Economic Report of the President

effect of raising prices. A later generation questioned whether thiseffect was desirable.THE TRADITIONAL RATIONALE FOR ECONOMIC REGULATIONThe two traditional justifications for economic regulation havebeen to preserve the potential economic efficiencies associated withnatural monopoly in some industries and to eliminate the inefficienciesthought to be associated with excessive competition in others.Natural MonopolyA natural monopoly exists when the entire relevant demand for agood or service can be satisfied at the least total cost by a single firm.At the local level it is probably wasteful to have duplicate distributionsystems to provide telephone, electric, gas, and water services.Among industries regulated at the Federal level, major gas pipelinesand high-voltage electric lines are often considered natural monopolies.Long-distance telephone transmission may also be a natural monopolyin areas of low density. Railroads are a potential natural monopolyonly for that declining share of rail traffic for which the shipperdoes not have an effective choice of carrier or mode of transport.Such industries present a dilemma. Competition may result in unnecessarilyhigh production costs through duplication of facilities, butan unregulated monopoly may not act in the public interest. Withoutregulation, a monopoly would probably set prices too high and producetoo little, with consumers willing to pay more for additionaloutput than the cost of supplying that output. A typical solution tothis dilemma is maximum price regulation. The primary objective ofprice regulation is to set the monopoly's price as close as possible toincremental cost while still assuring the monopoly a market rate ofreturn on its investment.The growth of demand or the introduction of substitutes for aproduct can often transform a natural monopoly into what—in theabsence of regulation—could become an effectively competitive industry.Oil pipelines, for example, are often assumed to be naturalmonopolies. However, these pipelines now face competition fromother pipelines and other modes of transportation. Regrettably, priceregulation often continues long after it is efficient, restricting theemergence of a competitive market. The history of the railroads providesa compelling illustration. In many parts of the country rail lineswere few and far between in the 19th century. But as the market fortransportation services grew, and as technology developed, automobiles,buses, and airplanes provided increasing competition forpassenger traffic, and trucks, barges, and pipelines provided increasingcompetition for freight. The natural monopoly justification for98