Economics 24
Mr. Klein
Notes on Rate Regulation

A natural monopoly is a business which experiences decreasing average costs as its output rises. In such a business, economies of scale make it more economical for a market to be served by one supplier than by several. This is because a single supplier, by operating at a larger scale, will enjoy lower costs. Unfortunately, a single supplier, if unregulated, would desire to charge a monopoly price. This is why these industries are generally either government owned, or regulated by the government. Examples of natural monopolies include local distribution systems for telephone, electricity, natural gas, cable TV. In their early days, railroads exhibited many characteristics of a natural monopoly.

The legality of government regulation was not assured by the Constitution. In fact, the constitutionality of an 1871 Illinois law establishing rate (price) regulation was challenged, and affirmed by the Supreme Court in 1877 in the case Munn v. Illinois. The case involved a question of whether the state of Illinois could regulate the prices charged by a grain elevator, or whether such price regulation violated the 14th amendment to the Constitution, which prohibits any state from depriving "any person of life, liberty, or property, without due process of law... ." In Munn, the Court decided that in certain industries "affected with a public interest," such regulation was legal. The phrase "affected with a public interest" refers to businesses, often natural monopolies, which provide some essential service, for which there are no substitutes. Transportation, communication, and utility industries fall into this category.

Regulators must balance the interests of consumers (who want low prices and adequate service), and of the stockholders of the regulated business (who might prefer to restrict output and raise price, especially if they enjoy a monopoly position in the market). Price regulation is sometimes called rate of return regulation. The problem is as follows. Regulators would like to establish a price (p) for the output (Q) which generates a fair rate of return (r*) on invested capital (K), while owners would like to maximize profits. Write a firm's revenues as pQ, and its costs as wL + rK, where w is the price of labor, and L is the quantity of labor employed. (In this example, we consider L to be the only variable input). The total return to capital is thus pQ - wL, or total revenue less variable (or operating) cost. Expressed as a return on capital, this becomes:

                    r = pQ - wL
                               K

Rate hearings, at which prices are set, involve discussions (arguments) between regulators and the regulated business over several variables: