metadata: authors: 0: author: Bradburd, Ralph
count: World
docna: 0: docna: Privatization of natural monopoly public
            enterprises : the regulation issue
docty: Policy Research Working Paper
subtopic: Human Rights,Disability,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Services & Transfers to Poor,Energy Policies & Economics,Hydrology,Economic Assistance,Privatization,Access of Poor to Social Services,Energy Privatization,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Law and Development,International Economics and Trade,Environment,Macroeconomics and Economic Growth
abstracts: cdata!: Many developing countries are
            considering the privatization of public enterprise natural
            monopolies. Such as monopolies in charge of electricity,
            natural gas, water and sewer, and telephone service.  The
            author tries to answer two questions: (i) how great would
            the efficiency losses be, if any, if a public natural
            monopoly were privatized and allowed to function as an
            unregulated entity? and (ii) how much could performance be
            expected to improve if the privatized natural monopoly
            operated as a regular firm?  The author argues that the
            deadweight losses from monopoly pricing by unregulated
            privatized natural monopolies are likely to be modest and
            may well be outweighed by improvements in technical
            efficiency.  He also argues that regulation is not costless
            and may well foster static and dynamic efficiency losses
            greater than the deadweight monopoly losses it is intended
            to prevent. Also, the reduction of allocative inefficiency
            is only one of several objectives of regulation.  If the
            case for regulation on efficiency is weak, then much greater
            attention must be paid to how these other objectives can
            best be achieved.  Historically, achieving distributional
            equity has been an important objective of regulation. We
            have very little systematic knowledge about the actual
            distributional consequences of privatization and
            deregulation, so more research is needed.
repnme: repnme: Privatization of natural monopoly public
            enterprises : the regulation issue
display_title: Privatization of natural monopoly
            public enterprises : the regulation issue
listing_relative_url: /research/1992/04/699709/privatization-natural-monopoly-public-enterprises-regulation-issue
topicv3: Water m1326522 137,Power and Electricity Sector m1327094 515,Social Assistance m1327201 1466,Privatization m1327236 1283,Discrimination m1505707 3379
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,International Economics and Trade,Environment,Macroeconomics and Economic Growth
origu: Policy Research Department (PRD)
no_of_pages: 48
model_extractions: **Policy Research**

# **P1.bc Sector Management and Private Sector Development**

# WPS 864

TIhis paper - product of thlic Public Sector Management **and** Private Sector IDevelopmnicit Division, Counftr-y Econonics Depairtinrnt --- is part of' **a** latrgr cllort in **dte** deparuicnrnt to analyt/e **ric** n.,lations betcwen privatizalioni and rcgulation. (Copies of the piper arc available free hIor the World Banik, 18 1 8 H Street NW, Washinuton, DC 20-433. Plca'.e contlact Fist ina Madrot1a, **ro10m** N9-057. xteusNioni 38526 (April 1992, 44 pages).

M.any5 dcveloping countries **aic** co isid nring **Itic** privatization of public enterprise natural n-iionopolics -- niortopolics inl ciarge ol electric it, naturall gias, v ater and swr, aInid telcphoniic services If there is not already an apparatus or regulating p,riate monopolics, these coulitries face a difficult choicc: xhcither to continue letting inefficient public niterprises operate, to create a regul atorN apparatus, or io rpF l;ce pLubhlic monopolies with unrceulated private rnonopolics, Improving aliocalivc ciicicncy. thoughl not the only objective of reoul,ation, is cetrailiv an111 important one, and onc tlhat has rcceix ed a great deal ol attention Irom economists. In theory, regulating private niatural monopolies can improvc allocative el ficicncy. In, practice, sometimes **it** does, a-id somctimes **it** does not. So Bradburd tried to answver **two** (lucstions: I low grcal x ould lhc c tficieric v losses be. ii I any, if a public natural nonopolv were prnvati/L d and allowed to function ais **ant** unrgulated entitv'U H low mtuchI couid pcrfomancice be c'.pected to improve if lthc privati/ed natural monopol\ operated as a regulated lin!i' Bradburd argues that **thC** deadxxcighit losses front monopoly pricillng b unreglliated pliVdti/ed natural monoipolies are likelv to be irnodcst nldi 1r1x x e1l be our\kCighed **b%** 1iprox 11tIIs er in lteclih al H etici'n ie llso argucs that re- ulIalion is niot costlcss anIk ma\ **xclIl** tOster static andl dynamlic cIficicins losses roreaer than llhe d'ad\\dcishl 11hol opoly losses **iL** is ilitciidcd ) prevent.

But Bradburd also notcs ih:it rcd(uctioni ol allocative imel tiiciticv is only one ol secxc:dl objct cliv c> \l **i** eu lal oioll I I lieL _cXsC to0_ c **e Ia:.** n or' FficicnCx rovund **s** is \x cak . thcn much **_rFealtr_** at tention mlust be p lid to h ow- these other objectix es can _hcst be_ achie ved.

isiutoricall I. achieCx rig distributional Cqluit has been al importanilit o)jcctilxc ofi regulation. We **L\x** _c_ very littlc systematic krno\A ledgc about ijht &., lua; distributional conscqucnces of privati/al;otr an,,, dcregulation, so morc rcsearch **is needed.** ..\lolher ohjectix c oti ruldation cart be to help) rte **onfid;lince** in tllhe stabiilitx of th envi rolillent in xx Ich bu>iness act ixvitics take pilace. If 1nctrpric.eizs are **l)1iVat1i di** **_1'ed_ Unt'reu-** **_I_** _tucd_ in 111 clVilx (nmenlt in **%k** hlich propert\ riglhts arc n(ot secure, manae;;mnient is likel\ to take an c\uicolncl shotl-ltill **v icWx** oi **piOll I1** ia\imi/aotion, 'Ihe icniplirit "take thc moncx and ruin'' policies **\x il** icl(i all tCe undesir.btle dcadxx chlt lo;scs **ol fl** oto)poly and none of tlce benclit o Cl i 1- **_cW11e \_ ind** imrT3M0A; **9ckis1**

**The(( t%I' ResCarti Wor(kinES l'.1ipc 4U; r cx(II xIiii** .I](;II;(H itic SIic 1. **I \Vi** r {t!I;! **uin,cr** 1'T' **iii iwli' tnl Ai, ohic_\.. 1I ' 'cii i",** in cci **thei>** finding'. **i'ui** quickk~C **cti il C 1ijL,tIi;iiiin% at, Itthi:n** I **uh) tTlh. 1mdmaIr,. I riciI"Iii'OW 1,** cnnct!iSorTh in IhCCe pa **d** t 11 not'i> I cpiL **cxci!** Oft **II** : Bn P.i p.

**P 1 t .dticd t** h\ **_lic_ P'** 11 **c** R **cl T s,li I)imano.'v rni ( ce Ic**
# Evaluating the Asset Based Minimum Tax on Corporations: An Option Pricing Approach

by Antonio Estache and Sweder van Wijnbergen

# Table of Contents

1.

|1.|Introduction|2|
|---|---|---|
|2.|The Design of a Minimum Tax|4|
|3.|A Framework to Assess the Value of Minimum Taxes|6|
||3.1 Introduction<br>3.2 Option Pricing and the Minimum Asset Tax|6<br>8|
|4.|Monte Carlo Evaluation of the Minimum Asset Tax|11|
||4.1 A Simulation Model<br>4.2 Simulating the Incentive Effects of Various Tax<br>Designs<br>4.3 The Lessons for Brazil|12<br>13<br>22|
|5.|Conclusions|26|
|Refe|rences|27|

The authors are indebted to S. Ahmed for providing the data used in this paper. They thank Stijn Claessens, Ricardo Martin, and Jack Mintz for helpful comments and discussions.
2 Introduction Many LDCs are currently considering efforts to privatize public enterprise natural monopolies that produce services corresponding to those of regulated "utilities" in the United States: electricity generation, transmission and distribution; water and sewer services; telephony services; and natural gas distribution. If there is not at present any apparatus for regulation of private monopolies, these countries face a difficult choice: whether to permit inefficient public enterprises to continue to operate, to create a regulatory apparatus, or to replace public enterprise monopolies with unrecqulated private monopolies.

There are several objectives that may be served by regulating monopolies, and the socially optimal regulatory choice will clearly be a function of the rates at which society is willing and able to make tradeoffs between them. Let us consider some possible regulatory objectives.

One important goal of regulation is to reduce the extent of allocative inefficiency--the deadweight losses of monopoly. This is the aspect of monopoly regulation that has traditionally attracted the attention of neoclassical economists.

Greater distributional equity, or income redistribution more generally, is a second objective of regulation; this normally takes the form of constraining the monopolist's ability to extract surplus from consumers. Economists have not devoted
3 great attention to this objective of regulation, neverthelessi historically, it has played an important role in the establishment of regulatory institutions.

A third objective of monopoly regulation is to encourage consumption of the regulated good through constraints on the producing firm's pricing. The goal here is more than simple redistribution designed to increase the welfare of some target group, which could in principle be effected by a cash<sup>grant that</sup> would enable the consumers to purchase the (socially) desired amount of the good in question if they wished to do so; rather, the social objective is actually increased consumption of the good in question, either because it is a merit good such as health care or because it is a good such as local telephony services that is characterized by significant network (or<sup>other)</sup> externalities. Historically, this regulatory objective has also been quite important.

A fourth reason for establishing regulatory institutions<sup>is</sup> to create confidence in the stability of the environment in<sup>which</sup> business activitiew 7.1st take place. The constraints imposed by public regulation o.. monopoly may not be the first-best<sup>choice of</sup> a firm that might be regulated, but they may be preferable<sup>to the</sup> kind of institutional uncertainty that accompanies the<sup>complete</sup> absence of articulated public policy, particularly<sup>in an</sup> environment that is politically dynamic. Although this<sup>function</sup> of regulation has not received much attention in the past, the enormous institutional changes occurring in Eastern Europe<sup>and</sup>
4 LDCs may increase the attention it receives in the future.

In some circumstances, pursuing the first of these objectives will also further the others; in other circumstances, there may be tradeoffs between them. For example, if a monopoli3t practices uniform pricing and maxirizes short run profits, setting the appropriate price ceiling may well reduce static allocative inefficiencyl, transfer surplus from the monopolist to consumers, and increase consumption of the regulated good. In contrast, if the monopolist's normal practices involve very effective price discrimination, efforts to achieve the second through fourth regulatory objectives listed above are likely to increase allocative inefficiency, which would have .een near zero in the unregulated environment.

In this paper we will focus our attention on jvst the first of these regulatory objectives: reducing the allocative inefficiency associated with monopoly pricing. We do so because improvement in allocative efficiency is the aspect of monopoly regulation that has received the most attention from economists and also because, whatever regulatory objectives actually motivate the establishment of monopoly regulation, allocative efficiency is frequently the motivation that is claimed. If public enterprise natural monopolies are to be privatized, and if resources must be expended in regulating them, then suund public policies must reflect an appreciation of regulation's costs and 1 This assumes that the deadweight losses avoided are greater than the cost of the regulatory apparatus.
5 benefits in terms of the allocative efficiency objective as well as an understanding of the possible conflicts between &llocative afficiency and the other objectives, particularly distributional equity. If regulation's effect on allocativa efficiency turn out to be incertain, the policy debate and research need to be refocused on the other regulatory objectives.

In theory, regulation of private natural monopolies can improve the efficiency of the economy. In practice, sometimes it does, other times it does not. Therefore, we ask two questions: 1. How great would the allocative efficiency losses be, if any, if a public enterprise natural monopoly were privatized and allowed to function as an unregulated entity? and 2. How much of an improvement in performance could be expected if the privatized natural monopoly operated as a "regulated" firm?

Public enterprises presumably have less incentive to maximize profits. To the extent that this causes public enterprises to abstain from exploiting their ability to elevate price above marginal cost, society benefits from the reduction in monopoly deadweight losses. However, if a lack of concern with profit maximization takes the form of inattention to minim'zing costs, society bears the burden. If we assume that a private monopoly will be more likely to maximize profits than a public enterprise, then from a policy perspective, it is clearly important to have some idea whether the production efficiencies that might be gained from privatization of a public enterprise natural monopoly will be sufficient to compensate for any
# allocative efficiency losses that occur.

This study will first consider the extent of the social lossas or gains that may occur when a public enterprise natural monopoly is rnplaced by an unregulated private monopoly. We do this by simulating welfare<sup>2</sup> losses from unregulated monopoly assuming reasonable bounds for demand elasticities, monopoly price increases, and relative production efficiencies of public and private monopolies. Next we will consider the potential allocative efficiency gains or losses arising from public regulation of the privatized natural monopoly. We conclude with some general comments regarding optimal regulatory policies.

# II. Deregulated Private Monopoly vs. Public EnterDrise

In analyzing the effects of natural monopoly privatization and deregulation, it will be useful to distinguish between static and dynamic consequences. We will begin our analysis by considering static efficiency, and then will go on to weigh the importance of some dynamic efficiency considerations.

# A. Static Efficiency Considerations:

2 When we speak of "social welfare" gains or losses in the discussion below, we refer to changes in the sum of consumer and producer surplus.
7 Under the heading of static effects,<sup>we must consider three</sup> factors: 1. welfare losses due to<sup>allacative inefficiency of</sup> monopoly pricing; 2. welfare gains or losies<sup>due to changes in</sup> firms' efficiency, and 3. distributional<sup>effects of monopoly</sup> pricing. We will consider these in<sup>turn.</sup> The extent of the welfare losses<sup>that might arise due to</sup> utility sector monopoly pricing following<sup>privatization is</sup> obviously of critical importance.<sup>If these are very small even</sup> in the absence of post-privatization<sup>efficiency improvements, it</sup> is difficult to make a strong case<sup>either for continued public</sup> ownership or for post-privatization regulation.

We will begin our analysis of<sup>the losses that might occur</sup> when an unregulated private firm replaces<sup>a public enterprise</sup> natural monopoly by assuming that the<sup>private monopolist cannot</sup> practice any form of price discrimination.<sup>That is, the firm</sup> must charga a uniform prtce for all<sup>units of output sold to all</sup> customers. Then we will consider the<sup>impact of assuming that the</sup> privatized monopoly will engage in systematic<sup>price</sup> discrimination.

# 1. Uniform Monopoly Pricing

In estimating the range of welfare<sup>losses consequent to</sup> privatization, we have employed a variant<sup>of the Hare.erger</sup> (1954) technique, which involves some formulaic<sup>computation combined</sup> with sensitivity analysis. Because<sup>the results vary with the</sup> parameter values assumed, it is important<sup>to review the</sup>
8 underlying assumptions of the approach.

For simplicity, the model we employ assumes constant marginal costs in the relevant range of production and a linear demand curve. It also assumes that prior to privatization, the public enterprise produced the "competitive" or "socially optimal" output, i.e. that at which price equaled marginal cost. We assume that the private unregulated firm that replaces the public enterprise produces the output that maximizes short run profit in the absence of price discrimination.

Taken together, these assumptions imply that the private monopolist's output (in physical units) will always be exactly one half the output of the public enterprise for any level of marginal cost. Further, they imply that every possible public enterprise equilibrium output is associated with a unique price elasticity of demand (depending upon where on the linear demand curve it is located) and that for each pre-privatization demand elasticity we can determine the percentage increase in price that will occur after the public enterprise is replaced with the private unregulated monopoliat.

Thus, our assumptions allow us to create a schedule that associates. pre-privatization price elasticities with (maximum) post-privatization percentaae price increases. We provide this in Table 1.

As is evident in Table 1, if the public enterprise were producing at a point where the short run demand elasticity was
9 very low<sup>3</sup> , the private monopoly's shift to short run profit maximizing pricing will lead to a very large percentage increase in price. Conversely, the higher the pre-privatization elasticity, the smaller the percentage price incre;'se. Some of the percentage price increases seem extremely large, but depending upon initial conditions, they are not infeasible.

The relation between demand elasticity and percenta4e price increase is quite important. The schedule in Table 1 allows us to employ a variant of tha well-known Harberger formula to calculate the deadweight loss resulting from the shift to monopoly pricing.

The Harberger (1954) formula for the deadweight losses due to the allocative inefficiency of monopoly pricing is '. - }*P*Q*e*d (1) where: P = the competitive price;

- Q = the competitive output;

- e - the price elasticity of demand for the monopolized product; and

- d =the percentage increase in the price of the product consequent to monopoly.

In the analysis below, we modify the Harberger formula 3 Recall -r assumption that public enterprises prcduce where price equals utrginal cost. Thus, in terms of a demand curve, a low pre-privatization demand elasticity implies that price equals marainal cost well below the mid-point of the demand curve. With a linear demand curve, the elasticity at any given price will equal the distance along the ordinate axis from the origin to the that price, divided by the distance from that price to price intercept of the demand curve.
10 TABLE 1

# PERCENTAIE PRICE CHANGES AFTER PIUVATIZATION CORRESPONDING TO PRE-PRYVATIZATION PRICE ELASTICITIES

CHANGE IN PRICE FOLLOWING MONOPOLY PRICE (%) ELASTICITY

|0.111111|450|
|---|---|
|0.176471|283.3|
|0.25|200|
|0.333333|150|
|C 428571|116.7|
|0.538462|92.86|
|0.666667|75|
|0.818182|61.11|
|1|50|
|1.222222|40.91|
|1.5|33.33|
|1.857143|26.92|
|2.333333|21.43|
|3|16.67|
|4|12.5|
|5.666667|8.824|
|9|5.556|

(Note: a 450% price increase should be interpreted to mean that the new prlce is 5.5 times the old price.)
11 slightly in order to measure welfare losses as a percentage of of industry sales measured at the competitive price and output.4 Table 2 below provides estimates of the welfare loss (as percentage of industry sales) that would occur if a competitive - pricing public enterprise were replaced by short run profit maximizing uniform pricing monopolist. Column 1 is the preprivatization demand elasticity; column 2 is the postprivatization percentage price tncrease; and column 3 is the welfare loss due to monopoly pricing expressed as a percentage of industry sales. We will return to columns 4 to 6 momentarily. The first thing to note in Table 2 is that the simulated losses due to monopoly pricing vary greatly. With a price increase as large as 93%, the deadweight loss is about 23% of industry sales. A 41% price increase would cause a deadweight loss of about 10% of industry sales, and a 21% price increase produces a deadweight loss of about 5% of industry sales. Although we will return to this subject later, we should note here t'.at this table provides information on the range of the benefits that could be obtained from regulating the privatized 4 In some circumstances it may be useful to consider welfare changes as a percentage of GDP. This is readily accomplished by multiplying the welfare loss (or gain) as a percentage of industry output by the share of GDP accounted for by the industry in question. As is evident in Appendix 1, the utilities sector accounts for a relatively modest share of GDP in developing countries --around 1 to 2 percent-- and therefore welfare changes as a percent of GDP are likely to be quite small.
12

# TABLE 2

## SOCIAL WELFARE GAINS OR LOSSES FROM PRIVATE MONOPOLY OPERATION OF NATURAL MONOPOLIES

|(1)|(2)<br>PERCENT<br>CHANGE|(3)<br>SOCIAL WELFARE<br>CHANGE AS %|(4)<br>SOCIAL WE<br>AS % OF I|(5)<br>LFARE C<br>NDUSTRY|(6)<br>HANGE<br>OUTPUT|
|---|---|---|---|---|---|
|PRICE|_IN_|OF INDUSTRY|IF<br>COSTS|DECLINE|BY:|
|ELASTICITY|PRICE|OUTPUT||||
||||0.1|0.2|<br>0.3|
|0.111111|450.00|-112.50|-104.96|-97.33|-89.62|
|0.176471|283.33|-70.83|-63.27|-55.57|-47.74|
|0.25|200.00|-50.00|-42.41|-34.62|-26.66|
|0.333333|150.00|-37.50|-29.87|-22.00|-13.88|
|0.428571|116.67|-29.17|-21.51|-13.52|<br>-5.22|
|0.538462|92.86|-23.21|-15.51|-7.41|<br>1.10|
|0.666667|75.'0|-18.75|-11.00|-2.75|<br>6.00|
|0.818182|61.11|-15.28|-7.47|0.95|<br>9.98|
|1|50.00|-12.50|-4.63|4.00|<br>13.38|
|1.222222|40.91|-10.23|-2.27|6.61|<br>16.40|
|1.5<br>|33.33<br>|-8.33|-0.27|8.92|<br>19.23|
|1.857143|26.92|-6.73|1.47|11.05|22.04|
|2.333333|21.43|-5.36|3.02|13.14|<br>25.02|
|3|16.67|-4.17|4.46|15.33|<br>28.46|
|4|12.50|-3.13|5.88|1'i.88|<br>32.88|
|5.666667|8.82|-2.21|7.42|21.29|39.42|
|9|5.56|-1.39|9.49|27.11|51.49|

Note: This table embodies the following assumptions: constant marginal cost the relevant range of production; a linear demand curve; price equal t marginal cost prior to natural monopoly privatization; short run profi maximizing behavior by the privatized natural monopoly; no price discrimination; no pyramiding welfare effects of cost distortions involving downstream purchasers of the natural monopoly's products.
13 natural monopoly.5 Column 3 gives the deadweight loss of monopoly pricing relative to a public enterprise that produces the socially optimal output, that at which price equals marginal cost. Absent efficiency improvements, the most that one could hope for from regulation is that the regulated firm would produce the socially optimal output, so the figures in column 3 tell us the benefits perfect regulation can provide.

To this point, we have assumed that a private monopoly is no more efficient than a public enterprise. However, there is a significant body of literature arguing that public enterprises are less efficient than privately owned firms, and we need to take this into account in framing our analysis.

# a. Efficiency Gains from Privatization

i. Theory In evaluating the effects of changing from public enterprise provision of natural monopoly services to provision by private unregulated firms, we have to this point focused on allocative efficiency issues, implicitly assuming that there are no differences in the efficiency with which private and public enterprises produce their output. If the production techniques of private profit-oriented firms are more efficient than those of public enterprises, the cost-savings resulting from private ownership might offset or even outweigh any deadweight welfare S This assumes no efficiency changes after privatization, an issue to which we will turn immediately below.
14 losses due to monopoly pricing. We must therefore examine some theory and evidence relating to the relative efficiency of public enterprises and private fl-ms.

"Efficiency" is a broad term. A firm could be "inefficient" because it fails to choose the appropriate capital/labor ratio given technological opportunities and given relative factor prices; it could be "inefficient" because it uses more inputs than necessary to produce a given level of output (even if it uses them in the "right" proportions), or equivalently, because it produces less output than it could for a given level of input use; and it could be "inefficient" because it overpays for the inputs it uses. Economists have attempted to distinguish between these kinds of efficiency. However, in practice they tend to meld together, and so we will simply equate differences in inefficiency with differences in cost for any given level of output.

There are several reasons to believe that public enterprises will be less efficient that private enterprises producing the same products First and foremost, there is no residual claimant in a public enterprise who receives the profits.<sup>6</sup> Consequently, there is nobody who has a strong interest in ensuring that the difference between revenues and costs is as large as possible. To the contrary, if the outside auditing of the public enterprise 6 Borcherding et al. (1982) discuss both "property rights failure" and "public choice" explanations for the greater inefficiency of public enterprises. They do not find either approach entirely convincing.
15 is relatively ineffective, its employees (at all levels) have an incentive to capture as many rents within the firm as is possible. To be sure, this problem exists in private firms as well as public enterprises, as the large "managerial firms" literature attests. However, the extent of internal rent capture is likely to be much smaller in private firms.<sup>7</sup> A second reason that public enterprises are likely to be less efficient than private firms is that their managers are largely shielded from the effects of the market for corporate control. For better or worse, managers of private firms are forced to keep profits up by the fear that low earnings will encourage a corporate takeover. This threat is absent for public enterprises.

A third reason for greater relative public enterprise inefficiency is that managers must often try to satisfy multiple objectives determined by politicians. When there are multiple objectives and no clear rules as to the optimal trade-offs between them, it is difficult to measure performance. If performance cannot be measured, then employees are freer to engage in internal rent capture.

"Soft budget constraints" of public enterprises also play a role in promoting inefficiency. Managers and employees of public enterprises are aware that shortfalls in revenues relative to 7 A recent study (Bradburd et al., 1991) of internal rent capture in American firms found that employees are able to capture about 14% of the potential profits in the form of higher wages and benefits.
16 costs can be remedied by recourse to government subsidies. This affects employees' behavior in seeking greater compensation and lighter workloads, and managers' behavior in resisting them. Further, managers are not unaware that efforts to cut costs and earn a surplus in the current period may be rewarded with nothing more than a corresponding cutback in government support in the future.

Finally, the risk-reward structure in public enterprises is less encouraging to risk-taking and innovation than is true in private enterprises. Without the potential for large gains, there is very little incentive to take risks that might result in failure. This latter problem affects dynamic efficiency rather than static efficiency, but is sufficiently important to require mention.

ii. Evidence There have been many studies of the relative efficiency of public and private enterprises. These span many industries and many countries. A very thorough review of the literature was performed by Borcherding et al. in 1982,8 in which they survey the results of over fifty intra-industry studies of the relative efficiency of private and public firms. As they report, of the more than fifty studies, only three studies found public firms 8 A book on the subject of public enterprise economics (Bos, 1986) published in 1986 makes numerous references to Borcherding et al., suggestir. that no major changes in thinking occurred in the intervening period.
17 produce at lower cost than private<sup>firms, and two of these three</sup> studies were considered invalid<sup>because the public firms were not</sup> producing the same product as<sup>the private firms.</sup> In the electric utilities sector,<sup>three of four studies</sup> found public firm production<sup>to be more _ostly than private</sup> production. One study found public<sup>production costs to be 40 to</sup> 75% higher, with investment<sup>levels 40% higher per kWh for public</sup> firms.<sup>9</sup> For water utilities, three studies<sup>found private firms</sup> to be more efficient than public<sup>firms by amounts ranging from</sup> 15% to 40%. In non-utility<sup>industries, several studies found</sup> efficiency differences greater than<sup>50%.</sup> Taken together, the studies<sup>reviewed by Borcherding et al.</sup> offer quite convincing evidence<sup>that private firms are more</sup> efficient than public firms,<sup>and that this holds true in a number</sup> of different country settings<sup>and industries. Further, the</sup> efficiency differences are<sup>in many cases very large.</sup> iii. Impact on Simulated Welfare<sup>Losses</sup> The theory and evidence concerning<sup>the production</sup> inefficiency of public entemprises<sup>relative to privately owned</sup> firms suggest that we should consider<sup>how total surplus is</sup> affected when a competitive pricing<sup>public enterprise is replaced</sup> by a monopolistic private firm<sup>that sets its price to maximize</sup> 9 The one anomalous study among<sup>those reviewed in the survey</sup> article occurs in the electric<sup>utility industry. This study found</sup> weak evidence that private firms<sup>had higher costs of production.</sup>
18 short run profit but that is also more efficient in producing its outptt.

This analysis is more complicated than the last. As noted by Oliver Williamson (1968a, 1968b, 1969) and others, if a monopolist is a more efficient producer than the (more competitive) firm(s) it replaces, the net change in total surplus depends upon the relative values of both the deadweight loss of monopoly pricing and the resource savings made possible by more efficient production. Further, because the monopolist's marginal cost is lower, for any given initial price elasticity, the percentage increase in price due to monopoly pricing will be lower than that shown in column 2.

The formula employed to calculate the net welfare loss (or gain) is given in Appendix 2. It is similar in concept to that of Williamson (1968b), though altered to present the welfare changes as a percentage of the value of industry output evaluated at the competitive price and output.

Column 4 of Table 2 provides estimates of the change in social welfare (measured as a percentage of industry output) for each initial elasticity if a competitive pricing (P = MC) public enterprise is replaced by a profit maximizing monopolist that has 10% lower marginal costs of production. Several items are noteworthy. For initial elasticities of 1.5 or less, the welfare losses of private monopoly are reduced somewhat. For initial elasticities of 1.5 or greater, the privatization actually results in increased total surplus, though the improvements are
19 relatively modest.

Columns 5 and 6 repeat the exercise of column 4, except that they assume efficiency improvements relative to the public enterprise of, respectively, 20% and 30%. Here, it is only in the cases of the lowest elasticitiss --those that would have produced monopoly price increases of 75% and more in the absence of efficiency improvements-- that privatization without regulation leads to a reduction in total surplus .he evidence reviewed above concerning efficiency differences between public and private enterprises suggests that 20% to 30% improvements in efficiency following privatization are not unlikely.

As is clear from Table 2, whether or not privatization is likely to cause a significant drop in social welfare depends upon the initial price elasticity of demand. It is therefore useful to consider some empirical estimates of the demand elasticity for services produced by natural monopolies.

Lester Taylor (1975), in a survey article drawing on the Houthakker-Taylor (1966) demand elasticity study as well as many others, reported that the estimated short run price elasticity of demand for electricity seemed to range from .14 to .90 (in absolute value) and that the long run elasticity ranged from 1.0 to 2.0. Further, as Alfred Kahn reports in his treatise on regulation (1971, pp. 102-3), the Houthakker-Taylor and other studies suggest that the price elasticity is significantly higher in poorer areas of the United States and abroad.

These elasticity estimates suggest two things. First, for
20 the ranges of demand elasticities found in most developing countries, the losses due to privatization without regulation are likely to be quite small; if there are e?ficiency improvements, countries may even enjoy net gains.<sup>1 0</sup> Second, if private monopolies practice price discrimination, as we will argue below is likely, poorer groups in society, with their higher demand elasticities, are leas- likely to suffer significant losses.

Simulation results are worth no more than their underlying assumptions. We must now ask if our approach embodies any assumptions that might bias our estimates of the costs of unregulated monopoly.

One aspect of our analysis in Table 2 may lead us to underestimate the social losses due to unregulated monopoly. The figures in columns 3 to 6 of Table 2 assume that all electricity is sold to final demand. However, we know that electricity is sold as an intermediate input to businesses as well as to final consumer demand.

Holding the demand elasticity constant, the welfare loss from a given monopoly price distortion for an intermediate input is likely to be greater than for a final good because the price distortion becomes a cost distortion that affects downstream output decisions. Depending upon the model employed, the welfare 10 We note again here that our use of "social welfare losses" (or "gains") refers to changes in combined consumer and producer surplus.
21 losses can be as much as 40% higher<sup>1</sup> llwhich would<sup>suggest that</sup> the welfare losses in Table 2 are underestimated.

Table 3 below assumes that all monopoly price distortions cause deadweight losses 40% larger than those in<sup>Table 2. It is</sup> important to note that because the effect is proportional,<sup>for</sup> most elasticity values and/or elasticity-efficiency improvement combinations, unregulated monopoly's effect on<sup>social welfare</sup> remains very small.

There is another factor that might seem to increase the social cost of monopoly pricing of utilities services. The elasticity of demand for electricity and other utility-like natural monopoly services is higher for industrial use<sup>than for</sup> consumer final demand. Therefore, because, as equation<sup>(1) above</sup> shows, welfare losses are proportional to the<sup>elasticity of</sup> demand, the total welfare losses might seem more appropriately located in the viLinity of the larger rather than<sup>smaller values</sup> in columns 3 to 6. This effect could appear<sup>to be significant in</sup> LDCs, where the proportion of electricity, gas<sup>or telephony</sup> services sold as an intermediate input is almost<sup>certainly higher</sup> than it is in industrialized countries.<sup>12</sup> We do not think this is a serious problem. Industrial<sup>use</sup> lScherer and Ross (1990, pp. 665-667) discuss<sup>this issue in</sup> some detail.

12 In 1972, in the United States, intermediate<sup>input use of</sup> electricity accounted for about 54% of total<sup>electricity demand.</sup> (See U.S. Department of Commerce, The Detailed<sup>InRut-Output</sup> Structure of the U.S. Economy: 1972. (Washington, U.S.G.P.Ot 1979): 173-178.
22

# TABLE 3

# SOCIAL WELFARE GAINS OR LOSSES FROM PRIVATE MONOPOLY OPERATION OF NATURAL MONOPOLIES WITH EXPECT OF PYltAMIDING VERTICA DISTORTIONS

(4) (5) (6)

|(1)|(2)|(3)|(4)|(5)|(6)|
|---|---|---|---|---|---|
|PRICE<br>|PERCENT<br>CHANGE<br>IN<br>|SOCIAL WELFARE<br>CHANGE AS %<br>OF INDUSTRY<br>|SOCIAL W<br>AS % OF I<br>IF COSTS|ELFARE CH<br>NDUSTRY<br>DECLINE|ANGE<br>OUTPUT<br>BY:|
|ELASTICITY|PRICE|OUTPUT||||
||||0.1|0.2|0.3|
|0.111111<br>|450<br>|-157.50<br>|-148.96<br>|-140.36<br>|-131.67<br>|
|0.176471<br>|283.333<br>|-99.17<br>|-90.61<br>|-81.94<br>|-73.15<br>|
|0.25<br>|200<br>|-70.00<br>|-61.42<br>|-52.67<br>|-43.77<br>|
|0.333333<br>|150<br>|-52.50<br>|-43.89<br>|-35.07<br>|-26.03<br>|
|0.428571<br>|116.667<br>|-40.83<br>|-32.19<br>|-23.28<br>|-14.08<br>|
|0.538462<br>|92.8571<br>|-32.50<br>|-23.82<br>|-14.80<br>|-5.42<br>|
|0.666667<br>|75<br>|-26.25<br>|-17.53<br>|-8.38<br>|1.20<br> <br>|
|0.818182<br>|61.1111<br>|-21.39<br>|-12.62<br>|-3.33<br>|<br>6.50<br> <br>|
|1<br>|50<br>|-17.50<br>|-8.68<br>|0.80<br>|<br>10.93<br>|
|1.222222<br>|40.9091<br>|-14.32<br>|-5.42<br>|4.27<br>|14.76<br> <br>|
|1.5<br>|33.3333<br>|-11.67<br>|-2.68<br>|7.28<br>|<br>18.22<br> <br>|
|1.857143<br>|26.9231<br>|-9.42<br>|-0.32<br>|9.99<br>|<br>21.51<br> <br>|
|2.333333<br>|21.4286<br>|-7.50<br>|1.76<br>|12.53<br>|<br>24.83<br>|
|3<br>|16.6667<br>|-5.83<br>|3.64<br>|15.07<br>|28.44<br>|
|4<br>|12.5<br>|-4.38<br>|5.43<br>|17.83<br>|32.83<br> <br>|
|5.666667<br>|8.82353<br>|-3.09<br>|7.25<br>|21.28<br>|<br>38.99<br> <br>|
|9|5.55556|-1.94|9.48|26.76|<br>49.88|

Note: This table embodies the same assumptions **as** the previotus table except that it assumes that the pyramiding vertical distortion effects of intermediate **good** price distortions increase the welfare losses of monopoly pricing by 40 percent.
23 of natural monopoly services as intermediate<sup>inputs plays a role</sup> in determining which elasticity price-increase<sup>combinations are</sup> likely. The elasticity of demand for intermediate<sup>input demand</sup> is higher because industrial users have greater<sup>substitution</sup> possibilities than private residential users,<sup>including</sup> generating their own power. This clearly<sup>constrains monopolies'</sup> ability to raise prices significantly, and<sup>therefore probably</sup> rules out in practice the larger percentage<sup>price increases in</sup> the upper part of Tables 2 and 3.

For at least some reasonable elasticity values in<sup>Tables 2</sup> and 3, monopoly pricing app^ars to produce<sup>non-negligible costs,</sup> even if the private monopoly produces<sup>more efficiently than the</sup> public enterprise it replaces. However,<sup>just as our simulation</sup> assumptio a might cause us to underestimate<sup>the social costs of</sup> private unregulated monopoly, they<sup>can also cause us to</sup> overestimate them. Two of our assumptions<sup>have this effect.</sup> We have assumed in the above analysis that<sup>the public</sup> enterprises price their products at marginal<sup>cost. To the extent</sup> that this is not the case, the welfare loss<sup>estimates are lower.</sup> If the privatized public enterprise was pricing<sup>its product below</sup> marginal cost, the price was actually being<sup>set inefficiently</sup> low, and the allocative efficiency losses are<sup>not as large as a</sup> straightforward application of the Harberger formula<sup>would</sup> suggest. However, it is much more likely<sup>that the public</sup> enterprise was setting its price above marginal<sup>cost. In this</sup> case, it was already acting to some degree<sup>like a monopolist, and</sup>
24 therefore, for any initial price elasticity, the private monopolist's percentage price increase would be smaller. The welfare losses would be correspondingly smaller.

We have also assumed that the private unregulated monopolist considers only the maximization of short run profit in setting price. Clearly, in an industry where tha long run price elasticity is significantly greater than the short run elasticity, this is not a rational strategy. Consumers can adjust their patterns of electricity, water, or telephony consumption just as they adjusted to high oil prices by purchasing more efficient automobiles and heating systems.

Further, as we have seen in the case of telephony, entry is not impossible even in sectors long considered naturally monopolistic. These longer run considerations will significantly affect the monopolist's optimal pricing strategy. Thus,the estimates in Tables 2 and 3 almost certainly exaggerate the losses due to monopoly and underestimate the gains from efficiency improvements.

On balance then, we would argue that even with single-price monopoly pricing and without any significant efficiency improvements, static welfare losses are likely to be no more than )0 to 15 percent of the value of pre-privatization output. These are not wholly insignificant figures, but neither do they suggest a crippling of the economy. Further, it is important to ncte that if even relatively modest efficiency improvements accompany privatization, welfare losses are replaced by gains.
25

# 2. Price Discrimination

To this point in our analysis of tha deadweight losses of unregulated monopoly pricing, we have assumed that the monopolist would be unable or unwilling to price discriminate among customers or groups of customers. Given the possibilities for profitable price discrimination in the natural monopoly situations we are considering, this seems an unlikely eventuality. Even in the early part of the twentieth century, (unregulated) utilities in the United States were able to implement price discrimination practices (Shepherd and Wilcox, passim); today, with firms' ability to determine customer groups' reservation prices or demand elasticities so much greater, and with the costs of monitoring customer usage so much lower, it is hard to imagine that a profit-maximizing unregulated monopoly would make the sacrifice in profits necessitated by charging a uniform price to all customers for all units of output.

Price discrimination will have an impact on income distribution and on static allocative efficiency. Let us examine these effects in turn.

Systematic monopoly price discrimination always has the effect of sh-.fting surplus from consumers to the monopolist, else the monopolist would practice uniform pricing. Given the likely patterns of asset ownership in LDCs and the patterns of residential and industrial use of utility services, this effectively means that price discrimination will increase real income inequality, and this would almost certainly be viewed as
26 undesirable. It should be noted, however, that in many countries the poorest citizens have very limited access to utilities services, or none at all. The effect of monopoly price discrimination on their rcal income is therefore likely to be small. Nevertheless, if there were no compensating allocative efficiency advantages of price discrimination, requiring unregulated monopolies to practice uniform pricing might seem an attractive policy.

Price discrimination can either increase or decrease static allocative efficiency. As is well-known, simple first and second degree price discrimination always increase output relative to the uniform price monopoly profit maximizing equilibrium and therefore reduce the static deadweight welfare losses due to monopoly. In the case of first degree price discrimination, where each unit of output is sold at its reservation price, output is expanded to the point where marginal cost is exactly equal to price, and there is no monopoly deadweight loss at all. The effects of third degree price discrimination depend'3upon demand and cost conditions, and cannot be generalized.

The non-linear pricing systems such as two-part or multipart tariffs that are employed by regulated utilities in the United States are forms of second degree price discrimination; as such, they have the effect of improving economic efficiency 13 Third degree price discrimination involves dividing consumers into groups according to type and pricing according to group demand elasticities.
27 precisely because they move output closer to the point where marginal cost equals price. If utility-type natural monopolies were deregulated in LDCs, they would almost certainly want to implement non-linear pricing schemes, and consequently, the welfare losses due to monopoly pricing would be significantly lower than those shown in Table 1.14 This is very graphically demonstrated in Table 4 below, which juxtaposes in two columns the proportion of monopoly deadweight losses (DWLs) avoided as output increases from the short run monopoly profit maximizing level in the direction of the competitive output. As is apparent in the Harberger formula for deadweight loss of monopoly, in which the DWL increases in proportion to the sauare of the monopoly price distortion, a disproportionately large fraction of the DWL costs can be avoided by increasing output part of the way to the competitive equilibrium. For example, the DWL is cut in half by increasing output a third of the way from the monopoly equilibrium to the competitive equilibrium output; it is cut by three-quarters if output is increased to a level halfway from the monopoly equilibrium to the competitive equilibrium. Deadweight losses are reduced less than 10% by the last 30% of the total potential movement.

14 Regulated utilities in the United States have frequently been stymied in their efforts to implement non-linear pricing schemes by state utility commissions. This has not only led to inefficient pricing, but has also blocked the introduction of new services the profitability of which depends upon use-based prices.
28 Thus, a very large part<sup>of the dead'ieight losses of monopoly</sup> are avoided if the possibility<sup>of profitable price discrimination</sup> induces the monopolist to increase<sup>output above the monopoly</sup> uniform pricing profit maximizing<sup>equilibrium by even a</sup> relatively modest amount.

# B. Dynamic Efficiency Considerations:

To this point, we have discussed<sup>only whether static</sup> efficiency will increase or<sup>decrease if a public enterprise</sup> natural monopoly is replaced<sup>by a private unregulated monopoly.</sup> We turn now to dynamic efficiency<sup>issues.</sup> The most important dynamic efficiency<sup>consideration is</sup> whether an unregulated private<sup>natural monopoly will make the</sup> investments necessary to offer<sup>the quality of service appropriate</sup> to the country's changing needs<sup>over time. Natural monopolies'</sup> services are an important part<sup>of a nation's infrastructure, and</sup> if they are suboptimally provided,<sup>this can be an impediment to</sup> growth.<sup>1 5</sup> Economists by now generally agree<sup>that, barring extreme</sup> values of either, gains from<sup>improvements in dynamic efficiency</sup> will usuaily begin to outweigh static<sup>inefficiency losses over a</sup> relatively short time horizon (Scherer<sup>and Ross, pp. 682). If an</sup> unregulated private firm would be significantly<sup>more likely to</sup> 1 5 The "public interest" associated with the services of many natural monopolies was one of the<sup>bases for introducing regulation</sup> of pricing and output. See Shepherd and<sup>Wilcox (1979, pp.287-288).</sup>
29

# TABLE 4

REDUCTIONS IN DEADWEIGHT LOSS AS OUTPUT MOVES PROGRESSIVELY CLOSER TO SOCIALLY OPTIMAL LEVEL <!-- Start of picture text --> (1) (2)<br>PROPORTION %<br>OF DISTANCE FROM DWL<br>TRAVERSED FROM REMAINING<br>MONOPOLY OUTPUT<br>TO COMPETITIVE<br>OUTPUT<br>Competitive Output (P-MC) 1.00 0<br>.90 0.01<br>.80 0.04<br>.70 0.09<br>.60 0.16<br>.50 0.25<br>.40 0.36<br>.30 0.49<br>.20 0.64<br>.10 0.81<br>Monopoly profit max. output 0 1.00<br><!-- End of picture text --> Note: These figures assume linear demand and marginal cost curves.
30 introduce product/service improvements<sup>or cost-saving innovations</sup> than would a public enterprise,<sup>there is a strong presumption</sup> that absent strong distributional<sup>consideration, private firm</sup> provision of natural monopoly<sup>services is preferable to public</sup> enterprise provision. Similarly,<sup>if an unregulated private</sup> monopoly will be more dynamically<sup>efficient than a regulated one,</sup> then the private monopoly is probably<sup>better left unregulated.</sup> There may be dynamic efficiency effects<sup>of price</sup> discrimination as well. In many<sup>LDCs, the quantity and quality16</sup> of service of publicly-owned utilities<sup>is sub-optimal. Upgrading</sup> service will be very costly, and private owners' upgrading efforts may be financially constrained.<sup>The increased profits</sup> from price discrimination may provide<sup>both the means of financing</sup> capital improvements and the incentive<sup>to do so.17</sup> 16"Quality" here subsumes both the range of services provided and the reliability of service<sup>provision.</sup> 17 It night be asked why we assume<sup>that a privately owned</sup> natural monopoly would engage<sup>in price discrimination and/or</sup> provide service improvements to<sup>agreater extent than a publicly</sup> owned firm would. Although publicly<sup>owned natural monopolies do</sup> practice price discrimination, they<sup>probably do not pursue it as</sup> aggressively as would a private firm<sup>for the same reason that many</sup> public enterprise utility services<sup>were priced artificially low:</sup> political expediency. In the case<sup>of service improvements, the</sup> matter is more complicated, but three<sup>factors probably play a role.</sup> First, the financial resources<sup>necessary to expand and upgrade</sup> service must come either from other<sup>government budgets or from</sup> raising the price of the natural<sup>monopoly's services, neither of</sup> which is politically appealing.<sup>Second, governments may reason</sup> that additional resources provided<sup>to natural monopoly public</sup> enterprises would be diverted to<sup>the benefit of those enterprises'</sup> employees rather than used as intended. Third, managerial initiative may be blunted because<sup>the rewards to individual</sup> managerial effort and initiative in<sup>a public enterprise tend to be</sup> lower than in private profit-oriented<sup>companies.</sup>
31 Although there will be some negative redistributive effects of permitting unregulated natural monopolies to engage in price discrimination, in practice these may not be large. In this case, the potential redistributive effects of price discrimination migh, be outweighed by the potential benefits in the form of improved static allocative efficiency and dynamic efficiency effects of service improvement.

We should note here the importance of government assurances that privatized natural monopolies will not be expropriated in the future. Without some confidence that this is true, risk averse operators of unregulated natural monopolies will attempt to make as much profit as possible from *.urrent physical capacity, increasing short run static efficiency losses in the process, but will be very reluctant to invest in new physical plant. The effect of this will be continued sub-optimal provision of services. Given that the "public interest" served by utilities' products provided much of the rationale for public operation or regulation of natural monopolies in the first place, this would clearly be undesirable.<sup>18</sup> As the evidence from the Eastern European economies clearly demonstrates, a low-priced good or service that is unavailable is not preferable to a higher JA Note that multilateral lending organizations may be able to play an important role in this situation. If a private utility is funded to some significant degree by an international lending organization, then the government may view expropriation or confiscatory regulation as potentially very costly. This might provide the assurance necessary for private investors to take a long run view of asset management.
32 priced one that is.

III. Benefits of Regulating Privatized Natural Monopolies To this point we have focused our attention on whether society's losses due to monopoly pricing in a privatized natural monopoly sector are likely to be large or small.<sup>We have argued</sup> that the static welfare losses of monopoly pricing appear<sup>to be</sup> quite modest given reasonable assumptions regarding the price elasticity of demand for natural monopoly services, the<sup>gains</sup> from greater efficiency of private firms, and the likelihood that unregulated private monopolists will engage in price discrimination. If efficiency gains are in the 20% to 30% range, improvement in static allocative efficiency is a distinct possibility. We have further argued that dynamic efficiency arguments suggest that even if LDCs had to accept some static efficiency losses in the short run, within a short period of time these would be outweighed by the dynamic efficiency benefits.

We must now address the question: Could LDCs do even better by privatizing the public enterprise natural monopolies and then reoulatinq them to try to ensure that they set price and output close to the competitive equilibrium?

One way to answer this question is to consider the maximum benefits that LDCs could obtain from natural monopoly<sup>regulation.</sup> Again, Tables 2 and 3 provide some guidance. Even perfect regulation can do no more than eliminate the welfare losses<sup>of</sup> monopoly. If we take the middle range of column 3 in either
33 Table 2 or 3 to bracket the likely range of welfare losses due to uniform pricing monopoly, this implies that costless and perfect regulation would probably reduce welfare losses by no more than an amount equal to 5% to about 20% of the value of industry output. If we admit the possibility that a private unregulated monopolist would implement a non-linear pricing scheme as a means of price discrimination, the effect of which is to substantially reduce welfare losses due to monopoly, then even if we continue to assume no efficiency gains after privatization, the likely static allocative inefficiency losses avoided by Rerfect and costless regulation are not likely to be more than 2% to 10% of industry output.

Unfortunately, even in the best of all worlds, regulation is not costless. In the world in which we live, it does not remotely approach perfection. Bradburd and Ross (1991) provide a survey of the regulatory experience in the United States; for the most part, it is a history of regulatory misdirection and regulatory failure.

There are many reasons for regulation to be imperfect. Perhaps some may be minimized by excellent design of regulatory mechanisms. Others are almost impossible to avoid.

Regulators do not have access to good information, much less perfect information, regarding demand and best-practice cost conditions. As a consequence it is only by chance that they will set the optimal price. Further, in an economy that is undergoing change, as one would hope would be the case in LDCs, the optimal
34 price is a moving target, making it difficult even to employ decision rules based on incrementalism.

Shepherd and Wilcox (1979, Chapter 11) provide a concise summary of what factors regulators must try to take into account when setting rates and rate structures and when determining the regulated firm's allowed rate of return. They also discuss many of the things that can and do go wrong with the process. They conclude (pp. 315-16) that serious problems with efficiency and investment arise under regulation that seem to have no easy solution, and that in some cases the social costs of regulation4 nducad inefficiency are possibly large enough to outweigh regulation' s benefits.

Shepherd and Wilcox discuss a number of problems gaused by regulation. One is a tendency for regulators to come to defend the regulated utilities against competition and to therefore reinforce their monopoly status. Bradburd and Ross (1991) discuss some institutional factors that make this likely.

A second problem arises from the fact that regulators have imperfect information. Consequently, in setting rates, they soon come to rely upon a cost-plus system under which the firm charges cost plus a profit margin. Such a system encourages inefficiency, and as Shepherd and Wilcox argue, because the managers are quite free of constraints, the degree of inefficiency is likely to affect all inputs and be quite significant.

This by no means exhausts Shepherd and Wilcox' list of
35 problems, but it suffices to make clear that regulation is not a simple and foolproof process, nor one guaranteed to yield net benefits.

It is helpful to once again think about likely costs and benefits of regulation. We argued above that the static efficiency costs of unregulated monopoly are unlikely to be greater than 10% of the value of industry output. If regulation operates in a manner that increases the regulated firm's costs by 10% or more relative to what they would be in the absence of regulation, then regulation will yield a net reduction in static efficiency for society rather than a net improvement.

There is another potential problem with regulation that Shepherd and Wilcox do not mention, perhaps because it is more likely to surface in a developing country context. There will be great political pressures in a developing country context to keep regulated products' prices low, reflecting the second and possibly the third of the regulatory objectives discussed in the introductory paragraphs. The danger is that if they are set too low, firms will lack the resources to maintai% the integrity of the services they now provide, much less have adequate resources to expand and improve those services. The dynamic efficiency losses associated with this problem are likely to be both very costly, and very difficult to avoid.

# A. Alternatives to Direct Regulation

Competition is a very inexpensive and efficient form of
36 regulation. If all traditional<sup>natural monopolies were in fact</sup> protected by insurmountable<sup>barriers to entry, then this very</sup> appealing method of preventing<sup>monopoly pricing would be</sup> unavailable. However, many<sup>traditional natural monopolies have</sup> recently been shown to be less<sup>naturally monopolistic than was</sup> once thought to be the case.<sup>This is certainly now the case in</sup> long distance telephony, and<sup>may soon be in local telephony as</sup> well (Bradburd and Ross, 1991).<sup>Changes in energy generation and</sup> co-generation technology have<sup>made the power sector more</sup> competitive as well. Now, many industrial customers<sup>of</sup> electricity utilities are capable<sup>of satisfying their own needs</sup> without incurring excessive<sup>costs;</sup> some even produce surplus power that they sell to<sup>utilities.</sup> In effect, in the absence of<sup>government protection, at least</sup> some degree of competition<sup>is a real possibility for many</sup> "natural" monopolies. The<sup>figures presented in Table 4 above</sup> suggest that the bulk of the<sup>static deadweight losses associated</sup> with monopoly will be avoided<sup>i' privatized natural monopolies</sup> must price their products<sup>with an eye to the threat of potential</sup> competitive entry, or to the<sup>possibility that industrial</sup> customers will find alternative<sup>methods of meeting their needs.</sup> Non-linear pricing schemes are<sup>likely to reduce welfare losses</sup> still further. It is difficult<sup>to justify a complex regulatory</sup> apparatus, at least on efficiency<sup>grounds, when market forces</sup> might operate to achieve the bulk<sup>of the potential benefits of</sup> regulation without any of<sup>the costs.</sup>
37 Another policy alternative is to ch,ose nt to reulate at Rregent, but to craft legislation tnat w')uld allow for regulation at some point in the future if prices at that time are found to be unreasonably high by international standards. For reasons that have already been discussed, this would probably have the effect of significantly diminishing static inefficiency.

However, unless the legislation were written in a way that provides great assurances against expropriative regulation in the future, it might result in underinvestment and dynamic inefficiency more costly than the static inefficiency avoided.

# IV. Summary

We have argued 'La this report that the deadweight losses due to monopoly pricing by unregulated privatized natural monopolies are likely to be modest, and that they may well be outweighed by the benefits of improvements in efficiency. We have also argued that regulation is not costless, and that it might well foster static and dynamic efficiency losses greater than the deadweight monopoly losses it is intended to avoid. on balance, it is not obvious that LDCs will experience an increase in combined consumer and producer surplus in either the short run or the long run if their natural monopoly public enterprises are regulated after privatization.

Our results do not suggest much support for regulation on the basis of its effect on allocative efficiency, and they certainly indicate the importance of avoiding costly regulatory
38 systems. However, this does not necessarily imply that regulation is socially undesirable: as we stated in our introduction, there are several possible objectives of regulation. What our results do sug4est is the need to<sup>devote</sup> greater attention to the other objectivea of monopoly regulation, especially those involving income distribution and investor confidence in institutional stability.

Distributional consequences of monopoly pricing are politically potent. Government policies are undoubtedly influenced by the fear that, unless privatized public enterprisea are regulated, they will significantly raise their prices and the poor will suffer as a consequence. It is hard to implement<sup>good</sup> policies with inadequate information, and unfortunately,<sup>we have</sup> very little systematic knowledge about the actual distributional consequences of privatization and deregulation. Research is needed to determine how price changes after privatization have affected various income groups, and how those price changes differ with the extent and nature of regulation.

The role of regulation in shaping the institutional environment may also be important. If natural monopoly public en'erprises ars privatized and unregulated in an environment in which property rights are not secure, management is very likely to take an extremely short run view of profit maximization.<sup>The</sup> "take the money and run" policies implied by this will yield all the undesirable deadweight loss and distributional consequences of private monopoly and none of the afficisncy and service
39 improvement benefits. Attention must be devoted to ensuring an institutional environment in which firms will have an incentive to invest substantial resources to improve the quantity and quality of the services they provide.