minimized.

Misrepresentation of costs

For any choice of effort, the natural monopolist can report AC strategically and thereby misrepresent costs (within bounds of credibility). A natural monopolist, depending on circumstances, can gain by reporting higher or lower than true AC.

The government agency therefore does not know in advance the direction of strategic cost misrepresentation.²⁸This is a distinctly different problem from the principal–agent problem that is the result of unobservable effort. Here, the gov-ernment regulatory agency does not know true costs. In the previous principal–

agent problem, the government agency could observe and therefore knew costs but could not observe effort.

Capture

The case against subsidies includes capture, which occurs when the government regulatory agency does not pursue the public interest but rather accommodates public policy to the interest of the natural monopoly.²⁹ Being “captured” is here voluntary. The capture is ostensibly in the interest of the employees of the government agency because, otherwise, they would have no reason to agree to be captured. In its most explicit form, capture is achieved through bribery.

There are more subtle means of capture than outright bribery. Employees of the government agency might be provided with jobs after they leave government employment – which is also a form of bribery. Capture can also be part of the political principal–agent problem. The government agency determining the sub-sidy to be provided to the natural monopolist may be accountable to political supervisors, who benefit from campaign contributions and other expressions of political gratitude of the natural monopolist.

Competitive bidding

Subsidies can be avoided by a public policy of competitive bidding for the price at which supply will take place. The outcome is then the solution at point 3 in figure S2.1 and the offer of the self-financing price P_B.

Revenue maximization

A government seeking maximal revenue from the winning bid would ask for bids for the right to be an unconstrained monopolist that can set price P_Mand supply outputQM. By inviting bids for the right to be the monopolist and leaving open the choice of the price that the winning bidder can set, the government transfers

28 The subsidy in figure S2.1 depends on the claim regarding marginal cost of supply c. A lower than true value of c expands the quantity on which the subsidy is paid but reduces the value of the per-unit subsidy. A higher than true value for c reduces the quantity on which the subsidy is paid but increases the value of the per-unit subsidy. Therefore, the value of the total subsidy payment can sometimes be increased by higher claims of cost than true costs and sometimes by lower claims.

29 The problem of capture was noted in 1971 by George Stigler (1911–91), who was a professor at the University of Chicago. Stigler received the Nobel Prize in economics in 1982.

the present value of monopoly profits to itself and leaves the public to confront the unregulated profit-maximizing monopolist.

Incomplete contracts

Competitive bidding for the price at which supply will take place avoids the prob-lems associated with payment of subsidies to a natural monopolist but introduces new problems. The right to provide water, electricity, or cable television can be determined by competitive bidding, with the winning bidder having the right of supply for a designated number of years. During those years, technology and quality standards in all likelihood will change. The contract for supply, therefore, should include contingencies for such change, but the types of changes that will take place, in general, are not known before the changes actually occur. Because of the impossibility of including all contingencies in the contract designating con-ditions of supply, the supply contract is incomplete. There may then be legal dis-putes when the unforeseen contingencies arise.

Transfer of ownership of infrastructure

If an incumbent supplier loses in a round of bidding, ownership of infrastruc-ture needs to be transferred to the winning bidder. A firm may have invested in infrastructure to provide cable-television services. After a designated number of years of natural monopoly, competitive bidding takes place to determine the future supplier, and the initial supplier loses the bid. The initial supplier owns the infrastructure but, after losing the bid, no longer has the right to use the infra-structure to provide cable services. It is inefficient for the new supplier to invest anew and duplicate the existing infrastructure. Duplication would defeat the pur-pose of competitive bidding, which is to allow supply under conditions of sharing of nonduplicated fixed costs. Reaching an agreement on price for the transfer of ownership of the infrastructure can involve complex bargaining and can delay the transfer of the right to supply.

Open access

An incumbent natural monopolist could be legally required to provide open access to use of infrastructure to all potential competitors. For example, cable companies might be obliged to allow other suppliers to offer Internet access through their cable system. The right of access can apply to use of electricity sup-ply grids, rail lines, gas pipelines, and telephone lines. When open access is made compulsory, property rights are compromised. The initial natural monopolist, who made the investments and owns the infrastructure, did not envisage being compelled to allow competitors to use the infrastructure. Open-access require-ments are retroactive and without compensation contradict the rule of law.

Waste management

A special case of natural monopoly is the storage of waste, particularly hazardous waste. The circumstances are special because waste is brought to the disposal site

and a payment is made for delivering the waste. Usually, payment is made by a seller to a supplier. However, in the case of delivery of waste, the supplier makes the payment. The payment is not voluntary. There are incentives, therefore, for illegal disposal of waste to avoid the cost of transporting the waste and the com-pulsory payment to the operator of the waste-disposal site. The incentive to dump waste illegally is reduced if no payment is required when delivering waste to the disposal site.

If the monitoring of disposal of waste is imperfect, the socially preferred policy requires paying for waste delivered to the disposal site (although never paying enough to justify generating waste for delivery). Payments for waste delivered require government subsidies to the private owners of disposal sites.

A private owner, of course, could never make a profit without a subsidy if obliged to pay when waste is delivered to the site. Competitive bidding could still establish a least-cost operator of the waste-disposal site. The bids are now for negative prices – that is, for how much the government will pay the waste-disposal operator.

Ownership by government and privatization

The principal–agent problems between a government regulatory agency and a privately owned natural monopolist are avoided when government is the owner of a natural monopoly. The government as natural monopolist knows the sub-sidies that accompany efficient supply, which can be directly financed through the government budget. Problems of incomplete contracts in competitive bidding solutions do not arise because there is no need for contracts when the government is itself the supplier. Problems of transfer of ownership or use of infrastructure do not arise because no transfer of ownership takes place.

Throughout most of the 20th century, the solution of government ownership and supply was prominent almost everywhere, with the exception of the United States.³⁰A natural monopoly under government control was often referred to as a state-owned firm. The natural monopoly, however, was effectively a department of government, and appointments to senior management and to the board of directors were often political decisions.

In the latter part of the 20th century, governments in Europe and else-where embarked on a process of privatization, or conversion of natural monop-olies to private ownership. Privatization reflected awareness of the bureaucratic principal–agent problem.

30 Outside of the United States, natural monopolies tended to be government-owned. In the United States, electricity generation and supply were privately owned, as were the firms that shipped and marketed natural gas and producers of defense equipment. Among natural monopolies, only water supply in general has been provided in the United States by public entities. In the United States, the natural-monopoly telephone company, AT&T, was privately owned. When technology changed, AT&T local services were divided among regional firms, and AT&T became a long-distance car-rier subject to competition from other firms.

Political will to implement privatization was required because of the politi-cal benefits of government ownership. Privatization was often resisted because of rents available to the administrating bureaucracy and employees of the state-owned firms. Often, compensation had to be paid for the rents lost. The mag-nitudes of the rents were reflected in the extent of opposition to privatization and in the value of the payments required to compensate employees for agreeing to privatization. After privatization, the magnitude of the rents enjoyed under government ownership was revealed in the profits of the firm under private ownership.

Privatization introduces the need for public-policy decisions toward privately owned natural monopoly, which returns us to the beginning of this supplement.