the government subsidize the decreasing-cost producer. (Government-owned
utilities often follow this route, financing deficits from general tax revenues.)
An alternative method is for the utility to institute so-called two-part pricing.
Here each customer pays a flat fee (per month) for access to output and then
pays an additional fee, equal to marginal cost, according to actual usage. Thus,
customers are encouraged to consume output at marginal cost. At the same
time, the flat-fee charge allows the firm to cover average cost; that is, it covers
the firm’s large fixed costs. Though beneficial, two-part pricing is not a per-
fect remedy for the pricing problems associated with declining average cost.
The problem is that the fixed fee may deter some potential customers from
purchasing the service altogether, even though their marginal benefit exceeds
marginal cost.
Average-cost pricing is the most common regulatory response, and it goes
a long way toward implementing the virtues of competitive pricing in the nat-
ural-monopoly setting. However, it is far from perfect. First, the regulator/rate
setter faces the problem of estimating the monopolist’s true costs over the rel-
evant range of potential output. At regulatory rate hearings, the natural
monopolist has a strong incentive to exaggerate its average cost to justify a
higher price. Imperfect or biased cost estimates lead to incorrect regulated
price and output. Second, the regulated monopolist has a reduced incentive to
minimize its cost of production. Indeed, if the regulatory agency were able to
maintain PRAC at all times, any cost change would be immediately reflected
in a price increase. The firm would have no economic incentive (although it
might have a political one) to hold costs down. Interestingly, the presence of
“regulatory lag”—the fact that prices are reset periodically, sometimes after
long delay—bolsters the firm’s cost-cutting incentives. In the typical case of
escalating costs, the monopolist profits from cost-cutting measures during the
period over which the regulated price is fixed.
Finally, critics of price regulation point out that over time government
intervention has spread into many areas that are a far cry from natural monop-
olies—trucking, airlines, and banking, for example. Furthermore, they point
out that, by intention or not, regulation frequently reduces true competition:
Regulated rates can hold prices upas well as down. In this sense, regulators are
“captured” by the firms over which they are supposed to exercise control, in
effect maintaining a status quo protected from new competition. For instance,
until the emergence of airline deregulation, the express purpose of the Civil
Aeronautics Board (the governing regulator) was to fix prices and limit entry
into the airline market. In the late 1970s, the CAB, under economist Alfred
Kahn, changed course dramatically, freeing fares and allowing the entry of no-
frills airlines. The result was the present era of significantly lower airfares.Before 1996, most communities in the United States received local telephone
service and cable television services by single, separate companies. Created by
the breakup of AT&T in the 1980s, the “Baby Bells” provided local telephone334 Chapter 8 MonopolyA “Natural”
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