The world often
seems of puzzles yet they go unnoticed. Yet to an economist or rather a student
of economics, these puzzles are the ones which challenge their mind and thought
process. Let us take a few instances. Across countries, we find a single railway
company operating railway lines. If there are multiple companies, they operate
in different geographic zones. For example, one would not find multiple
companies laying railway lines between two cities let us say Mumbai and Delhi.
Similarly electricity transmission too observes just one company operating as
the power gets transmitted from the power generation source to the local
transmission set ups for further distribution to households, industries and
commercial establishments. The same observation can be made of water
distribution companies. From the source of water till the local water tanks,
one finds only pipeline being laid and there are no competitors found in this
instance.
In economics,
competition is the bedrock of market economics. Competition offers consumers
multiple alternatives thus in many ways, embarrassment of riches. As the firms
compete to garner the attention of the consumers, perhaps the prices are
biggest casualty. The firms lose control over the prices thus driving them
down. The lower prices, absence of supernormal profits at least in economic
theory will drive social welfare upward. Yet, the above instances seem to
reflect the contrary. However while there are cases were these have extracted
higher prices, these are normally an exceptions. An instance that is often
cited is the energy prices rising high in California. Another element that
might explain the low price abuse in these industries could be the fact, that
in most countries, the government themselves operate these industries. Despite
this, when competition is supposed to be the foundation of economic welfare,
why one does not observe the presence of competition in these industries along
with some others. The answer lies in the structure of the firms as we shall
examine soon.
Firms have to
incur costs to produce goods. The costs are classified into fixed and variable
costs. Fixed costs do not vary with the output while the variable costs vary with
the output. In case of industries which have high fixed costs, these costs can
be recovered only when they apportioned over large levels of output. As the
fixed costs remains the same irrespective of output, at higher volumes, these
costs get apportioned over larger levels of output thus bringing the average
fixed costs down. In case of a graphical answer, the average fixed cost curve
slopes downwards virtually moving towards touching the x-axis. If variable
costs are low, these lowering average fixed costs bring down the average total
costs significantly. The decline in average cost following every unit increase
in output is what economists call the economies of scale. There are cost
savings that are leveraged only at high volume. Thus the term economies of
scale. Large industries function on this very paradigm.
In some
industries, the leverage of economies of scale becomes possible only at very
high volumes. This implies that presence of multiple players will make it difficult
for the firms to reap the benefits of economies of scale. Consider the example
of an electricity industry. The structure of industry is significantly
predisposed towards fixed costs. If there were to be only one electricity
consumer, he or she will have to pay for all the costs. As the volume
increases, the costs will be recovered through spreading them across multiple customers.
Given the nature of industry, it is difficult to lay transmission cable lines
from the source of generation to the local transmission centres and from the
local hubs to the households and commercial establishments by multiple players
at the lowest possible price and cost. There is of course a first mover
advantage who gets to lay the transmission line at the shortest possible route.
This advantage is something witnessed across these utility industries.
In the water
supply industry, the giant water pipelines that bring water from the reservoir
to the water tanks for further distribution can be achieved at lowest cost only
by a single player. Multiple players each using different pipelines would
result in the scenario wherein the revenues required to recover the costs
cannot happen at the lowest possible price. There is actually a decline in
economic welfare. Therefore, it would make sense for only one player to operate
in this zone. This is what one is observing in gas pipelines and distribution
grid that is underway for transport and distribution of gas to households and commercial
establishments.
In railways too,
the possibility of laying railway lines between two cities in shortest possible
distance thus generating lower prices is possible for only one player. It is
not possible to create parallel railway lines between two cities unless one is
ready to brace up for a high opportunity cost. Thus in these industries, the
economies of scale are possible to be harnessed only when a single player is
present. Therefore, economists call it the case of natural monopoly. The natural
monopolies occur when the cost structure of industries is such that high fixed
costs and very low variable costs make it impossible for multiple players to
coexist and still keep the prices low. Thus perhaps the one who has moved in
first will have significant advantage in these industries.
In many
countries, these industries are viewed as possible sources of market failure. It
might not be a market failure given the nature of industry but the functioning
of the industries and the regulatory framework often creates conditions for
market failure. Often, in other countries, one might observe a regulatory
capture in these industries. Given the nature and thus the first mover
advantage, firms which have moved in first exercise significant bargaining
power over customers and thus create conditions for market failure. Given their
alleged hold on the government, conditions become fertile for regulatory
capture.
These reasons
make the governments wary of bringing in private sector in these industries. The
case for nationalization thus becomes strong. No doubt, that countries including
India opted for nationalization of these utility industries. Railways will
remain nationalised with respect to operating infrastructure, water and power utilities
continue to government owned in most states though in some states the final
chain, the last mile delivery is slowly getting privatized or at least the
private players are being allowed to operate. As one went through this
analysis, this apparent puzzle of natural monopolies seems to have been
resolved.
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