We are given the demand curve for taxi trips as follows:
P = 400 − .001T (demand curve)
If P = 200, the total number of trips taken must be T = 200 000
A licence costs £10 000 and we are asked what monopoly rent per year this implies for each driver. An intuitive way of looking at the question is simply to note that with i = 10 per cent and a licence costing £10 000, a taxi driver would have to make £1000 per year simply to service a loan taken out for the purpose of buying the licence. Thus it is worth buying the licence if a rent of £1000 per year is anticipated.
Each taxi driver makes 200 000/20 = 10 000 trips per year. Thus, monopoly rent per trip is £(1000/10 000) = £0.1. Free entry into taxi-driving would reduce the average price from £2.00 to £1.90.
It is worth noting that individual taxi drivers receive ‘monopoly rents’ even though new drivers will make only a normal return on the financial commitment they make to the business (including the cost of the licence). Their business accounts may show a competitive rate of return on the basis of the licence being treated as a capital asset. From an economic point of view, however, £1000 per year of their revenue is a receipt of rent. It is not strictly required to elicit their services as taxi drivers. This can be seen from the answer to (b). Suppose free entry were allowed and the price per trip fell to £1.90. This would not result in existing taxi drivers leaving the business. They would take a big capital loss, of course, because their ‘licences’ would now be worthless, but they would have no particular incentive to leave taxi-driving and do something else (except out of pique). Thus the entire return to their ‘licence’ is pure economic rent – a rent created by a monopolistic trade restriction.
Rent-seeking losses occurred when the resources were devoted to establish the restriction in the first place. Assuming that everyone now accepts the system and expects it to last indefinitely, people can gain access to the flows of monopoly rent only by buying a licence, and there is no necessary further loss of real resources through rent-seeking. If consumers banded together to lobby for free entry into taxi-driving, however (a somewhat unlikely eventuality – why?), it might be argued that their activities were a form of rent-seeking since they are attempting to gain at the expense of taxi drivers. Although a liberal economist might applaud such efforts there is a clear danger that more resources will be used in the attempt than the social benefits achieved. The potential gains to consumers are over £20 000 per year, but most of this is simply a gain at the expense of existing taxi drivers.
Assuming that the new highly skilled taxi drivers achieve these skills at zero cost, the monopoly rent per trip would now be 20 pence, and at 10 000 trips per year the yearly flow of rent would be £2000. This implies that under competitive conditions (there are many such skilled drivers) the licence will rise to a capital cost of £20 000. Older less-skilled drivers will leave the industry and sell their licences. The prevailing rate of interest is 10 per cent, so that they can invest the proceeds from the sale of their licences and receive a flow of £2000 per year instead of the £1000 achievable through driving taxis.
Clearly, if licences were not tradeable the new taxi drivers would not take over, and the old ones would continue in the industry. The gains from more efficient taxi drivers (10 pence per trip) would not be achieved. For the market as a whole this amounts to £20 000 per year on a present value of £200 000. With non-exchangeable licences the industry is not technically inefficient as usually defined, however, because for the given resources being used greater technical efficiency could not be achieved. The non-exchangeability of licences is a form of mobility barrier, and the inefficiency involved is a form of allocative inefficiency.
The transmission of telephone messages is usually considered to have natural monopoly characteristics because of the fixed costs involved in establishing the telephone lines. In the case of bus services, the transport of passengers does not appear to have the same fixed cost characteristics. Concentrating entirely on the physical movement of passengers, it is not clear that a single fleet of ten buses will involve lower costs than ten fleets of one bus each. A moment's reflection reveals, however, that the difference between the two cases depends upon the assumption that bus fleets do not have to construct and maintain the roads along which they travel. If transmission services could be separated from the maintenance and construction of telephone networks, it would not be obvious that data transmission was a natural monopoly. Indeed, it is this possibility that has led to recommendations that providers of telecommunications services should be able to lease lines from the supplier of the network. The Beesley Report (1981), Liberalisation of the Use of British Telecommunications Network, for example, recommended unrestricted resale of BT's capacity.
Although the sunk costs involved in networks make them uncontestable, this is not so clearly the case for the services which use the network. Because a bus will rarely be specific to a given route and can easily be resold or switched between routes, the sunk costs of serving a particular route are not great. This in itself does not make the market contestable, however. An incumbent firm which can adjust its price downwards before the new entrant can attract customers will be safe from new entry. Jaffer and Thompson (1986) suggest that National Express maintained its dominant position in the market after liberalization by this means (among others).
In telecommunications, switching cannot be regarded independently of the network. More direct links will economize on switching costs and vice versa. A bus terminal similarly has natural monopoly characteristics because of the economics that it offers in consumer information costs and transactions costs. A single bus station in a town will involve lower costs than a whole set of separate ones for different companies. The ability of a large bus company to exclude others from its terminals, however, makes new entry more difficult. It increases the cost of switching between carriers. Jaffer and Thompson (1986) criticized National Express for using this strategy. This is the basic case for separating the ownership of bus stations from the bus companies that use them. An MMC Report (17 February 1988c) found the exclusion by Southern Vectis of other operators from its bus station to be anti-competitive. A difficult problem would arise if a bus company wished to establish reputation for luxury travel and could not rely on the stations to deliver the necessary facilities. One response short of full integration, however, would be to permit the leasing of parts of bus stations by particular companies – a form of quasi integration.
Where terminal equipment for telecommunications or travel accessories for bus transport are concerned, natural monopoly would not appear to be such a significant problem as it is with network services. A single supplier is less likely to have a significant cost advantage over a set of smaller ones. Contestability is a more difficult attribute to judge. A general answer is not possible without knowledge of the production processes involved in the different areas. It may be that certain types of electronic equipment require for their production some highly specific equipment, and that therefore significant sunk costs are involved. In other areas, the specificity of capital requirements may be negligible.
Littlechild's ordering is as follows:
Protection against monopoly
RPI − X
Max rate of return
No constraints
This ordering can be justified by the output expansion incentives associated with price control. RPI − X is most likely to result in the lowest price and highest output of all the alternatives. Clearly, with no constraints at all, the natural monopolist is most able to exploit the consumer. The maximum rate of return is placed between the other two forms of regulation.
Production efficiency and innovation
| 1 | RPI − X and no constraints |
| 3 | Max rate of return |
Some rather delicate judgements are involved here. With no constraints, all the profit incentives will exist for production efficiency, but the absence of competition and the presence of easy profits may result in X-Inefficiency and a disinclination to innovate. Under price control, the pursuit of production efficiency and lower costs should be encouraged providing the firm does not come to believe that the regulatory authorities will immediately reduce prices. It is for this reason that the price control formula makes no reference to costs. As discussed in the text, however, it is a moot point whether, in practice, price control and the prevailing cost level can or should be separated. Maximum rate of return is placed last because of the Averch-Johnson effects with which it is associated, and because innovation is unlikely to be stimulated with a limit on the rate of return that can be made.
The burden of regulation
No constraints
RPI – X
Max rate of return
Clearly if there are no regulatory constraints there can be no burden from this source. RPI – X is considered superior to rate of return regulation because the latter is more likely to result in complicated negotiations between firms and regulators over the measurement of capital assets. Information requirements are greater and the number of regulators will be higher. It may even lead to the danger of ‘capture’. As we saw, however, if the value of X requires periodic re-negotiation, some of the same problems arise with price control.
Promotion of new competition
No constraints
RPI – X
Max rate of return
Here the judgement is that high profits in the absence of regulatory constraints will be the most powerful inducement for new competitors to think of ways of undermining an incumbent's position. The obvious problem with a maximum rate of return is that, if the same regulatory environment faces a new entrant, there is no chance of a handsome payoff. An important objection to this reasoning is that with no regulatory constraints, a natural monopolist may have very little to fear from new entry and that regulation may be necessary to increase the chances of new entry where the market is not remotely contestable. For example, price regulation, it could be argued, may be necessary to prevent predatory price responses to new entry. Similarly, as we have seen, the control of common carriage rates may be important for facilitating entry into gas or electricity supply.
The most obvious point is that the Competition Act 1998 specifies much higher penalties for running a prohibited agreement than in the past have been imposed for non-registration. Because a first offence under earlier legislation had involved virtually no penalty, there had been a temptation to run an agreement until found out. Linking the penalty to a firm's turnover provides a means of exacting a bigger penalty as contraventions of the law become more economically significant.
Deterrence depends not only on the penalty but the chance of detection. Detection depends upon resources devoted to monitoring. Monitoring is not quite the same as investigation, however, and resources devoted to uncovering illegal agreements would savour of the secret police. By encouraging private actions the authorities use the monitoring power of all potentially affected parties and not just the resources of an official bureaucracy. However, private actions have been possible under existing legislation but have not been greatly used. Legal action is in itself costly, and people will not use it unless the prospects of success and the ‘prize’ associated with it are sufficiently favourable. Thus, encouraging the monitoring and enforcement potential of private actions depends on legal institutions.
A standard fee independent of the outcome of a case has important implications from a principal-agent perspective.
It implies that all the risk is shouldered by the plaintiff (principal) and none by the lawyer (agent).
Where the plaintiff has neither the expertise nor the resources to monitor his lawyer's behaviour, the incentive to the latter to shirk is increased. A counter to this argument is that there exists a form of ‘market’ sanction in that a poor record will reduce the fees that a lawyer can command, thus providing the effort incentives. (This is the same sort of mechanism as is sometimes suggested operates to discipline managers of state or other enterprises (see Module 8).)
The incentive to take legal action will also be determined by conventions governing the award of damages. In the US incentives such as triple damages make litigation more attractive. In the UK, the White Paper suggests that a litigant's costs should be included in a claim for damages.
