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Advances in Economic Design pp Cite as. This paper deals with the design of incentive compatible regulatory mechanisms for natural monopolies to provide for quality of service when quality cannot be observed by consumers and cost information is asymmetric.

Regulatory economics

In particular, we are concerned with the creation of incentives for process innovations as a means to compensate for the quality induced price increase. Unable to display preview. Download preview PDF. Skip to main content.

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Advertisement Hide. This is a preview of subscription content, log in to check access. Armstrong, M. Baron, D. In: Schmalensee, R. As discussed below, in many of the so-called public-utility industries of the late 18th and early 19th centuries, there were often literally dozens of competitors. During the late 19th century, when local governments were beginning to grant franchise monopolies, the general economic understanding was that "monopoly" was caused by government intervention, not the free market, through franchises, protectionism, and other means.

Large-scale production and economies of scale were seen as a competitive virtue, not a monopolistic vice.


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For example, Richard T. Ely, cofounder of the American Economic Association, wrote that "large scale production is a thing which by no means necessarily signifies monopolized production. Large-scale production units unequivocally benefited the consumer, according to turn-of-the-century economists. For without large-scale production, according to Seligman, "the world would revert to a more primitive state of well being, and would virtually renounce the inestimable benefits of the best utilization of capital.

Like virtually every other economist of the day, Columbia's Franklin Giddings viewed competition much like the modern-day Austrian economists do, as a dynamic, rivalrous process. Consequently, he observed that. We should inquire, further, to what degree market competition actually is suppressed or converted into other forms.

In other words, a "dominant" firm that underprices all its rivals at any one point in time has not suppressed competition, for competition is "a permanent economic process. David A. Wells, one of the most popular economic writers of the late 19th century, wrote that "the world demands abundance of commodities, and demands them cheaply; and experience shows that it can have them only by the employment of great capital upon extensive scale.

The above quotations are not a selected, but rather a comprehensive list. It may seem odd by today's standards, but as A. Coats pointed out, by the late s there were only ten men who had attained full-time professional status as economists in the United States. The significance of these views is that these men observed firsthand the advent of large-scale production and did not see it leading to monopoly, "natural" or otherwise. In the spirit of the Austrian School, they understood that competition was an ongoing process, and that market dominance was always necessarily temporary in the absence of monopoly-creating government regulation.

This view is also consistent with my own research findings that the ''trusts" of the late 19th century were in fact dropping their prices and expanding output faster than the rest of the economy — they were the most dynamic and competitive of all industries, not monopolists. The economics profession came to embrace the theory of natural monopoly after the s, when it became infatuated with "scientism" and adopted a more or less engineering theory of competition that categorized industries in terms of constant, decreasing, and increasing returns to scale declining average total costs.

According to this way of thinking, engineering relationships determined market structure and, consequently, competitiveness. The meaning of competition was no longer viewed as a behavioral phenomenon, but an engineering relationship. With the exception of such economists as Joseph Schumpeter, Ludwig von Mises, Friedrich Hayek, and other members of the Austrian School, the ongoing process of competitive rivalry and entrepreneurship was largely ignored. There is no evidence at all that at the outset of public-utility regulation there existed any such phenomenon as a "natural monopoly.

Six electric light companies were organized in the one year of in New York City. Forty-five electric light enterprises had the legal right to operate in Chicago in Prior to , Duluth, Minnesota, was served by five electric lighting companies, and Scranton, Pennsylvania, had four in Before , six competing companies were operating in New York City … competition was common and especially persistent in the telephone industry … Baltimore, Chicago, Cleveland, Columbus, Detroit, Kansas City, Minneapolis, Philadelphia, Pittsburgh, and St.

Government intervention

Louis, among the larger cities, had at least two telephone services in In an extreme understatement, Demsetz concludes that "one begins to doubt that scale economies characterized the utility industry at the time when regulation replaced market competition. A most instructive example of the non-existence of natural monopoly in the utility industries is provided in a book by economist George T.

The history of the Gas Light Company of Baltimore figures prominently in the whole history of natural monopoly, in theory and in practice, for the influential Richard T. Ely, who was a professor of economics at Johns Hopkins University in Baltimore, chronicled the company's problems in a series of articles in the Baltimore Sun that were later published as a widely-sold book.

Much of Ely's analysis came to be the accepted economic dogma with regard to the theory of natural monopoly. The history of the Gas Light Company of Baltimore is that, from its founding in , it constantly struggled with new competitors. Its response was not only to try to compete in the marketplace, but also to lobby the state and local government authorities to refrain from granting corporate charters to its competitors. The company operated with economies of scale, but that did not prevent numerous competitors from cropping up.

Brown states that "gas companies in other cities were exposed to ruinous competition," and then catalogues how those same companies sought desperately to enter the Baltimore market. But if such competition was so "ruinous," why would these companies enter new — and presumably just as "ruinous" — markets? Either Brown's theory of "ruinous competition" — which soon came to be the generally accepted one — was incorrect, or those companies were irrational gluttons for financial punishment.

By ignoring the dynamic nature of the competitive process, Brown made the same mistake that many other economists still make: believing that "excessive" competition can be "destructive" if low-cost producers drive their less efficient rivals from the market. In there were three competing gas companies in Baltimore who fiercely competed with one another. They tried to merge and operate as a monopolist in , but a new competitor foiled their plans: "Thomas Aha Edison introduced the electric light which threatened the existence of all gas companies.

Nevertheless, no free-market or "natural" monopoly ever materialized. When monopoly did appear, it was solely because of government intervention. This approach is especially pervasive today in the cable TV industry.

Regulating Natural Monopolies – Principles of Economics

Legislative "regulation" of gas and electric companies produced the predictable result of monopoly prices, which the public complained bitterly about. Rather than deregulating the industry and letting competition control prices, however, public utility regulation was adopted to supposedly appease the consumers who, according to Brown, "felt that the negligent manner in which their interests were being served [by legislative control of gas and electric prices] resulted in high rates and monopoly privileges. The development of utility regulation in Maryland typified the experience of other states.

Not all economists were fooled by the "natural-monopoly" theory advocated by utility industry monopolists and their paid economic advisers. In economist Horace M.

Gray, an assistant dean of the graduate school at the University of Illinois, surveyed the history of "the public utility concept," including the theory of "natural" monopoly. With regard to "public" utilities, Gray records that "between and , the policy of state-created, state-protected monopoly became firmly established over a significant portion of the economy and became the keystone of modern public utility regulation.


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In support of this contention, Gray pointed out how virtually every aspiring monopolist in the country tried to be designated a "public utility," including the radio, real estate, milk, air transport, coal, oil, and agricultural industries, to name but a few.

Along these same lines, "the whole NRA experiment may be regarded as an effort by big business to secure legal sanction for its monopolistic practices. The role of economists in this scheme was to construct what Gray called a "confused rationalization" for "the sinister forces of private privilege and monopoly," i.

More recent economic research supports Gray's analysis. Two decades ago, Tirole explained why Netflix is always complaining about Comcast.

How to fight regulatory capture. The financial crisis brought public attention to the problem of regulatory capture, when public agents wind up serving private interests they are supervising, either because of implicit or explicit bribes, or simply bad culture. But Tirole has also found he had to adjust his model of regulatory behavior to account for the fact that some regulators are public spirited and not completely self-interested, an interesting case of behavioral economics creeping into his worldview. Why is there open-source software?