Publisher Summary This chapter examines some of the optimal policies that are used to control a natural monopoly. Although the traditional view suggests that government intervention and natural monopoly go hand in hand, economic analysis since the late 1960s has suggested rather forcefully that there are ways to introduce competition for a market, even if a natural monopoly structure exists within a market. The chapter provides an overview of possible competitive approaches to the natural monopoly problem. It discusses some of the major concepts in optimal pricing in regulated industries. These include peak load pricing, Ramsey pricing, and nonlinear outlay schedules. The chapter reviews a set of issues related to the fairness of regulated prices is discussed in the context of cross-subsidy or interservice subsidy.

Chapter 23 Optimal policies for natural monopolies

This article considers two schemes of regulationforfirms that serve both monopoly markets and markets subjected to substantial competition. The first form ("cost-based" regulation) combines elements of rate-of-return regulation (on monopoly markets) with filly distributed cost pricing, much like the form of regulation currently in place in the domestic telephone industry. The secondform ("price-based" regulation) would establish rate caps on noncompetitive services, and allow the firm to enter into competitive markets and charge whatever prices it might like in those markets. Models of both forms of regulation are developed and analyzed with respect to incentives for cost misreporting, choice of technology, cost-reducing innovation, choices of prices and output levels, and diversification into competitive markets.

Diversification incentives under "price-based" and ";cost-based" regulation

: Defense firms typically produce a large number of products and it is often difficult to keep track of the cost of producing each separate product. Much as the rest of American industry, defense firms have typically dealt with this difficulty by directly charging a small fraction of their costs. The remaining costs are grouped together in overhead pools and allocated across products usually in proportion to direct labor use. The purpose of this report is to explain a problem that this creates for the defense procurement process. The problem occurs because the responsiveness of price to accounting cost varies between products.

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Overhead Allocation and Incentives for Cost Minimization in Defense Procurement

While cross-subsidization is understood theoretically as involving the sustainability of a cost allocation scheme, it is invoked in regulatory policy contexts, such as the divestiture of ATT we conclude with observations on strategic behavior and regulatory policy.

Cross-subsidization and cost misallocation by regulated monopolists

A substantial body of recent research finds thatprice-cap regulation is superior tocost-based regulation in that many of the distortions associated with the latter are reduced or eliminated entirely. We prove that the hybrid application ofcost-based and price-cap regulation that characterizes current regulatory practice in the United States telecommunications industry may generate qualitative distortions greater in magnitude than those realized undercost-based regulation. It follows thatprice-based regulation in practice may be welfare-inferior tocost-based regulation. The analysis further reveals that the firm subject to this modified form ofprice-based regulation may have incentives to engage in pure waste.

Superior regulatory regimes in theory and practice

The profit-maximizing price structure of a multiproduct firm subject to fully distributed cost rules is considered. It is shown that a firm that sells in both regulated and unregulated markets would choose a dominated price vector. Similar incentives for inefficient pricing are provided to a firm that sells in markets subject to different regulatory authorities.

George Sweeney

Papers

Welfare Implications of Fully Distributed Cost Pricing Applied to Partially Regulated Firms