Infrastructure in a Market Economy – HKS

A few days ago I had the utmost privilege of attending a workshop (Infrastructure in a Market Economy) conducted by Harvard (John F. Kennedy School of Government) for executives from all around the world. There were executives from internet search engine providers, federal government, delegates from developed nations and also developing nations. None from Sri Lanka. So technically, it would not be inaccurate to say that I was representing my country at “Infrastructure in a Market Economy” workshop.

Due to copyright reasons I shall not present the case study which was discussed in the workshop. One of the unique ways of teaching at Harvard is attributed towards the case study approach. Having met the faculty chair of the infrastructure in a market economy program, when I mentioned that I was from Sri Lanka, he told me that one of the longest case studies was in fact from Sri Lanka on Bus reforms in 1987. Later on I learned that those proposals were never implemented. Of course, I have educated myself enough to inquire about such details in passive ways.

Role of the Goverment – Infrastructure in a Market Economy

However, I believe that the theory behind the case study is important to any person to understand the best solution in deciding the involvement of the government. In a market economy, the role of the government should be kept minimal as possible (the easiest that a government can get away with). There are four methods as to how the government can execute its regulatory powers.

  1. Deregulate in a competitive industry
  2. If there’s a monopoly -> Perform contract regulation in a manner which is easy to understand and fair to all
  3. Discretionary regulation -> Perform price caps and create a set of incentives to keep the regulatory body disinterested in formulating prices.
  4. State Owned Corporation (SOC) -> Only if nothing else works

As you can see, a competitive industry will be the best option. Prices will fluctuate based on the demand and supply of the competitive forces and there would be growth. But there are certain cases where infrastructure can create a monopoly. Electricity, railway, water, telephones and broadband are some of the examples.

Infrastructure Vs Services

However, the key to understand is that there are two components. The infrastructure component and the service component. For example, in railway, the infrastructure amounts to the railroads. The service component amounts to providing train services (by operations). In the same way for electricity, the infrastructure amounts to cable & wires and the service component amounts to power generation. Limited ownership of infrastructure creates a monopoly, not the service component.

Some governments, having realized the fact, have enforced open access by the incumbent (most dominant player) in the market. That is, the builder of the infrastructure must provide access to new entrants to the market to provide services using its infrastructure (known as open access). However, this creates a situation where the incumbent company can favor its own service. Therefore, governments enforce unbundling / vertical separation of these companies to identify the infrastructure company and the service company. Even with these in effect, the government will have to regulate the quality of the service provided and inter-connection prices when it deems necessary.

Two Rules to Identify a Monopoly

At this point, it’s worthwhile to figure out how to determine whether a company is exploiting its monopoly power.

  1. Barrier to Entry
    1. Natural reasons (Economies of Scale) / Inherent in Technology
    2. Created (through licensing)
  2. No close substitutes

For example, in the case of water, laying out the pipes is a major investment and the economies of scale are so significant that even increasing the pipe size would not affect the profit of the company. If another company was to lay pipes on the same street, that would be a waste of resources. That’s where open access comes in. Thus moving the focus from retail level to the wholesale level.

However, there is a cost. Essentially, we are trading off synergies & coordination against the competition. Having dominant access in a market provides more opportunities for a company to employ better coordination.

At the end, the professor compared rail road access to electricity and explained why most countries are now privatizing electricity generation. Train operations require a significant level of coordination (for example, to decide who’s responsible for super elevation, deciding different train plans and destinations). However, electricity is a homogeneous product. It’s just a flow of electrons using a voltage induced. Most of the European countries are moving into privatized electricity because of the low switching cost. The competitive nature drives down the prices and ensures economic growth.

Having read the post, it’s clear that Sri Lanka has a long way ahead. One might blame the partisan politics prevailing in the country impeding the growth. However, I believe there is a fundamental question, hidden beneath, embedded to the DNA, that we have not addressed: The fear of an open market.

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