Why Johnny Can't Regulate: The Case of Natural Monopoly

By Ergas, Henry | Agenda: A Journal of Policy Analysis and Reform, January 1, 2013 | Go to article overview

Why Johnny Can't Regulate: The Case of Natural Monopoly


Ergas, Henry, Agenda: A Journal of Policy Analysis and Reform


This paper examines the difficulties inherent in regulation as a solution to market failure and, especially, to natural monopoly. It highlights the way regulation itself introduces new risks into the supply of natural monopoly services, including the risk of regulatory opportunism, and argues that delegating regulatory functions to 'independent ' regulators does not in itself solve those risks.

Imagine that, in visiting a primary school, a politician were to ask a child what he or she wants to do as a grown-up. Now, if the child said 'I'm going to be a pilot', the politician would exude the milk of human kindness, pat the infant on the head, and move swiftly on to the next photo-opp. But what if little Johnny said 'When I grow up, I want to be a regulator'? Surely a moment of bewilderment would follow. After all, no one could impugn a child's aspiration to be a pilot, doctor, plumber or nurse; at a pinch, even neighbourhood dope peddler, pole-dancer or economist, all professions whose origins lie lost in the mists of time. But what would one make of the desire to be a regulator, other than a diagnosis of early-onset power-hunger? And could one in good conscience commend that career choice, as one likely to ultimately lead to personal fulfilment and worthwhile community service?

To raise that question is not to chastise the vocation of regulator. But is there a sense in which - to borrow Enoch Powell's famous dictum about politics (Powell 1977: 151) - all regulatory careers are doomed to end in failure? Because that is in the nature of regulation and human affairs? While any such assertion might go beyond the evidence, all those familiar with the regulation of natural monopoly would agree that it is inherently contentious in process, controversial in its results and all too often disappoints the expectations vested in it.

To a degree, that could be viewed as simply confirming the fact that there are no perfect solutions to market imperfections. But that is both trite and unrevealing - it says little about why the problems occur. Yet a better understanding of those problems is needed if issues such as the scope of regulation and its design are to be sensibly addressed.

In exploring those problems, this article seeks to go behind and beyond conventional explanations of the difficulties inherent in natural monopoly regulation. Although diverse, those explanations often boil down to the view that regulation would work tolerably well if only pesky interest groups would not derail the process. Yet that obviously assumes the regulator - with its own interests and objectives - would merely pursue the public interest, presumably defined in terms of maximising social welfare. Why that cannot be simply assumed then has implications for the framing of mechanisms that hold regulators accountable.

The implication of this analysis is not that regulation is per se undesirable but that we need to pay more serious attention to the importance of providing effective safeguards against the abuse of regulatory discretion. In contrast, recent years have seen moves to water down those safeguards. The present course of regulatory policy in Australia therefore poses some serious issues, which deserve more attention than they have received.

The problem being addressed

Any introductory textbook in economics will explain that we regulate so as to correct market failures; that is, situations where voluntary exchange will not result in the best use of society's resources. It will cite a number of factors that may give rise to such failures, including public goods, natural monopolies and decision-relevant externalities.

If it is a good textbook, it will then go on to explain that none of those market failures in itself justifies regulation. After all, it will say, it may be that bargaining between individuals could address those market failures, so long as property rights are well-defined. Take, for instance, natural monopolies and local public goods. …

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