This chapter has two objectives: (1) to describe some basic issues associated with the regulation of natural monopoly firms and (2) to set out a theoretical framework in which to examine both the nature of competition and the need for regulation in natural monopoly or natural oligopoly markets. A “natural oligopoly” is a market in which the number of firms that minimizes total industry cost is greater than one but not so large as to make the market competitive.

Section 7.1 is concerned with the possible objectives of regulation in a natural monopoly or natural oligopoly market. These may include a desire to promote efficiency, fairness, or stability. In this section five more specific objectives are enumerated and discussed, with special attention to the interrelationships and possible conflicts among the objectives.

The need for regulation to promote efficiency in a market is considered in more detail in Section 7.2. In particular, it is argued that the need for this form of regulation may be less than commonly imagined. Although in an efficient natural monopoly market there can be only one active firm, many inactive firms may exist. That is, there may be firms producing closely related products that would be willing and able to enter into competition with, and ultimately replace, the incumbent firm if that firm does not produce at the lowest possible cost or produce the set of outputs desired by consumers.