The University of Chicago Chicago’s Best Ideas Lecture Series April 14, 2003 Natural Monopoly and Its Regulation Randal C. Picker Leffmann Professor of Commercial Law The Law School The University of Chicago 773.702.0864/r-picker@uchicago.edu Copyright © 2003 Randal C. Picker. All Rights Reserved.

Copyright © 2003 Randal C. Picker 21 Stan L Rev 548 (1969) November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Four Sections I. The Grounds for Regulating Prices, Entry, or Other Business Conduct in a Natural Monopoly Market II. The Theory and Practice of Public Utility Regulation III. Proposals to Reform the Regulatory Process IV. Alternatives and Recommendations November 8, 2018 Copyright © 2003 Randal C. Picker

Natural Monopoly Profits “Thus, although a natural monopolist should be able to extract large profits, it is difficult from an ethical standpoint to distinguish an individual who obtains a high return by virtue of an interest in a natural monopoly from one who owns a strategically located plot of land and watches its value rise year after year without any skill or effort on his part.” November 8, 2018 Copyright © 2003 Randal C. Picker

Regulation: The Balance Sheet “Summarizing the discussion to this point, there are different degrees of justifications for regulatory controls, but in no case do the benefits clearly outweigh the costs.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. “There is no persuasive case for the regulation of specific rates in, or of entry into, natural monopoly markets; yet these have been important areas of regulatory activity, whose principal result has been to promote inefficient pricing and to create unjustified barriers to entry and competition.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. “The case for limiting a natural monopolist’s profits turns out, on careful examination, to be weaker than generally assumed. Moreover, either the cure may be worth little because regulatory agencies cannot clamp an effective lid on monopoly profits, or it may be worse than the disease.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker In Conclusion “Our analysis of proposals for reforming public utility regulation confirms our preliminary conclusion that is contribution to social and economic welfare is probably negative. … Regulation may be likened to the treatment of an ailment whose gravity is not known with a costly and dangerous drug whose efficacy is highly uncertain. It can be improved, but I do not see how we can realistically hope to transform it into a fruitful instrument for advancing the public welfare.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker In the Future “In the long run, there may be few natural monopolies, perhaps none, such is the pace of change in consumer taste and in technology in a dynamic economy. It is not completely fanciful to envisage a time in which electric utilities will have to compete with manufacturers of nuclear-powered home generators or telephone companies with CATV operators. It regulation is not extended to embrace potential competitors of regulated firms, it may eventually wither away.” November 8, 2018 Copyright © 2003 Randal C. Picker

1996 Act’s Local Competition Framework Three Key Changes Kills State Entry Barriers Feds preempt state entry barriers (47 USC 253(a)) Quarantine RBOCs Can’t enter long distance unless facilities-based local competitor exists (47 USC 271) November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. Incumbent Local Exchange Carrier Access Rules (47 USC 251(c)) Interconnection Exchange and completion of telephone calls Unbundling More on this Resale Offer telecommunications services for resale at wholesale rates November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Why UNEs? Long Distance Success Story Separate local calling from long distance Microwave entry—facilities-based entry—as starting point Creates lots of competition in long distance Best example of unbundling (Kearney & Merrill, 1998) Mental model for 1996 Act approach November 8, 2018 Copyright © 2003 Randal C. Picker

UNE Access Standards under 47 USC 251(d)(2) (2) Access standards.--In determining what network elements should be made available for purposes of subsection (c)(3), the Commission shall consider, at a minimum, whether— access to such network elements as are proprietary in nature is necessary; and November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. the failure to provide access to such network elements would impair the ability of the telecommunications carrier seeking access to provide the services that it seeks to offer. November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Iowa Utilities (U.S., 1999) Two Issues FCC vs. State Jurisdiction Resolved in favor of feds, but not our issue Scope of Sharing Rules Rejected FCC rules Too broad, no limiting principles, redo them November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker USTA (D.C. Cir. May 24, 2002 Overturned FCC’s Second Set of Sharing Rules Insufficient market-by-market examination of needs for unbundling of particular elements Stayed Until Feb. 20, 2003 November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker FCC Feb. 20, 2003 Orders D.C. Circuit Stay Expired Feb. 20, 2003 Revised FCC Orders Announced On Time So far, just press releases, no orders November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Key Features from PR UNE-P “The Commission finds that switching - a key UNE-P element - for business customers served by high-capacity loops such as DS-1 will no longer be unbundled based on a presumptive finding of no impairment. Under this framework, states will have 90 days to rebut the national finding.” “For mass market customers, the Commission sets out specific criteria that states shall apply to determine, on a granular basis, whether economic and operational impairment exists in a particular market. State Commissions must complete such proceedings within 9 months.” “Upon a state finding of no impairment, the Commission sets forth a 3 year period for carriers to transition off of UNE-P.” November 8, 2018 Copyright © 2003 Randal C. Picker

What is a Natural Monopoly? “If the entire demand within a relevant market can be satisfied at lowest cost by one firm rather than two or more, the market is a natural monopoly, whatever the actual number of firms in it.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Natural Monopoly Is … Natural Monopoly = Lowest Cost of Production of Any Amount of Good Using Single Facility Example Production Function: F(Q) = K + cQ November 8, 2018 Copyright © 2003 Randal C. Picker

Why Facility and Not Firm? Natural Monopoly ≠ One Owner Terminal Railroad (U.S., 1912) Electricity Grid Independent System Operators Regional Transmission Organizations November 8, 2018 Copyright © 2003 Randal C. Picker

Posner: Entry and Natural Monopoly “The possibility that more than one firm will find itself selling in a natural monopoly market is not, however, a substantial basis of concern about performance under natural monopoly. The situation is inherently unstable.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. “As explained earlier, the fear of ruinous competition seems largely groundless. If a prospective entrant realizes there is room for only one firm in the market, it will not enter unless confident of being able to supplant the existing monopolist. …” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. “So long as a single firm can meet the market’s entire demand most efficiently, one can be reasonably confident that the market will shake down to a single firm … .” November 8, 2018 Copyright © 2003 Randal C. Picker

Natural Monopoly and the Number of Firms Natural Monopoly ≠ Monopoly May see entrant even with incumbent having natural monopoly production function Incentive to enter depends on entrant’s expectations about incumbent’s response Econ literature suggests “over-entry” problem (Mankiw & Whinston, (1986)) November 8, 2018 Copyright © 2003 Randal C. Picker

Case No. 1: The Tough Incumbent Entrant believes that Incumbent monopolist will slash prices to c, marginal cost, in response to entry Will E enter? Answer No, just covers marginal costs, and loses fixed cost of K November 8, 2018 Copyright © 2003 Randal C. Picker

Case No. 2: Price Competitors E believes and E and I will compete on price More precisely, an outcome of their interaction will be a situation in which E is happy with her price, given I’s price, and vice versa. Will E enter? November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Case No. 2 Answer Probably not. Most natural outcome of this process, called Bertrand competition, is P = c. Lowering prices slightly diverts the entire market to the seller and increases profits. This repeats scenario 1 outcome and no reason to enter November 8, 2018 Copyright © 2003 Randal C. Picker

Case No. 3: Quantity Competitors Switch from prices to quantities (Cournot competition) Look for an outcome in which E is happy with her quantity, given I’s quantity, and vice versa. Will E enter? November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Case No. 3 Answer Perhaps. Depends on: Parameter values Willingness of incumbent to share facility voluntarily November 8, 2018 Copyright © 2003 Randal C. Picker

Natural Monopoly Isn’t … Natural Monopoly ≠ Monopoly May see entrant even with incumbent having natural monopoly production function Incentive to enter depends on entrant’s expectations about incumbent’s response But threat of entry also alters incentive of incumbent to give access to facility November 8, 2018 Copyright © 2003 Randal C. Picker

Entry and Voluntary Access Mandatory Access Central Issue of Modern Natural Monopoly Regulation Evaluating the Law Need to know scope of voluntary sharing that would otherwise take place to assess how law changes private ordering November 8, 2018 Copyright © 2003 Randal C. Picker

One Product & One Technology Start with Technology Natural monopoly production function from above Any firm could build facility with that production function All facilities produce the same product November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Four Stage Game 1. First firm chooses whether to build facility 2. If built, firm chooses whether to give access to facility to others 3. After access licensing done, other firms choose whether to build facility 4. Firms with access to product engage in Cournot competition in product market November 8, 2018 Copyright © 2003 Randal C. Picker

Key Point: Unlicensed Entry is Wasted Opportunity If an unlicensed firm would enter at stage 3 by building a facility, given what has happened at stages 1 and 2 and given what is anticipated will happen at stage 4, the incumbent should have issued one more license during the second stage November 8, 2018 Copyright © 2003 Randal C. Picker

Don’t Want Multiple Facilities, Don’t Get Them Don’t Want Multiple Facilities (Facilities-Based Competition in FCC Speak) On assumed natural monopoly technology, single facility can produce everything November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Cont. Don’t Get It If no threat of entry, no voluntary access given and no entry takes place If threat of entry, incumbent sets access deal with potential entrant November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker No Over-Entry Problem Over-Entry Problem (Mankiw & Whinston, 1986) Overstated Voluntary access deal when real threat of entry “Coasian” Result November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker Posner Was Right? Posner in Natural Monopoly and Its Regulation Not concerned with too much entry in natural monopoly settings Right Result, Wrong Analysis Cournot competition models suggest over entry possible Voluntary access analysis suggests won’t happen November 8, 2018 Copyright © 2003 Randal C. Picker

1969: Why Is the System Broken? “Lawyers in fact dominate the regulatory process. Commissioners and leading staff members are almost wholly drawn from their ranks. Most legislators are lawyers and so are most of the representatives of the regulated firms who appear before the agencies … . A lawyer’s training and experience are indispensable to the practical implementation of social policy.” November 8, 2018 Copyright © 2003 Randal C. Picker

Law Schools Don’t Do Econ “Unhappily, the overwhelming majority of lawyers involved with regulation are largely ignorant of the principles of economics. … Most law schools do little to remedy this deficiency. A law student’s exposure to the regulated industries is normally limited to the administrative-law class, which deals with procedural questions, not economic policies.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker No Good Casebooks “Few law schools offer regulated-industries courses at all, let alone courses with a substantial economics content. The best casebook … contains no systematic presentation of the economic concepts relevant to an evaluation of the regulatory process ….” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker No Good Professors “It assumes that the instructor is fully conversant with the economic principles relevant to regulation, an assumption that in most cases is probably unwarranted.” November 8, 2018 Copyright © 2003 Randal C. Picker

Copyright © 2003 Randal C. Picker If You Want More The Original Richard A. Posner, Natural Monopoly and Its Regulation, 21 Stan L Rev 548 (1969) Two Papers for This Talk Lichtman & Picker, Entry Policy in Local Telecommunications: Iowa Utilities and Verizon Forthcoming Supreme Court Review http://papers.ssrn.com/sol3/papers.cfm?abstract_id=368040 Picker, Why Facilities-Based Competition? Very prelim draft http://www.law.upenn.edu/ile/seminarseries.html November 8, 2018 Copyright © 2003 Randal C. Picker