Regulating Monopolies: A History of Electricity Regulation

Release Date
February 10, 2012



Prof. Lynne Kiesling discusses the history of regulating electricity monopolies in America. Conventionally, most people view regulation of monopoly, such as the Sherman Antitrust Act, as one of government’s core responsibilities. Kiesling challenges this notion, and finds that government regulation of monopoly actually stifles innovation and hurts consumers.

The American electricity industry was booming in the 1890s, with several small firms competing against one another. Over time, Kiesling argues that the fixed costs began to escalate, increasing the cost of entry into the industry. Put another way, large competitors gained a significant competitive edge over smaller competitors through economies of scale. Eventually, in places like New York and Chicago, Kiesling claims that the competitive process led to one large firm.
These monopolies were feared by the public, and led to demands for government regulation. The electricity industry, knowing that regulation was coming, used these demands for regulation as cover to construct legal barriers to entry. Ultimately, the regulations passed by the government reduced competition by granting legal monopoly privileges to powerful firms within a certain geographical territory.
In modern times, we are seeing the real cost of these old one-size-fits-all regulations:
  1. People aren’t adjusting their energy consumption behaviors. For instance, in peak hours, technological solutions that could smooth electricity consumption are being ignored.
  2. The electricity industry doesn’t evolve and account for new types of renewable energy.
  3. Innovations have been discouraged.
If these archaic regulations were removed, innovations and improvements beneficial to consumers would flourish.

Regulating Monopolies: A History of Electricity Regulation
One way we usually associate with government intervention or government activity is the regulation of monopolies. And we think of legislation like the Sherman Antitrust Act as a way that we control the growth of monopoly, market power, and the ability of firms to come to dominate one industry. The history of this kind of regulation teaches us a lot about the economic processes that drive innovation and economic activity and whether or not regulation in these natural monopoly situations actually provides value and makes consumers better off.
Take for example the electricity industry. By the 1890s it’s really starting to grow, especially in large cities like New York and Chicago. Initially they were very rivalrous. A lot of firms entered the market to provide electric service in larger cities and competed against each other. The kinds of innovations that happened in this industry were on a big scale: large generators, lots of long wires connecting large generators, in places like Niagara Falls to cities like New York.
That changed the cost structure of the industry. It changed the cost structure of the industry in a way that the electric company that owned this generator, their fixed cost was very, very high for building these big generators, but then their cost for serving an additional customer was really, really, really low. And so that meant that their average cost per unit of electricity they sold and their average cost per customer really fell and fell over the course of serving a large number of customers. In economics we call this economies of scale, and this economies of scale in the big technologies and industries like electricity really make it challenging to have rivalrous competition.
In Chicago, for example, in the late 1890s there were about a dozen different firms providing electric service in the Chicago market, but, as they competed against each other they competed so much that they were lowering their prices, lowering their prices, lowering their prices until price would go so low that they couldn’t actually pay all of the fixed costs that they had incurred to build the generators in the first place. Not all of the companies could stay in the market. That process, over time, led to the consolidation of the electricity industry in cities like New York and Chicago into one large firm. That firm could, as a monopoly in that market, charge a high price to consumers.
That was very much a part of the kind of public-interest motivation of regulation, this progressive era suspicion of large corporate activity, suspicion of large companies, and also the progressive era belief in the ability of government regulation to stand in for competition and correct the imperfections that they saw. There is also a more kind of public-choice motivation, looking at the incentives and the interests of both policymakers and the industry. They have an incentive to embrace regulation, because regulation constructs a legal entry barrier and says in a particular geographic territory, you will be the only firm allowed to provide retail electricity service to the people living in this area, and no one else is allowed to do that.
In return for government protection of your monopoly power, we will regulate the profits that you earn on your assets, and in that process regulate the prices you can charge to consumers. And we’re going to shoot for trying to keep those prices at around average cost per unit of output to try to keep prices as low as are sustainable in the long run but still consistent with the firm investing in assets, entering a return on their assets. That’s the regulatory compromise, and that’s one reason why industry actually embraced regulation in electricity.
One of the presumptions on which regulation is built in this industry is one of stability, that we have a static environment. And so, this is the cost structure in this industry, boom. This is what kinds of assets firms are going to build, boom. And so we can figure all that out and back out what the right profits are and what the prices are. The information required to get that right is, I would argue, unknowable. They just think, okay here’s this demand for electricity and we have to meet this demand. But now, especially with air conditioning, we see demand fluctuating dramatically over the course of the day. And yet we pay this fixed average retail price that gives us as individual consumers no incentive to change our consumption even at 5:00 when it’s 95 degrees out on an August afternoon.
I would argue that today—here we are early in the 21st century—that now is when we’re really seeing the cost of regulation in terms of how it stifles innovation. I attribute this to a misunderstanding in the late 19th and early 20th century about what competitive processes actually entail and what drives them and what they create. And that’s where we are now is trying to deal with the fact that the regulatory system of the past century doesn’t address, hasn’t adapted to, hasn’t evolved along with the ways we use electricity, the new ways we may generate electricity, including renewables. It hasn’t evolved to take into account the growth of digital technologies that we can use to basically program and monitor our own electricity use and respond automatically to price changes. And so I think that where we are now is on the brink of recognizing the costs of regulation.
We’ve focused so long on the benefits to consumers of having these low, stable, fixed prices and universal service. But now these low, stable, fixed prices are leading to a lot of electricity consumption in peak hours when it’s really expensive to provide it for us. And also the environmental concerns: it’s generating a lot of emissions in the process. So those are the 21st century challenges.