In Chapter 2 we stated the fundamental dilemma facing a strong natural monopoly: Efficient marginal-cost prices result in a deficit. Historically, this dilemma has been the principal justification for government regulation of natural monopolies. As Schmalensee (1979, p. 18) has stated, “control of natural monopoly is another policy area where a single clear objective can be productively adopted … that objective should be economic efficiency.” Throughout Chapters 3–6 we examined pricing policies designed to make the natural monopoly financially solvent while simultaneously adhering as closely as possible to efficient pricing principles.

Recent developments in the theory of natural monopoly and industrial organization, however, justify broader regulations for some natural monopolies, whereas for other monopolies they have suggested that there is no need for any regulation. Table 2.1 indicated which possibility applied in the single-product case. Table 7.1 extends the taxonomy to the multiproduct case. Sector (1.1) in Table 7.1 represents the subject matter in Chapters 3–6. The purpose of this chapter is to explore in detail the remaining sectors, all of which represent different roles for regulators. In doing so, we develop the concepts of cream-skimming, cross-subsidization, and sustainability. This chapter addresses a number of questions, including the following:

Our framework for posing and answering these questions will be a somewhat stylized numerical example in the spirit of Kahn's railroad-and-barge scenario (Kahn, 1971, Vol. 1, pp. 166-8).