Typically, this concept is used as a justification for regulating monopolies – specifically, monopolies that affect the prices consumers pay. And the regulation typically takes several forms – either price regulation, quantity and quality of service requirements, or both.
Monopolies result when fixed costs are high and variable costs are low. In particular, when variable costs are so low that the average cost of goods continues to fall as quantity increases across the entire demand curve, there will be a natural ability for the dominant seller in the market to lower prices below the average cost of other sellers and still be able to make a profit. When this can happen, there is a fear in this country that the dominant seller will lower prices temporarily to drive competitors out of business and then raise prices after the competition has disappeared. Naturally, consumers of the product, having become accustomed to low prices don’t like the idea (or reality) of having to pay higher prices for the same good at a later time – particularly when they have no apparent alternative or negotiating leverage over the price.
The flourishing of various natural and legislated monopolies (such as the Charles River Bridge) from the colonial period through the late 1800’s ultimately led to the populist reaction illustrated in Munn v. Illinois . By the end of the nineteenth century, courts generally perceived that monopolistic control of some resource of significance implied an obligation to the public, usually in the form of a requirement to furnish an “adequate supply or service without discrimination” (Harr and Fessler, “The Wrong Side of the Tracks”). Courts used four different rationales to justify this requirement:
1) Imposition of a right of common access based on the concept of a “public calling, essential to individual survival within the community”
2) The duty to serve all equally as an outgrowth of natural monopoly power.
3) The duty to serve all parties alike, as a consequence of a grant of the power of eminent domain
4) The duty to serve all equally, flowing from consent express or implied.
The fundamental assumption behind all of these is built into the definition of “adequate supply”. Realistically, this means at a price significantly lower than optimal price a monopolist would charge, because such a price would result in reduced consumption – in effect, price driven rationing. For goods such as energy which have a significant impact on society, this rationing was perceived to be unacceptable due to collateral societal impacts – the poor, for example, may not be able to afford to heat their homes in the winter, which could result in some of the poor freezing to death.
In order to forestall such unacceptable scenarios, state and federal governments were required, if they were to regulate prices, to determine a price regulation scheme that would minimize consumer prices to the extent practicable while still incentivizing private industry investment in the regulated markets. In electricity markets, the scheme ultimately settled is formulated as:
R = B*r + O
R is the monopoly revenue requirement (the total amount needed to recover costs and return a profit sufficient to incentivize investors.
B the rate base, which is based on capital investment in plant and other assets
r the allowed rate of return
O operating expenses / variable costs such as fuel and labor
Once R has been determined, price is simply
P = R/V
P is the price per unit volume
V the volume of units expected to be sold.
This formulation, while apparently simple, has some implications and complexities. The most obvious implication is the strong incentive for investment in capital equipment over labor or other variable costs. This incentive has led in some cases to abuses, which has, in turn, led to a need to closely monitor what can actually be included in B, the rate base.
This eventually led to the rule that, in order for capital to be included in the rate base, it must be deemed “used and useful” in supplying consumers. Costs for capital not meeting that requirement could still be recovered by recovering the ongoing capital expense as part of the operating expense O. This kept investors from losing money, but did lower their mean rate of return.
It should be noted that regulation has not been uniformly successful. This is largely because regulators have failed to recognize occasions when legal or market forces no longer give the regulated entity a monopolistic advantage. In the case of Market Street Railway Co. v. Railroad Commission of Ca., Market Street Railway continued to face price regulation even though it competed with a municipal railroad as well as rising automobile traffic and, after years of declining service and revenue, went bankrupt. It isn’t clear whether Market Street would have survived had it been unregulated, but the fact that its ridership and revenues continued to decline should have been a signal that it no longer possessed monopoly power, assuming it ever did.
This illustrates the core problem with government regulation: once started, it can be very hard to stop. Technology changes and monopoly power changes with it. Canals had lucrative monopolies until railroads came along. Railroads had monopoly power until cars became affordable. Failure to recognize this change can create systemic problems that are never allowed to heal.
In fact, regulation could well thwart rapid innovation. Because regulation keeps prices (artificially) low, it can delay the introduction of new technologies that could enervate the existing monopoly. This is particularly true in the field of energy. By regulating retail prices, we lessen the incentive to develop conservation technologies. While high prices can be painful in the short term, that pain is exactly the incentive that motivates investment in cheaper alternatives.