Farid Gasmi, Jean-Jacques Laffont, and W. W. Sharkey
"The natural monopoly test reconsidered: an engineering process-based approach to empirical analysis in telecommunications "
Keywords: empirical industrial organization, telecommunications
Abstract: This paper suggests an extension of the traditional natural monopoly (cost-subadditivity) test as it has been implemented in Telecommunications. We explore two dimensions of generalization that we believe are important when evaluating the relative performance of monopoly versus duopoly. First, by using a flexible engineering process model of the local exchange network, we are able to generate market structure-specific cost data which are used to estimate various duopolistic firm cost functions. Second, we combine these cost functions, which correspond to specific entry strategies, with appropriate models of firm behavior to calculate market equilibria. This allows us to perform, in addition to a standard strictly cost-based natural monopoly test, a comparison of monopoly and duopoly on the basis of aggregate social welfare achieved under those alternative market structures. Our application of the methodology to a stylized local exchange market directs attention to a possible conflict between these alternative testing criteria and highlights the crucial impact of the nature of competitive entry on the (social welfare) performance of deregulated markets.