Regulation by Demand: A New Institutional Approach to the Natural Monopoly Problem

Abstract

Regulation-by-demand, a new institutional design for the natural monopoly system, is based on the demanders' participation in the industry's regulatory process. Conventional rate of return regulation fails to implement allocative efficiency and is subject to significant limitations and distortions in its information processing, which prevents the preferences from being disclosed. It is suggested that, if a utility function that encompasses quality characteristics is considered, the failures in the industry's performance are even more severe than what is usually acknowledged. Regulation-by-demand provides allocatively functional incentives for reliable information processing and for efficient performance of the industry. It has significant advantages of institutional flexibility if the industry looses its natural monopoly properties.

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