Is Protecting Sunk Investment by Consumers a Key Rationale for Natural Monopoly Regulation?

Why regulate natural monopolies? Conventional economic theory points to the price-marginal cost margin and the ensuing deadweight loss. But this hypothesis does a poor job of explaining the way that regulators behave in practice. In particular, regulators have tended to eschew forms of price discrimination, including Ramsey pricing and peak-load pricing, and have actively pursued stable pricing. When pressed, regulators justify rejection of the conventional theory on the grounds of pursuit of fairness' or equity. Could it be that the conventional economic justification for natural monopoly regulation is flawed? Some economists have emphasised the role of regulation in protecting the sunk investments made by regulated firms. But this hypothesis cannot explain the patterns of regulation we observe in practice, such as why regulators seem to focus more attention on keeping regulated prices down than on keeping prices up. This paper proposes an alternative hypothesis: that natural monopoly regulation exists to protect the sunk investments made by consumers of the regulated firm. This hypothesis can explain many of the practices of regulators which make little or no sense under conventional economic theory, such as the desire to pursue stable prices, the aversion to forms of price discrimination such as Ramsey pricing, and the role of incremental cost as a pricing floor. In my view, this hypothesis goes some way to bridging the remaining gap between economic theory and regulatory practice