Review of Industrial Organization (2006) 29:127–147 © Springer 2006
The Role of Competition in Natural Monopoly:
Costs, Public Ownership, and Regulation
JOHN E. KWOKA
Department of Economics, Northeastern University, 301 Lake Hall, Boston, MA 02115,
Abstract. Conventional policy for industries with very high economies of scale is to per-
mit monopoly but to subject it to regulation or public ownership. Since the latter may
not result in cost minimization, however, it is possible that competition, by forcing ﬁrms
to operate at the cost frontier, may be less costly despite sacriﬁcing some scale econo-
mies. The paper sets out the relevant analytical considerations, estimates a cost function
for electric distribution utilities in the U.S., and tests for the relative costs of monopoly
and duopoly utilities. Among other notable ﬁndings, it concludes that competition does
indeed lower net costs.
Key words: Benchmark competition, electric utilities, public ownership, regulation.
Although the relationship between competition and price receives more
attention, the effect of competition on costs may be at least as impor-
tant. By some measures the efﬁciencies gained from the latter exceed al-
locative improvements due to price competition (Scherer and Ross, 1990,
p. 672), and in any event, cost reductions are one reason for price declines.
All this makes cost competition seem universally advantageous, but where
production technology is characterized by signiﬁcant economies of scale,
classical competition involving multiple ﬁrms would seem to be an unprom-
ising approach: Competition may force ﬁrms to minimize cost for a given
output and thus operate at the cost frontier, but each ﬁrm produces less
output, fails to achieve minimum efﬁcient scale, and suffers excess unit
cost. For this reason, the preservation of multiple ﬁrms of suboptimal scale
is scarcely ever endorsed as good policy.
That conclusion may be too facile, however, for two reasons. First,
the trade-off between a closer approximation to the cost frontier and the
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