We may wonder, what makes airlines, a lucrative profession, a glamourous business to loose such large amount of money in recent times. What makes it imperative for even the most capitalist of all governments to keep some industries in tight control. Railways, or post or electricity distribution for example. These industries are a sort of natural monopoly. A natural monopoly is an industry which has a tendency to move towards monopoly. Such industries involve a network of some kind. Water distribution, electricity, telephone, railways and airlines may be taken as an example. They involve initial huge cost in setting up the network and subsequent lower costs in running the network. It is more economical for such enterprises to have an uniform single network rather than have two competing networks. We will not like two railway stations two post offices two telephone exchanges and two airports in the same city or town after all. Such duplicity will be a wastage of valuable resources. Once a network is formed, the companies running the network, compete inter se and because of competition and low cost of running the networks are forced to reduce the price to an extent that they are no longer in a position to meet their costs of production. It happened with railways which was ultimately saved by government intervention in many countries. Similarly airlines were monopolised. Thus competition is not apparently a good option for these industries. The next option is monopoly. A privately owned monopoly has its own disadvantages. The risk of amassing huge profits, because of absence of competition. Hence, what we find is that these industries are regulated. The prices in such industries is fixed by cost plus profit regulation.
Cost + profit is what the name suggests…cost+profit. Government either itself or through a regulator decides the costs involved in producing a good and the government also decides upon the profit which should be allowed in such industries. It sounds good. However, like all regulations ths regulatory mechanism suffers from some serious disadvantages. For example, this design some not provide any incentive to reduce costs. It rather encourages increasing costs because whatever might be the cost the company or the corporation would always be able to make steady profits. Since such industries often involve monopoly, they do not suffer the threat of extinction. Their prices are not market determined and hence if the demands are not elastic they can always get the costs, no matter how high they may be. Secondly these markets are prone to suffer from what one may call regulatory capture. Who is expected to read every fine print, peruse every detail, keep close track of the regulators and pamper the regulator with one nice trip now and then or may be a good after retirement job…of course the companies being regulated. No matter how the regulators are appointed they always end up providing the corporation a nice steady profit. It is not even surprising, if you begin from the proposition that competition is bad for these industries you are only a step away from concluding that your job is to save the industry and not the consumer. So these regulators end up providing the companies with nice and steady profit. The privatisation and liberalisation caused many industries to be deregulated. Once deregulated they ceased to be the nice and orderly industries they used to be. Take telecom as an example. We had same type of phones and same charges and same tedious corrupt way of getting a connection for very long time. Once deregulated these corporations were forced to innovate and shed their load. They were forced to become less costly just in order to survive. This lead to a large number of people loosing their jobs and nice wages. Their sufferings were real. It is estimated that in America alone consumers are saving something around 200 billions on account of deregulation. State did not owe these well paid persons 200 billions yearly merely because they can have nice salary and so on. Thus deregulation of many of these industries was for good. However deregulation will have to be more intelligent. Blind and foolish deregulation can cause a lot of harm and set back the process of deregulation itself.
So what is alternative to the deregulation. As already discussed, competition in these industries is obviously not working. So one of the alternative is a price cap regulation. Which means that considering that the prices of the technology is falling the government fixes a cap on the price of the product. If the company by some managerial and institutional changes is able to reduce it costs then the corporation should be free to fix its own price. This system of regulation has an added advantage that it provides incentive to innovate and reduce cost.
However, in most of the cases of natural monopoly it is possible to avoid regulatory system to a large possible extent. Even if it is imperative for the state control over an industry to remain, in many cases, core functions could be separated from other functions and the other functions could be outsourced. Tenders can be invited for fixed period for these external function. For example though the distribution of electricity has to be through a single electricity supply line, the task of collecting bills can be outsourced and made competitive. Secondly electricity can be produced be by private company. The price at which the government companies sell the electricity to the distributors should be deregulated. Railway engines and compartments can be made by private owned companies and can be deregularised. Even where it is not possible to separate the system, the main network could be broken down in small parts and competition could be increased between the parts.
Thus it is not sure that regulation is always the best idea. Even when regulation can not be avoided altogether it is best to regulate keeping in mind the principle of economics.