Private/Public Ownership of Natural Monopolies

A natural monopoly is a business that by nature would be impractical to duplicate. A subway system in a major city is a natural monopoly because you could not have two or more competing subway lines running on parallel tracks. The local utilities: gas, water, electricity, are natural monopolies. Even cable television is a natural monopoly. Governments often run these natural monopolies as quasi-independent government corporations. Sometimes these monopolies are owned privately and heavily regulated. In almost all cases, there is an attempt to set the price equal to average cost. Average cost pricing means no profits and therefore the consumer is getting the lowest possible price that can keep the natural monopoly going. Sometimes, the price is set below average cost and the government subsidizes the monopoly directly from tax revenue.

In a recent blog post by Atanu Dey in the new blog The Indian Economy, Atanu argues that the Indian railway service should adopt high-speed trains. He complains that the old trains in India putter along at just 80 kph (55 mph):

The so-labeled “super fast express” trains make their way at a stately 80 kms an hour average, pretty much what they were capable of doing forty years ago. Thirty years ago, the Shinkansens were doing 200 kms an hour and today they exceed 300 kmph. But in India, we maintain a dignified traditional 80 kms an hour for decades on end.

I was reminded of this when I read a recent article in the WaPo about a big subsidy that Congress was considering for the Washington Metro (our subway). The Metro nearly 30 years old and is showing its age. Trains have been derailing recently and the trains run about as fast as the Indian ones. The subsidy comes with strings attached to force this quasi-government corporation (WMATA) that runs the subway to become more accountable:

"We've seen bad management contracting on a fairly regular basis," said Davis, a Republican from Fairfax County who will introduce the bill this morning at a hearing before the House Committee on Government Reform, which he chairs. "These are built-in mechanisms that will make it harder to duplicate the kind of contractual failures that they've had in the last couple of years."

Finally, the bill stipulates that federal money would flow only if the Washington region creates a dedicated source of money for Metro, such as a portion of a sales tax earmarked for transit. That is a significant political challenge to regional leaders and would require the approval of legislatures in Maryland and Virginia as well as the D.C. Council.

"Our federal partners have thrown down the gauntlet," said T. Dana Kauffman, a Fairfax supervisor who chairs the Metro board. He said the lure of federal money might be enough to persuade local and state governments to create a stream of money for Metro. "This may be our best chance in a generation to get stable and reliable funding."

Read the full thing.

Have they considered raising ticket prices? That would cure the overcrowding problem and the revenue problem simultaneously, and it might reduce the need for additional trains.

However there is a bigger issue that both the Washington Metro and the Indian Railways share: these monopolies exhibit underinvestment. Instead of seeing new technology, we see the old technology persisting, and wearing out. Why is that? Well, if you price your commodity below cost, why would you want to invest more money in the production of it? Profits are the enticement that leads to new investment over time. But you need to be free to raise prices if you want to profit from improved service.

This is the fundamental issue with average cost pricing: the monopoly has no incentive to modernize and to reinvest money in maintaining its infrastructure. If the best you can do is earning zero profit, you can do that with the status quo.

Here is another possibility: suppose the government allows the natural monopoly to be fully private and unregulated but merely becomes a passive owner of a share of that company. Because firms will compete to be the owner of the natural monopoly, they will offer the government a sizable share of the stock in return for majority control of the monopoly. Then the government could earn a source of revenue by being a part owner of a lucrative monopoly.

The most important aspect of this plan is that the monopoly would then have the proper incentive to modernize. Profit would encourage the monopoly to modernize as soon as it becomes economically viable to modernize. And the decision to modernize would be based on sound economics and not on politics. When a politician gambles on a new public investment, he almost cannot lose. When a bureaucrat gambles on a new public investment, he almost cannot win. But when a owner risks his own capital on a new investment, he stands to lose his fortune if he is wrong, and he stands to make a fortune if he is right, so either way, his incentives are proper for him to make the correct decision.

The primary objection to this plan would be that it would probably increase fares substantially and the public would be hurt. Obviously fares would have to rise, but not as much as you might think. These natural monopolies have competition from other sources. A national railroad competes with airplanes and with cars. A subway competes primarily with cars. If the fares go up too much, utilization and revenue will fall. Also, the revenue that the government raises could help the poor, so the argument that the "poor will be hurt by a price increase" is not necessarily true. In any case, everyone will benefit from an investment in new technology if it is economically justifiable to use the new technology.

Another objection is that above cost pricing would be economically inefficient because some people would not ride the trains that could afford to pay the average cost price but cannot pay the monopolist’s price. These transactions would be lost in the economy and this is the classic “deadweight loss.” But we should recognize that this increased price would go partly to fund public services, since the government would be a co-owner of the monopoly. There is a deadweight loss associated with any tax, and this might not be any more inefficient that any other way of raising revenue. The biggest “deadweight loss” is the failure to reinvest in the monopoly. This plan would avoid this failure to reinvest.

Another benefit from privatizing the public monopoly is that other firms will try to buy that monopoly if they think they could run it better. I’m sure there are many corporations that could do a better job of running the Washington Metro than WMATA, but the Metro is not for sale at any price.