Thursday, August 5, 2010

Monopolist Regulation

In light of the depressing news regarding net neutrality coming out of Verizon and Google today, I thought I'd expedite a post I've been working on for a long time about how price regulation should work.
 Firstly, I should point out that it's ridiculous that the FCC doesn't have the ability to regulate cable companies. They are blatantly natural monopolies, and they're textbook cases for enforced neutrality. It makes no sense to me why congress is working so hard to regulate things that are borderline unfair but really were operating just fine before (debit interchange fees, for example) but are perfectly content to ignore something that's actually within their mandate
However, this naturally segues into a discussion about who should be regulated and how. Incentives and the business ecosystem can significantly influence outcomes. For example, US broadband coverage is much lower than France's, because of the interplay between how they're regulated on pricing and such, and the fact that the US is much larger, more geographically diverse and less population dense. I suspect that the regulation structure is probably pretty similar, but because of a different business ecosystem (in this case, a different demographic and geographic spread of customers), the incentives didn't line up properly. The rational calculus for broadband companies is "we should upgrade less frequently because we're so much less dense and can't make money off of new upgrades as easily", so we get screwed.
This is why monopoly pricing mechanisms are so important. A bad monopoly pricing mechanism gives you what we have - an aging electricity grid, crappy cable, etc., because people have all of a sudden forgot that maybe idiots ignore their incentives but CEOs definitely don't.
If it were just geographic, then you'd see CA, the northeast and major metroplitan areas be well-penetrated and developed and rural areas not well-penetrated; instead we see a very different outcome because of rate regulation.
There are a number of ways that rates can be regulated for a natural monopoly. There's rate-of-return regulation, there's revenue cap regulation, and there's price cap regulation (either marginal cost or average cost).
Rate of return regulation is where you are allowed to earn a given percentage (12%, for example) on your equity base or invested capital base. Revenue cap regulation (uncommonly used, I believe) is where a company can only make X revenue. Price cap regulation is where a company is not allowed to charge more than a specific amount, either determined by their marginal cost (cost for adding an additional user to the system) or their average cost (fixed plus variable costs divided by number of customers).
In very simplistic short-run theory, marginal cost regulation with government subsidy of fixed costs ensures maximum surplus.
However, let's look at these in the real world.
Firstly, let's dismiss revenue-caps as stupid in most instances. You don't want companies constricted on revenue because they will do nothing but costcut. Quality will suffer until you reach a point that enough people stop buying that the revenue cap isn't guaranteed to be reached. Unless quality (both service quality and product quality) literally doesn't matter, you don't want revenue caps.
Marginal cost and average cost caps, and also rate-of-return caps, are problematic because then the company never has an incentive to cut costs. There are often many ways of making operations more efficient, which would result in cheaper service to consumers, but if producers won't benefit at all, the companies will not do them. These mechanisms (price caps and rate-of-return caps) are how most US utilities are run.
This gets even more nasty in situations where input costs are changing. Most health insurance is rate-capped, and states are denying rate increases despite increasing healthcare costs. This exacerbates a number of other problems - insurance companies push back on their suppliers, hurting long-term medical R&D and making it harder for consumers to get coverage, making coverage more restrictive (less treatments) and when permitted, dropping coverage. You're struggling against their incentives.
Thus, in a lot of ways, we dont regulate monopolists very well. By that I don't mean "we need to regulate them more," but instead "we need to regulate them in a manner that is actually incentive-consistent with what they should be doing."
Here, I propose alternatives involving lags.
When cost-cutting is the biggest issue, you want a situation where companies can benefit from their cost cuts. You'd want them to be regulated based on lagged average cost or lagged marginal cost with fixed subsidy - that way, if you make the lag 8 years, for example, they'll cut costs because they'll benefit for 8 years (I chose 8 years so there's a roughly implied 12.5% ROIC for cost cutting, but this number could be flexible)
Similarly, if you use rate of return regulation, allowing a higher rate of return on recent investment gives them an incentive to continually invest or face declining profit. Of course, this could lead to overinvestment, but given where we currently are, that's not a bad thing for a while. So if a company invests $1b in the last 8 years, you'd let them earn 25% on that investment, and then 12.5% on whatever they did before the last 8 years. (again, allowing them an incremental 12.5% ROIC on investments they make).
This leads to a bigger question, raised by a friend, Sarah: what about promoting competition? is that a better way of dealing with monopolies, is there a way to do that?
In the case of a natural monopoly, the industry will naturally move towards one dominant competitor with others dying out. Thus, you either need to accept the monopoly and regulate its pricing, or you need to rig it so that companies constantly compete to be the monopoly winner but you make sure they never get there, and that's ok with them.
Which path is appropriate depends on the industry. I have argued a number of times before that health insurance falls into the latter category. You want a bunch of insurance companies fighting each other tooth and nail to try and win, but every time it looks like one of them is going to win, you reward the winner for winning, and then break them up into two smaller companies that have to fight each other again. Thus, everyone has an incentive to "win" - they'll be rewarded - but there's always competition driving for improvement.

 The reason you can do this is because their client base is distributed. If I had 2 customers in Aville, 2 in Btown, 2 in C city, etc, if i split it into 2 companies with 1 customer in Aville, 1 in Btown, etc, the monopoly disappears and they have to fight to win again. You can't do that with cable companies because if i have 2 customers in Aville, 2 customers in Btown, etc, it's still one cable that goes to Aville and someone owns it, so someone has a monopoly over Aville. Short of massively and inefficiently overbuilding (like RCN did, to their detriment),there's no way to compete with that existing capacity. So for cable companies you're better off accepting the 1 monopolist and then giving him incentives to improve.
An alternative - open access, where different providers can use that one cable - has been talked about, but even now, you need to make sure someone invests in it. If there's not one owner, you have a tragedy of the commons issue and you force the government to step in and manage a business they're unfamiliar with, and if there is one owner there's still a gatekeeper with power.
The US has (smartly) gone the latter route in some cases - competitors pay each other to use each others' networks so they dont all have to go crazy expanding and one company can do the investment, but you still haven't resolved the problem - if they have nothing to work towards, they won't work. If they can't realize greater profit they're not going to find ways to improve what they do.
Which brings me back to the theory of regulation. If your regulation changes incentives, it changes behavior. If behavior becomes better, the regulation is good, and if behavior becomes worse, the regulation is bad. That's why all these calls for "increased regulation" are dumb, in my opinion - you want more good regulation and less bad regulation. Both of these are responsible for what we're seeing in healthcare and cable and finance, not just "too little regulation". In the case of net neutrality, you want to be able to enforce net neutrality, because these are natural monopolists and net neutrality has substantial public benefits. Mandating net neutrality and then ensuring they get paid to uphold it and improve the speeds of everything means you get net neutrality, fast internet with wide access, for the best prices possible. That would be good regulation, and people have lost sight of that. 

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