ABSTRACT
This chapter focuses on natural monopoly regulation. Natural monopolies are defined in terms of cost subadditivity in both single- and multiproduct cases. The boundaries of natural monopolies are always relative within a specific period, and marked based on the current technological and economic situations. Once the boundaries for defining a monopoly market are set, it is important to consider the Averch–Johnson effect, the regulatory lag effect, and the credibility of investment regulation in a comprehensive manner. Based on the Averch–Johnson model, rate-of-return regulation that is expected to increase efficiencies may in fact lead to excessive capital intensity, thus resulting in productive inefficiency. However, the model has been criticized for its static nature, as regulation keeps changing, and regulatory lag and credibility generate uncertainties over return on investment. Thus, a firm concerned about future regulatory adjustments will lose its enthusiasm for investment as the review period approaches, resulting in insufficient investment and a negative impact on public interests. To address this problem, the regulator needs to provide a credible guarantee mechanism for regulated firms.
