Adverse Side-Effects of Government Interventions When Regulating Natural Monopoly Situations - Essay Example

Name: Tutor: Title: Adverse Side-Effects of Government Interventions When Regulating Natural Monopoly Situations Course: Institution: Date: Introduction Business organizations in modern market environments are increasingly encouraged and even pressured to be competitive to be able to deliver quality products and services to its end users andeffectively meet the changing needs of the global consumers (Giocchino, 2004).There are instances when for social and technical reasons, only one service provider can effectively and efficiently operate as one firmin the market and they are referred to as natural monopolies(Waterson, 1988). The main characteristics of natural monopolies is that they have significant cost advantage over potential market rivals, they enjoy substantial economies of scale and splitting the monopoly results in lost economies of scale. In addition, the main focus of natural monopolies is profit maximization, which explains the tendency for natural monopolies to set very high prices since they are the only market supplier(Kahn, 1970). Examples of natural monopolies include utility firms (water and electricity firms)such as NSW electricity. Ifthese natural monopolies are left on their own accord, they are more likely to produce output levels that are much lower than they ought to produce, which automatically stimulates a rise in demand and consequently, a spike in prices of services that increases the monopoly’s profit margins. In addition, they are more likely to provide their products and services at prices higher than it would be in a competitive environmentin a bid to guarantee maximum profits and also because they know they are the only suppliers in the market and consumers have no choice but to pay the setprices (Colm, 1994). As a result, the government has to intervene and regulate the monopolies in a bid to restore economic and cost efficiency. Although government interventions are intended for good, they often generate unintended adverse side effects. Some of the adverse side effects of government interventions in regulating natural monopolies include cost padding and gold-plating. This forms the basis of this essay that critically analyzes reasons for government interventions, what cost padding and gold-plating is, adverse side effects of government interventions and how to minimize the side effects. Reasons Why a Government May Regulate A Monopolist There are various valid reasons why a government might want to regulate a monopolist. Some of the reasons include the need to safeguard the interests of consumers (Kahn, 1970). Without government interventions, a monopolist has excessive market power to set high prices, which harms the welfare of consumer while generating allocative inefficiency (Kahn, 1970). Since they are the only ones operating in the market, monopolists can set their prices as high as they want without giving any thought to what the repercussions will be to the consumer. PM MC Cost PC D/AR MR QM QC This indicates a need for government interventions in a bid to tilt the variables and generate economic and cost efficiency as highlighted in graph below TC1 TC>TR LOSS TC When a government regulates a monopolist, it ensures that the monopolist provides quality services always since monopolist have little or no incentive to provide quality services (Kahn, 1970). When the government intervenesand regulates a monopolist, it ensures thatthey meetthe minimum standards of service. Among other reasons why a government may regulate monopolist is to promote competition, prevent abuse of monopoly power in natural monopolies and ensure monopolists do not take advantage of their monopsony buying power (Giocchino, 2004). Cost Padding When the government intervenes and regulates natural monopolies using price setting procedures, it is possible for the regulated monopoly to engage in cost padding, which refers to the deliberate falsification ofcosts by inflating them with the aim of increasing the cost reimbursement that monopolies obtain from the regulator (Bougheas& Worrall, 2009).Cost padding occurs when monopolies falsify their costs and underinvest(Albon& Kirby, 1983). For instance, the high prices of electricity experienced in New South Wales, in the end of year 2012 has been attributed to the fact that electricity is supplied by state owned monopolies that have no competition including network businesses. These monopolies were and are still are, vulnerable to cost padding through state ownership and generous decisions that favor monopolies by price regulators (Moran, 2012). Cost Padding and the Need for Governments Interventions There are various ways that natural monopolies can engage in cost padding and consequently, affect the way a government regulate them including increase in salaries, gold plating expenditures, charging depreciated assets, expense claims and failure to report a monopoly’s cost reduction improvements among others (Bougheas& Worrall, 2009).The most common form of government intervention in a monopoly is regulation through policies such as the Two Airline Policy introduced in Australia, which placed more focus on the behavior of the market(Kirby, 1979). Nevertheless, due to the increasing cases of cost padding and the need to prevent it, governments prefer to employ different tools of regulation including antitrust laws, which focus on both the behavior and structure of the market (Giocchino, 2004). In addition, use of high powered incentive schemes including price capping that generates cost minimizing behavior among natural monopolies, social regulation that entails ownership control policies, service obligations and entry restrictions (Albon & Kirby, 1983). Although the state owned monopolies and network businesses that supply electricity in New South Wales have effectively and efficiently supplied electricity to the residents, it has come with a high price with electricity consumers having to dig deeper into their pockets to meet the relatively high prices compared to other regions in Australia (Moran, 2012). It is speculated that although these natural monopolies are regulated, they often engage in cost padding by inflating their prices with the aim of increasing the cost reimbursement that they obtain from the regulatorand in so doing, maximizing their profit (Moran, 2012). As a result, more stringent interventions such as regulation policies and price cap regulations from the government are required to cushion the consumers from these monopolies. Nevertheless, it is crucial for the policies and regulations to be practical to ensure they do not do more harm than good. When natural monopolies engage in cost padding, they often lead governments to make misguided interventions, where regulators impose impractical regulatory policies and unsustainable conditions on the industry by overestimating or underestimating costs that can be managed using internal cross subsidies(Giocchino, 2004). This contributes to adverse effects on the stability of the market and on the welfare of consumers (Bougheas & Worrall, 2009). Gold-plating Gold plating refers to over investing among monopolists in their organizational processes and systems in a bid to accumulate more profits (Colm, 1994). Colm, (1994) notes that with the aim of regulating natural monopolies, majority of regulators from across the globe utilize rate of return regulation (ROR), which is a cost based approach that exerts pressure on monopolists to invest resources in an economically efficient way. Using ROR, monopolists are restricted in their ability to utilize their market power to obtain higher profits at the expense of other market players (Colm, 1994). Although rate of return regulation is efficient in ensuring monopolists do not set prices, which bear no connection to costs, it results in gold plating where it offers natural monopolies the incentives to over invest since the higher the capital base, the higher the profits that will be permitted given the rate of return target (Colm, 1994). How Gold-Plating Impact on the Cost Effective Supply of Electricity Gold-plating refers to over investment in systems and processes in an industry. It has significant impact on the cost effective supply of electricity in countries such as Australia by causing increases in electricity network prices(Colm, 1994). Be it as it may, the issue of gold-plating electricity networks seems a less evil compared to the economic costs attributed to reduced network reliability, regular power outages and power supply disruptions as a result of electricity network system failures attributed to underinvesting in electricity networks (King, 2012). Gold-plating allows development of electricity networks that have high degree of reliability and although this high reliability comes with high network charges, it leads to cost effective supply of electricity in the long term (King, 2012). This is achieved when electricity networks have excess capacity most of the time. The cost of underinvesting in electricity network or in other words, the impact of eliminating gold plating in electricity networks comes with a greater cost; reduced electricity reliability and a rise in electricity supply disruptions (King, 2012).King, (2012) notes failure to over invest in electricity means reduced cost of supplying and using electricity but increased risk of network system failures.Nevertheless, electricity consumers who have to dig deeper into their pockets may argue that it may be economically efficient to experience power outages every once in a while (reduce gold-plating)because it is possible to have such a thing as ‘excessive reliability of electricity networks’ as argued by King (2012). There is another perspective to the argument. In the electricity industry in NSW, which is run by state monopolies such as network businesses, these state monopolies can engage in gold plating their expenditures (Moran, 2012). This can be done to accumulate profits for the monopolists at the expense of other industry players and welfare of electricity consumers.The high electricity charges of supplying electricity acts as incentives for the monopolies to overinvest and participate in gold-plating, where they focus on the rate of return rather than on the price of output (King, 2012). This means that gold-plating by state run monopolies negatively affects the cost effective supply of electricity by continuously inflating the cost of supplying electricty. How Governments Can Negate The Adverse Side Effects of Gold-Plating and Cost Padding One of the most effective ways of insulating consumers, market and market players from the adverse effects of gold-plating and cost padding is the use of price cap regulations. In price cap regulations, the rate of increase in the price of services is less than the rate of increase in the overall price rate of the economy (Colm, 1994). Other than providing monopolists with incentives to reduce costs, price cap regulation does not provide an incentive for the monopoly to engage in gold plating, it allows monopolists the flexibility to alter the costs within the maximum cap and it prevents them from setting the prices too high at the expense of other market players(Colm, 1994). Price cap regulation provides an opportunity for the regulator to effectively and efficiently monitor the structure and behavior of the market and market players, which is vital in preventing adverse side effects of governmentinterventions such as gold-plating and cost padding(Bhattacharyya &Laughunn, 1987). According to Bhattacharyya &Laughunn (1987),price cap regulation provides regulators with an opportunity to monitor the natural monopolies’ rates of returns, degree of cross-subsidizing behavior, total output and structure of prices among other performance indicators in monopoly markets. Conclusions One of the most persistent questions when dealing with natural monopolies is whether to regulate or not to regulate them. This is because there are as many success stories of regulated monopolies as there are failures. One of the main reasons why governments find the need to intervene and regulate a natural monopoly is to protect the welfare of consumer from the monopolist. If left unregulated, monopolists are more likely to set very high prices and produce services at a much lower scale resulting in allocative evidence where the services produced cannot meet the demand and the prices are too high for consumers to afford. Although government interventions are intended for good, they often generate unintended adverse side effects, which include cost padding and gold-plating. Cost padding refers to the deliberate falsification of costs by inflating them with the aim of increasing the cost reimbursement that monopolies obtain from the regulator. Gold-plating refers to over investing in systems and processes in a bid to increase the profit margins. References Albon, R. P. & Kirby, M. G. (1983).Cost-Padding in Profit-Regulated Firms.The Economic Record, Vol. 59, No. 1, pp.16-27. Bhattacharyya, S.K. &Laughunn, D.J. (1987). Price cap regulation: can we learn from the British Telecom experience. Public Utilities Fortnightly. Bougheas, S. & Worrall, T. (2009). COST PADDING IN REGULATED MONOPOLIES. Manchester: University of Manchester. Colm, K. (1994). Regulating natural monopoly: are price caps an alternative to rate of return targets? Sidney: Centre for Applied Economic Research and Industrial Relations Research Centre. Giocchino, D. D. (2004). COST PADDING IN REGULATED MARKETS WITH DEMAND UNCERTAINTY. Working Paper, No. 72. Retrieved on 7th Sept 2013 from http://www.dipecodir.it/upload/wp/pdf/wp72.pdf Kahn, A.E. (1970). The Economics of Regulation. New York: Wiley. King, S. (2012). Risk, Gold-plating and Over-pricing for Electricity. Retrieved on 7th Sept 2013 from http://economics.com.au/?p=9198 Kirby, M. G. (1979). An Economic Assessment of Australia’s Two Airline Policy. Australian Journal of Management, Vol 4, No. 2, pp.105-118. Moran, A. (2012). Rise in Electricity Rates Offers A Chance To Grasp Nettle of Privatization. The Australian, 8th Aug. Retrieved on 7th Sept 2013 from http://www.ipa.org.au/sectors/economics-deregulation/news/2724/rise-in-electricity-rates-offers-a-chance-to-grasp-nettle-of-privatisation/pg/10 Waterson, M. (1988).Regulation of the Firm and Natural Monopoly.London: Blackwell. Read More