Introduction

One of the most important changes in industrial organization that has taken place around the world in the last fifteen years is the restructuring of industries which were historically considered to be natural monopolies and were subject to strict government price and entry regulation (and were often state-owned as well). These industries include telecommunications, electric power, natural gas transportation, and railroads. The primary goals of these restructuring initiatives have been to promote competition in those horizontal segments of these industries which are conducive to it, to shrink the scope of industry output organized as a regulated monopoly, and to introduce new regulatory mechanisms for residual regulated monopoly segments to provide better incentives for cost reduction and efficient pricing.

In Joskow (1991) I argued that transaction-cost economics (TCE) provides an indispensable set of tools for understanding how the organizations subject to reform had emerged, how they are likely to respond as economic and regulatory conditions change, and how effective industry restructuring can be accomplished. A major thrust of these restructuring initiatives has involved vertical separation of potentially competitive segments (e.g. electricity generation) from natural monopoly segments (e.g. electricity transmission). It has been my view that there are very sound TCE reasons why these industries evolved with vertically integrated structures. Other things equal, vertical integration conserves on a variety of transactions costs compared to an unintegrated governance structure. Accordingly, vertical restructuring to promote competition in certain horizontal segments must necessarily confront a trade-off between the potential benefits of market forces replacing inefficient regulated monopolies and the potential costs associated with various inefficiencies arising from vertical de-integration.