Review of Industrial Organization
13: 669–685, 1998.
1998 Kluwer Academic Publishers. Printed in the Netherlands.
A Test for Natural Monopoly with Application to
Norwegian Electricity Distribution
KJELL G. SALVANES
Department of Economics, Norwegian School of Economics and Business Administration and the
Foundation for Research in Economics and Business Administration
Department of Economics, University of Bergen and the Foundation for Research in Economics and
Abstract. Reorganization of public utilities is on the current political agenda in many European
countries. However, in many cases the most fundamental question in terms of public policy towards
these industries is not tested; does the underlying cost structure indicate a natural monopoly or not?
Evans and Heckman’s analysis of the US Bell System is one of the few exceptions, but their method
has a serious problem as their estimated cost function is not well behaved(negative marginal costs). To
solve this problem we propose to use the consistency region (i.e., the region where the estimated cost
function is well behaved) as the test region. We apply our testing procedure to Norwegian electricity
distribution and ﬁnd that local electricity distribution is characterised as a natural monopoly. Policy
implications of the result is also discussed.
Key words: Natural monopoly, test for subadditivity, consistency region, electricity distribution.
Reorganization of public utilities and industries such as electricity production and
distribution, telecommunication, railways and airlines, which was pioneered in the
early eighties by Britain and the US, is on the current political agenda both in the
European Union and in the Nordic countries. In very few cases, however, is a test
undertaken to address the most fundamental question in terms of public policy
towards regulation of these industries; is the underlying cost structure a natural
monopoly or not? One of the few research projects with the aim of testing for
natural monopoly was undertaken by Evans and Heckman (1983a, 1983b, 1984,
1986). They developed a test for natural monopoly based on Baumol, Panzar and
Willig (1988), and applied the test to cost data from the US Bell System. Their
majorﬁnding,that the Bell System wasnot a naturalmonopoly, played an important
role in the splitting of the Bell system into regional ﬁrms. However, there seem to
This paper was partly ﬁnanced by a grant from the Norwegian Research Council. We thank
Gary M. Fournier, Kjell Erik Lommerud, Bjørn Sandvik, Lars Sørgard, seminar participants at
Department of Applied Economics at Cambridge University, University of Bergen, Norwegian School
of Economics, EARIE’95 and EEA’96, for valuable suggestions and comments.