I have previously discussed the case of natural monopoly, and how it may pose problems in regard to allocative efficiency.
This diagram shows an industry with substantial economies of scale relative to market demand – indeed the minimum efficient scale is beyond the market demand curve. The market is almost certainly going to end up as a monopoly, because the largest firm is always able to dominate the market and undercut smaller competitors, as it has a natural cost leadership position. If the monopoly chooses to maximise profit, MC = MR, Q would be at x, P at b.
Such industries tend to have large fixed costs relative to marginal average cost. Railway systems, water and gas are all examples of this. The key problem is that, if these firms were force to set price equal to marginal cost, so Q was z, p was h, they would make a substantial loss.
In the past, one response to the situation would have been to nationalise the industry. This is because, the state wants maximal social benefit while the firm wants to maximise profits. These are completely incompatible in the case of a natural monopoly.
In order to prevent the losses becoming too substantial, many utilities adopted a pricing system known as a two part tariff system, under which all consumers paid a monthly charge for being connected to the supply, and a variable amount on top of that proportional to usage. The connection charge would cover the loss between m and n, spread across customers, and the variable charge would cover marginal cost.
However, as time went by this system became heavily criticized. In particular, it was argued that the managers of the nationalised industries were insufficiently accountable. It could be regarded as an extreme form of the principal-agent problem, in which the consumers (the principals) has very little control over the managers (their agents), a situation leading to widespread X-inefficiency and waste.
This led to much privatisation in the 1980s, with the hope that now the managers were accountable to shareholders this would encourage efficiency.
However, this did not remove the original problem: that they were natural monopolies. So, privatisation was accompanied by the imposition of a regulatory system, to ensure that the newly privatised firms did not abuse their monopoly situations.
Whenever possible, privatisation was also accompanied by measures to encourage competition, which was seen as a better way to ensure efficiency improvements. This proved to be more feasible in some industries than in others, because of the nature of economies of scale – there is little to be gained by requiring that there must be several firms in a market where the economies of scale can be reaped by one large firm. However, the changing technology in some of the industries did allow some competition to be encouraged – especially in telecoms.
Where it was not possible, or feasible, to encourage competition, regulation was seen as the solution. Attention of the regulatory bodies focused on price, and the key control method was to allow price increases each year at a rate that as set amount below RPI. This became known as the RPI – X rule and was widely used, as the idea is it forces firms to look for productivity gains to eliminate the X inefficiency that had built up. The X refers to the amount of productivity gain the regular can forsee the firm achieving in a year.
There are problems inherent in this approach. For example, how does the regulator set X? This is a problematic situation where the company has better information about the costs than the regulator – another instance of the problems caused by the existence of antisymmetric information. There is also the possibility that the firm will realise these productivity gains through the reduction of the quality of the product, or by neglecting long-term investment for the future and allowing maintenance standards to lapse.
It is also important to realise that as time goes by, if the RPI-X system is effective the X-inefficiency will be gradually squeezed out, and the X will have to be reduced as it becomes more difficult to achieve productivity gains.
In some cases, regulatory capture is a further problem. This occurs when the regulatory body becomes so closely involved with the firm it is supposed to be regulating that it begins to champion their cause rather than imposing tough rules when they are needed.
An alternative method of regulation would be to place a limit on the rate of return the firm is permitted to make, thereby preventing it from making supernormal profits. This too may effect the incentive mechanism; the firm may not feel the need to be as efficient as possible, or may fritter away some of the profits into managerial perks to avoid declaring a high rate of return.