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Optimal Regulation: the Economic Theory of Natural Monopoly.

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 that when demand is not perfectly foreseen regulatory constraints may not match actual circumstances well, and it examines implications of such outcomes.

Chapter 4 is devoted to Ramsey pricing. After brief illustration of single product cases, the multiple product case is introduced and Ramsey prices are presented thereafter in relative-price form. They are derived from presumed consumer trade-offs on one hand and a zero-profit condition for the firm on the other, without the use of a single derivative! The form given to Ramsey prices here is also exploited nicely in Chapter 5, which describes the Vogelsang-Finsinger efficient cost and pricing incentive mechanism. Using the machinery of Chapter 4, Chapter 5 is able to demonstrate in an elegant way how and why the Vogelsang-Finsinger mechanism induces the firm to pursue Ramsey prices.

Consumer surplus is needed in Chapter 6, which treats incentive schemes that attempt to transfer some of this surplus to the firm as subsidy in order to induce it to enlarge consumer surplus. Alternative mechanisms of Loeb and Magat, Sappington and Sibley, and Finsinger and Vogelsang are all explained. The presentation is simple and straightforward, and the main features of the schemes are revealed clearly and contrasted nicely.

From this point there are more straightforward treatments of various pricing situations. Chapter 7 describes multipart tariffs. The features of such tariffs, plus their rationales and their advantages are discussed in detail. Time-of-use pricing is introduced in Chapter 8, where peak-load pricing is treated extensively. Optimal peak and off-peak pricing is explained, along with the basis for determining optimal capacity in the circumstances of peak-and-off-peak demands. Michael Riordan's incentive scheme is then shown to be capable of inducing the firm to choose peak-load pricing and to select the optimal capacity.

Self-selecting tariffs are treated separately in Chapter 9. Self selection ideas would have enhanced the discussion of multipart tariffs in Chapter 7, particularly in connection with their Pareto-improving quality, but that chapter is already long. And treating the topic separately leads nicely to consideration of David Sibley's proposal for motivating firms to choose optimal prices by requiring the use of self-selecting tariffs, which occupies much of Chapter 9. It is noted here and in Chapter 7 that, perhaps because of risk aversion, consumers have preferences over tariffs as well as for goods and services themselves, and that these preferences about tariffs deserve attention when optimal tariffs are being chosen.

Finally, Chapter 10 considers ways to achieve optimal results without regulation. These ways include auctioning the monopoly franchise and also avoiding the monopoly franchise altogether through the use of free entry. The latter avenue is based on contestability ideas where they might apply and prices can be sustainable. The ideas needed to think seriously about these policies are introduced and discussed. An Appendix provides a description and analysis of price-cap regulation, which rounds out the coverage of current means of regulating prices.

Thus the book presents the major ideas needed to represent existing regulatory institutions, to define optimal prices, and to reveal the workings of a range of new incentive mechanisms. Although it requires extensive geometric interpretation, the presentation avoids advanced mathematics, specifically the use of calculus, and it is especially effective in presenting a host of incentive mechanisms that have been developed in little more than a decade. One hopes that exposure of teachers to this book will lead to more learning of the ideas in classrooms by future policymakers, and that exposure of current policy makers will make them aware of new incentive possibilities and encourage their application. The book demonstrates very effectively that we should be able to create better incentive arrangements than those we have been relying on for much of this century.

References

1. Averch, H. and L. L. Johnson, "Behavior of the Firm Under Regulatory Constraint." American Economic Review, Vol. 52, 1962, 1053-69.

2. Wellisz, S. H., "Regulation of Natural Gas Pipeline Companies: An Economic Analysis." Journal of Political Economy, Vol. 55, 1963, 30-43.
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Author:Sherman, Roger
Publication:Southern Economic Journal
Article Type:Book Review
Date:Apr 1, 1993
Words:1052
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