Chapter 19: Coase and the transaction cost approach to regulation
Network utilities – water and sewage, electricity, natural gas – are an essential element of modern societies. These utilities are characterized by large and non-redeployable (sunk) capital investment and limited area of service where they tend to be the single provider. Their natural monopoly features (i.e., multiple providers may render the service more expensive) and the socially sensitive nature of their services (i.e., politics comes into play) have led network utilities to face, starting around the second half of the nineteenth century – administratively, legislatively, or contractually – governmental regulation. At first, economic research on utility regulation focused on market failure: the limitation of monopoly pricing and negative externalities, as well as the proper incentives to invest in long-term assets. Coase’s multi-tariff marginal cost pricing prevailed in the academic debate (if not in practice) over average cost pricing or marginal cost pricing with governmental subsidy for investments. While his approach to externality regulation as a contractual issue unearthed the relevance of transaction costs, it failed to identify the interplay of transaction costs and political hazards faced by both public and private agents. Recent research points out how seemingly inefficient regulatory features (such a regulatory rigidities) reflect an efficient institutional adaptation to political hazards of opportunistic expropriation by the government and strategic challenges by interested third parties.
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