Regulation of natural Monopolies

This has been taken from our blog Brinks of economic Thoughts.

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Natural monopolies are conducive to industries where the largest supplier derives cost advantages and must be regulated to minimize risks.’’



Technological definitions

-Behavioral and market equilibrium considerations

-Sunk costs

-Empirical evidence on cost subadditivity





Economic efficiency considerations

–Other considerations

–Regulatory goals



-Franchise contracts and competition for the market

-Franchise contracts in practice 

-Independent “expert” regulatory commissions




  • A natural monopoly is defined by an incumbent in an industry where the largest supplier can theoretically create the lowest production prices, generally through economies of scale or economies of scope.
  • Natural monopolistic conditions are therefore at high risk of creating actualmonopolies, and society benefits from regulating these situations to even the playing field.
  • Regulating industries to minimize monopolization and maintain competitive equality can be pursued through average cost pricing, price ceilings, rate of return regulations, taxes and subsidies.
  • While the concept of a monopoly is generally perceived as a threat to free markets, there are specific circumstances where natural monopolies are either pragmatically useful (cost effective) or virtually unavoidable.


The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.

Government assistance to a business or economic sector.



A monopoly is a business or organization that maintains exclusivity of the supply of a particular product or service, and can evolve naturally or be designed specifically based on the nature of a particular market or industry. Monopolies on the whole are governed under antitrust laws, both on a national level in most countries and on an international level via institutions such as the World TradeOrganization (WTO).

The evolution of a monopoly is a critical component in recognizing which industries are at high risk of monopolization, and how these risks may be realized operationally. A natural monopoly is defined by an incumbent in an industry where the largest supplier can theoretically create the lowest production prices, generally through economies of scale or economies of scope . In this type of circumstance, the industry naturally lends itself to providing advantages for the single largest provider at the cost of allowing for competitive forces. Natural monopolistic conditions are therefore at high risk of creating actual monopolies, and society benefits from regulating these situations to even the playing field.


–History of regulation of monopolies


The societal and economic dangers of monopolies are clear. To combat the effects of these large corporations, the government has tried, through both legislation and court cases, to regulate monopolistic businesses. Though the strategies that the US has followed have varied, the aim of curbing market hegemony has been relatively constant. Though examples of attempts at government regulation are widespread, three stand out from the rest:railroads of the 19th CenturyMicrosoft, and IBM.

Most regulation in its early history revolved around the railroad industry. At first, the responsibility of control of public industries fell on the individual states. However, the ineffectual legislation that was passed and the inability to control railroad monopolies made the need for federal regulation painfully apparent. The passage of the Interstate Commerce Act in 1887 created the first interstate regulatory committee. Though this group was not extremely effective in curbing the practices of the railroad, the precedent for federal regulation had been set. Later legislation, such as the Sherman and Clayton Anti-Trust Acts had more of an effect on large businesses. The latter bill created the Federal Trade Commission, which is the major regulatory body of monopolies today.

The important question that arises from regulation is: Why does the government feel that it must control big businesses? Does this not violate the principles of freedom outlined in the Constitution? Indeed, the government never tried to stifle a corporation simply because it was strong. Instead, regulation exists to preserve competition and the freedom for smaller companies to enter the market. If one company controls the market share, smaller groups will never be able to flourish. For example, the dominance of Microsoft in recent years has raised the question of whether its practices are monopolistic. Because the corporation controls the majority of the market in nearly all of its markets, there is an overwhelming social pressure for regulation.

The earliest regulatory measures were not as focused on competition, however. The goal was to protect the consumer. For example, the Grangers (19th Century farmers) felt that they were being oppressed by unfair practices of the railroads. There was great social unrest in this population because of the practices of large corporations. To avoid revolt and turmoil, the state government passed the Granger Laws. This group of legislation was essentially an attempt to appease the troubled farmers. It was not until the end of the 19th Century and the beginning of the 20th that regulation made the turn toward preserving competition.

Another trend in regulation is the unfortunate tendency of legislation to have little effect. Most of the laws created to control railroads were simply ignored by the large corporations. Similarly, the action of the Federal Trade Commission against Microsoft is often viewed as a trifle. Judge Stanley Sporkin rejected the June 1995 decision regarding the Microsoft monopoly, saying that the ruling was a mockery and that stricter control must be taken. Most attempts at federal regulation have been mediated, modulated, or amended until they lose much of their original bite.

Clearly social and governmental history has shown an ever-present desire to curb the growth of corporations. The dangers of allowing one company to assume supremacy over a market have frightened the government into regulation. Though, in many instances, the legislation fails to achieve its original goal, governmental regulation has become a standard in interstate and international commerce. America was founded on the principle of free trade and freedom of competition. Therefore, the government has assumed the responsibility of preventing the formation of monopolies and curbing unfair practices of large corporations.



Why does the government regulate monopolies? 


The government doesn’t regulate monopolies. It effectively bans them. Or at least it used to before GWB allowed business to run wild.

This is done to protect the citizens and society at large. The thinking being that a monopoly has absolute power over its industry and, thus, control over the government and people it serves. While competition is better for society because it fosters lower prices and product innovation.


The government may wish to regulate monopolies to protect the interests of consumers. For example, monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through price capping, yardstick competition and preventing the growth of monopoly power.


Why the Government Regulates Monopolies


  1. Prevent Excess Price. Without government regulation, monopolies could put prices above. This would lead to allocative inefficiency and a decline in consumer welfare.
  2. Quality of service. If a firm has a monopoly over the provision of a particular service, it may have little incentive to offer a good quality service. Government regulation can ensure the firm meets minimum standards of service.
  3. Monopsony power. A firm with monopoly selling power may also be in a position to exploit monopsony buying power. For example, supermarkets may use their dominant market position to squeeze profit margins of farmers.
  4. Promote Competition. In some industries, it is possible to encourage competition, and therefore there will be less need for government regulation.
  5. Natural Monopolies. Some industries are natural monopolies – due to high economies of scale, the most efficient number of firms is one. Therefore, we cannot encourage competition and it is essential to regulate the firm to prevent the abuse of monopoly power.



How the Government Regulate Monopolies


  1. Price Capping by RegulatorsRPI-X

For many newly privatised industries, such as water, electricity and gas, the government created regulatory bodies such as:

  • OFGEM – gas and electricity markets
  • OFWAT – tap water.
  • ORR – Office of rail regulator.

Amongst their functions, they are able to limit price increases. They can do this with a formula RPI-X

  • X is the amount by which they have to cut prices by in real terms.
  • If inflation is 3% and X= 1%
  • Then firms can increase actual prices by 3-1 = 2%

If the regulator thinks a firm can make efficiency savings and is charging too much to consumers, it can set a high level of X. In the early years of telecom regulation, the level of X was quite high because efficiency savings enabled big price cuts.

RPI+/- K – for water industry

In water the price cap system is RPI -/+ K.

K is the amount of investment that the water firm needs to implement. Thus, if water companies need to invest in better water pipes, they will be able to increase prices to finance this investment.

Advantages of RPI-X Regulation

  1. The regulator can set price increases depending on the state of the industry and potential efficiency savings.
  2. If a firm cuts costs by more than X, they can increase their profits. Arguably there is an incentive to cut costs.
  3. Surrogate competition. In the absence of competition, RPI-X is a way to increase competition and prevent the abuse of monopoly power.


Disadvantages of RPI-X Regulation

  1. It is costly and difficult to decide what the level of X should be.
  2. There is danger of regulatory capture, where regulators become too soft on the firm and allow them to increase prices and make supernormal profits.
  3. However, firms may argue regulators are too strict and don’t allow them to make enough profit for investment.
  4. If a firm becomes very efficient, it may be penalised by having higher levels of X, so it can’t keep its efficiency saving.



2.Regulation of quality of service


Regulators can examine the quality of the service provided by the monopoly. For example, the rail regulator examines the safety record of rail firms to ensure that they don’t cut corners.

In gas and electricity markets, regulators will make sure that old people are treated with concern, e.g. not allow a monopoly to cut off gas supplies in winter.

3.Merger Policy


The government has a policy to investigate mergers which could create monopoly power. If a new merger creates a firm with more than 25% of market share, it is automatically referred to the Competition Commission. The Competition commission can decide to allow or block the merger.

4.Breaking up a monopoly.


In certain cases, government may decide a monopoly needs to be broken up because the firm has become too powerful. This rarely occurs. For example, the US looked into breaking up Microsoft, but in the end the action was dropped. This tends to be seen as an extreme step, and there is no guarantee the new firms won’t collude.

  1. Yardstick or ‘Rate of Return’ Regulation


This is a different way of regulating monopolies to the RPI-X price capping. Rate of return regulation looks at the size of the firm and evaluates what would make a reasonable level of profit from the capital base. If the firm is making too much profit compared to their relative size, the regulator may enforce price cuts or take one off tax.

A disadvantage of rate of return regulation is that it can encourage ‘cost padding’. This is when firms allow costs to increase so that profit levels are not deemed excessive. Rate of return regulation gives little incentive to be efficient and increase profits. Also, rate of return regulation may fail to evaluate how much profit is reasonable. If it is set too high, the firm can abuse its monopoly power.

  1. Investigation of Abuse of Monopoly Power.

In the UK, the office of fair trading can investigate the abuse of monopoly power. This may include unfair trading practises such as:

  • Collusion (firms agree to set higher prices)
  • Collusive tendering. This occurs when firms enter into agreements to fix the bid at which they will tender for projects. Firms will take it in turns to get the contract and enable a much higher price for the contract.
  • Predatory pricing (setting low prices to try and force rival firms out of business)
  • Vertical restraints – prevent retailers stock rival products
  • Selective distribution For example, in the UK car industry firms entered into selective and exclusive distribution networks to keep prices high. The competition commission report of 2000 found UK cars were at least 10% higher than European cars





Regulating Natural Monopolies

The consolidation of an industry into one sole supplier can represent a substantial threat to free markets and their consumers, as price can be easily manipulated through a thorough control of the supply. As a result, monopolies are generally viewed as illegal entities. Regulating industries to minimize monopolization and maintain competitive equality can be pursued in a number of ways:

  • Average cost pricing:
  • As the name implies, this regulatory approach is defined as enforcing a price point for a given product or service that matches the overall costs incurred by the company producing or providing. This reduces the pricing flexibility of a company and ensures that the monopoly cannot capture margins above and beyond what is reasonable.
  • Price ceiling:
  • Another way a natural monopoly may be regulated is through the enforcement of a maximum potential price being charged. A price ceiling is a regulatory strategy of stating a specific product or service cannot be sold for above a certain price.
  • Rate of return regulations:
  • This is quite similar to average cost pricing, but deviates via allowing a model that can create consistent returns for the company involved. The percentage net profit brought in a by company must be below a government specified percentage to insure compliance with this regulatory approach (i.e. 5%).
  • Tax or subsidy:
  • The last way a governmental body can alleviate a natural monopoly is through higher taxes on larger players or subsidies for smaller players. In short, the government can provide financial support via subsidies to new entrants to ensure the competitive environment is more equitable.

As with most regulatory approaches, none of these are perfect solutions and consolidation within industries conducive to a natural monopoly will continue to arise. Antitrust laws and the careful control of mergers, acquisitions, joint ventures, and other strategic alliances are critical in the regulation of natural monopolies. In extreme circumstances it is also a viable option for governments to break up monopolies through the legal processes.





For over 100 years economists and policymakers have refined alternative

definitions of natural monopoly, developed a variety of different regulatory mechanisms and procedures to mitigate the feared adverse economic consequences of natural monopoly absent regulation, and studied the effects of price and entry regulation in practice. The pendulum of policy toward real and imagined natural monopoly problems has swung from limited regulation, to a dramatic expansion of regulation, to a gradual return to a more limited scope for price and entry regulation. Natural monopoly considerations became a rationale for extending price and entry regulation to industries that clearly did not have natural monopoly characteristics while technological and other economic changes have erased or reduced the significance of natural monopoly characteristics that may once have been a legitimate concern.

After the most recent two decades of deregulation, restructuring, and regulatory reform, research on the regulation of the remaining natural monopoly sectors has three primary foci. First, to develop, apply and measure the effects of incentive regulation mechanisms that recognize that regulators have imperfect and asymmetric information about the firms that they regulate and utilize the information regulators can obtain in effective ways. Second, to develop and apply access and pricing rules for regulated monopoly networks that are required to support the efficient expansion of competition in previously regulated segments for which the regulated networks continue to be an essential platform to support this competition. Third, to gain a better understanding of the effects of regulation on dynamic efficiency, in terms of the effects of regulation on the development and diffusion of new services and new supply technologies. These targets of opportunity are being addressed in the scholarly literature but have been especially slow to permeate U.S. regulatory institutions. Successfully bringing this new learning to the regulatory policy arena is a continuing challenge.





BATCH 2011




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