How to Regulate a Monopoly

A better method for regulating monopolies than rate regulation is to require that monopolists' costs in marginal plant equal their selling prices. The traditional approach to protecting the monopolist's customer has been rate regulation—fixing the monopolist's price to achieve a certain desired return on investment. But ROI measures focus on average, rather than marginal, cost. So, in the model for traditional rate regulation, output expands until average cost equals price. If average cost trails marginal cost as output rises, the output level at which average cost equals price is even higher than the output level at which marginal cost equals price. Thus, conventional regulation of a monopolist's price results in an even higher level of output than would perfect competition.The better approach to regulating a monopolist is to measure the monopoly's variable unit cost—raw materials (including energy) and direct labor—and require the monopolist to increase output until the cost in the monopoly's marginal plant just equals what its customers show they are willing to pay. If regulators required a competitive level of output, letting customers set the corresponding price, then (1) regulation would be simpler and less controversial because variable cost is easier to estimate than average cost and because only current data would be required for estimating costs and (2) the risks of plant decisions would be borne by investors rather than by customers.