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Natural Monopolies: how to deal with them?

According to the preliminary draft of Grandes Opções do Plano, the Portuguese government plans to complete CTT’s privatization in 2014. After the announcement, which took place on September 10, the criticism multiplied, coming from various sources: opposition parties, trade unions and even political analyzers protested against the government’s move. In fact, there is nothing new: that privatization is just part of a set of sales from the government that have received a lot of objections in the past years. On the other side, there are some proponents of this type of policy: for example, on September 23, in the European Parliament, Draghi argued that there is still much to be done about Portuguese privatizations.

In order to realize this kind of positions, we have to understand what is a natural monopoly and its implications[1]. A natural monopoly may arise when there are enormously high fixed costs which become the market more efficient with one single firm; by other words, the concentration of the production may lead to the lowest long-run average cost. Additionally, the high costs are barriers to entry and exit. The natural monopolies are related with activities that require large scale infrastructure to ensure the supply and, therefore, they tend to appear in some specific markets (e.g., water and electricity services).

There are essentially three ways to deal with this this distinct type of monopolies. First of all, the government can let them work without restrictions. However, this creates a huge problem: the natural monopolies will use their market power (they will maximize their profits under a simple profit maximization problem) which will translate into a decrease in consumers’ welfare.

Secondly,   the government can control the monopolies. In an ideal world, this would be the best option because the government would be able to efficiently manage the companies according to the public interest; unfortunately, it does not happen. One of the reasons for this can be, for example, the fact that the managers’ incentives are different from “public interests”.

Finally, the government has an intermediate solution: the natural monopolies can be explored by private firms but they should be under strong regulation.

If the consumption of the good is very important or even essential for the consumers’ welfare (e.g., the consumption of water), the government has to find an alternative option that balances the advantages. In my point of view, the last option is not the ideal one but it is the better available option because of this.

However, we should be aware that the regulation also introduces some distortions in the market. For example, a strong regulation may reduce incentives of firms to invest in some progression because they may think that the high investments are not compensated by the future cash flows (because they don’t face competition and face a strong regulation, for example, in prices).

The privatization of firms has two advantages which may help Portugal to face the current crisis. First of all, it is expected that privatizations will translate into efficiency gains. Secondly, the extraordinary revenues may lead to a reduction in the public debt and, consequently, in the interest rates. However, I think that the government’s main concern should be the population’s welfare. Thus, public authorities have to regulate the market in order to decrease the use of the market power by the firms and to ensure the consumption of the essential goods. Moreover, the government has to balance the gains in efficiency and the losses in the welfare of consumers to decide if a company should or not be privatized.

Nevertheless, there is one conclusion that we should keep in mind (and think about it): the increase in government revenues through privatizations is done by ensuring monopoly profits which is contrary to the objective of regulation. According to “Lei quadro das entidades reguladoras”, the objectives of regulatory entities, which are independent (even from the government), are the regulation, promotion and defense of competition in economic activities. Therefore, it is easier to see that ensuring monopoly profits through privatizations lead to a controversial situation and this situation will probably continue to fuel our public debate in the near future.

[1] However, not all companies subject to privatization are natural monopolies. (e.g Caixa Seguros)


Filipe Silvério, #617


Author: studentnovasbe

Master student in Nova Sbe

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