Optimal Regulation: the Economic Theory of Natural Monopoly.

• Author: Sherman, Roger

Since the appearance of papers by Averch and Johnson |1~ and Wellisz |2~ thirty years ago, the theory of natural monopoly regulation has virtually been rewritten. Attention has shifted gradually to new proposals that not only provide incentives for efficient operation but can also induce the selection of socially desirable prices. Kenneth Train presents much of this literature in a remarkably simple way, relying on graphical analysis and occasional algebra, with practically no use of calculus.

The book aims at presenting the essence of a series of regulatory ideas, from a characterization of existing rate-of-return regulation to Ramsey pricing and then on through a variety of other pricing ideas and incentive mechanisms. The treatment is not intended to be exhaustive or authoritative, in that topics are not always traced to their sources or to the full basis of their assumptions. By adopting this narrower aim of revealing key ideas through simple means, a very useful exposition of them is achieved. Most important elements are put across in a clear and convincing way, allowing a considerably larger audience than before to think about them and apply them.

The first three chapters are related to the Averch-Johnson (AJ) type of model for rate-of-return regulation. Chapter 1 analyses the AJ model under static certainty conditions. This model is explained well, including the fact that the firm cannot be pushed to operate where demand is inelastic, although implications of this latter point for pricing incentives could have been stressed more. I say this because presenting new incentive mechanisms is one of the main purposes of the book, so it would have been useful to emphasize pricing distortions under rate-of-return regulation such as this avoidance of inelastic demand regions, in order to show the need for the incentive mechanisms. Chapter 2 considers mechanisms that might be seen as similar in form to rate-of-return regulation when there is one good or service, arrangements that would allow a profit return on output, or on cost or revenue, rather than on capital. Seeing effects of these alternative arrangements helps one to understand rate-of-return regulation. Chapter 3 examines some effects of uncertainty in the AJ model. It does not show all that might be shown about rate-of-return regulation under uncertainty, of course, nor does it reveal entirely how difficult it is to model the phenomenon. But the chapter does make the important point...