Regulation and Private Sector Development in Latin America
Utilities are characterized by three features: first, their required technologies are commonly considered specific, sunk investments; second, they display aspects of natural monopoly, including economies of scale and scope in the physical provision of basic services, economies of scale in network planning and management, network externalities and advantages in raising capital; and third, their products are massively consumed, usually by captive customers with fairly inelastic demand. Thus, for example, an electricity company's assets have very little value in an alternative use, network externalities and economies of density imply that it may not be economical to have multiple wires deployed on the same street, and finally, its product is consumed by a large proportion of a city's population, who have an inelastic demand for electricity. Compare this situation to that of the steel industry, also characterized by large sunk investments. While steel mills have very little value in alternative uses, the economies of scale and scope are trivial compared to the size of the market. Furthermore, while everyone indirectly consumes steel products, very few individuals pay any attention to the price of steel. Thus, utilities are not characterized simply by specific investments or economies of scale. Or consider the newspaper industry. There are clearly large economies of scale and scope in the operation of city newspapers. Increases in the speed of communication and computer design use have drastically amplified the sector's economies of scale. This has resulted in a reduced number of newspapers per city while readership numbers have remained relatively constant. While readers are usually a relatively large portion of the population (at least of the voting population), newspapers are not utilities, because while there may be a substantial amount of sector specific human capital (reporters' contacts with local politicians may be specific to the locality), the technology is increasingly generic and investments are transferable. Shutting down a newspaper and moving the printing presses, desks, computers, etc, elsewhere has become more and more common. Those three features that distinguish the utility sector from the rest of the economy are at the core of the contracting problems that have traditionally raised the need for governmental regulation of utilities. In the utility sector three types of contracting problems are particularly important: contracting problems between firms and the government, which distort the investment incentives of utility companies; contracting problems between firms and their customers that result in the exercise of market power by the incumbent utility; and contracting problems between governments and interest groups that require governments to distort utility pricing for income distribution (cross-subsidization) purposes. When correcting for these three contracting problems, appropriate regulation will provide the incentives for firms to invest to efficient levels, induce the firms to price their services to second-best levels, creates the framework for productive efficiency and minimize opportunities for cross- subsidization or interest groups capture.
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