The Natural Monopoly Conundrum

Historically, conventional wisdom has held that certain markets were “naturally monopolistic,” which means that, due to the presence of high fixed costs of which the average declines with increases in output, efficiency is best obtained when there is only one supplier. According to Kahn (1970, p. 15),

… the public utility industries are preeminently characterized in important respects by decreasing unit costs with increasing levels of output. That is indeed one important reason why they are organized as regulated monopolies: a “natural monopoly” is an industry in which the economies of scale are such that one company supplies the entire demand. It is a reason, also, why competition is not supposed to work well in these industries.

Included herein are the markets for electricity, natural gas, telephone, and water services. It has often been argued that what is driving this phenomenon is the irreversibility of the initial investment required to produce a particular good or service in a naturally monopolistic industry. More specifically, the underlying production technology of this product is such that a level of output exists for which average cost is minimized; at levels of output below this level average costs decline, and at levels above they rise. This is known as economies of scale and is investigated further in context to its relationship with the theory of natural monopoly.

Economists have spent many years attempting to assess that level of output at which the minimum efficient scale occurs. In some industries, such as the generation of electricity, a consensus has been reached that, at least in 1970, most firms were producing in and around this level, given a particular production technology (Christensen and Greene, 1976). In other words, economies of scale in the generation of electricity had been exhausted.

Until recently, no one questioned that the production of electricity was, in fact, a natural monopoly, as, like telephony, what is required here is a network—a complex, interactive, interdependent connection of wires (by which individuals gain access to the local distribution company, which is connected to the transmission grid at various nodes). This network represents an irreversible investment, which is characterized both by economies of scale and by those of network planning, and as such, yields a natural monopoly. Because this network leads to externalities, vertical integration has traditionally yielded the most efficient organization of the industry, especially for larger firms. But it is due to the vertical nature of electricity production that questions have arisen concerning whether any aspect of the production process may not be a natural monopoly. If this is the case, questions then become: would the market be better served by allowing competition into that component and would the gains from competition exceed the lost economies that would result? This is the critical element that needs to be explored.

Things are not always so clear, however. While there has been little work done in the areas of testing whether the transmission and distribution processes are natural monopolies, they are usually assumed to be so, as both are characterized by what is known as network economies. Network economies arise due to the interconnectedness of the national transmission grid so that significant saving in inputs and direct routing yield both economies of scale and economies of scope. These are defined later in this chapter, along with a review of the relevant literature.

Defining Natural Monopoly

Older industrial organization theory cited that the presence of scale economies determined whether an industry was a natural monopoly. It is important to note that much of the theory of natural monopoly is concerned with the precise meaning of “increasing returns” or, equivalently, decreasing average costs. Scale economies exist when a proportionate increase in output leads to a less-than-proportionate increase in cost. Mathematically, a cost function (one output) is said to exhibit global (local) economies of scale if

(2.1)

for λ > 1, q ≥ 0.

According to Marshall (1927), increasing returns can be either internal or external to the firm and, similarly, internal or external to the industry. A natural monopoly tends to arise due to high fixed costs, which tend to be asset specific and, as such, are largely sunk. As a result, average cost tends to decline as output is expanded over a large range, thus rendering a single provider socially optimal. In addition, economies of scale can be either technical (relating to the production process) or pecuniary, that is, related to the prices paid for inputs.

One of the difficulties in testing for natural monopoly is the practical application of testing for subadditivity of a firm’s cost function, which is critical, as local (global) subadditivity is a necessary and sufficient condition for local (global) natural monopoly (Evans, 1983). In addition, it is necessary to distinguish between single-output and multiple-output natural monopolies, which is done next.

Economies of Scale

Of the three cost concepts just described, average cost is...