Economics of infrastructures

Characteristics of competitive markets and relevance for infrastructures

The goods in competitive markets may vary based on if these goods are subtractable (Rival)
in use and/or difficult to exclude others from using these goods.
1. A rival (subtractable) good is a good whose consumption by one consumer prevents
simultaneous consumption by other consumers.
2. A good or service is called excludable if it is possible to prevent people (consumers)
who have not paid for it from having access to it.

DIFFICULT TO
EXCLUDE
OTHERS

High

RIVAL
High
Common resources

Low
Public goods

Low

Private goods

Toll goods

What makes infrastructures special

Physical network-industries, including energy, communication, transport, water

Specific, large scale technologies
They perform fundamental socio-economic functions

Important drivers for the liberalization of infrastructures

Technological innovation; Allows for a much lower Minimum Efficient Scale of

production, competition became economically feasible.
High economic inefficiency. There was no inherent incentive for enhancing efficiency
due to overcapacity.
Experiences with liberalization in other sectors

Market structure, conduct and performance (SCP)

The industry performance is determined by the conduct of the firms within the boundaries of
this industry, which in turn depend on the structure of the market.
Structure: those set of variables that are relatively stable over time and affect the behavior
of sellers and/or buyers. The way in which markets fail to follow perfect competition
conditions, depends basically in the degree of: supply concentration, demand concentration,
product differentiation and market entrance barriers.
Conduct: The way in which buyers and sellers behave, both amongst themselves, and
amongst each other.
Performance: The results of firms along the industry (benchmark) in efficiency terms.

Neoclassical model for perfect competition

Homogenous products: In many infrastructures there is little product differentiation.
Hence, this assumption might hold in infrastructures in many cases as well.
Many buyers and seller: In infrastructures there is often only a limited number of sellers.
There are often oligopolistic or monopolistic markets.
Free entry and exit: Entry infrastructure markets requires considerable unique investments
that can not be recovered ex post (sunk costs). In addition, entry to some infrastructure
markets might be restricted or regulated, especially with respect to network related
activities.
Equal and complete information: Incumbent suppliers often have private information
that is not available for outsiders. Hence, there is significant information asymmetry between
incumbent and possible entrants.

Competitive markets

Conduct of sellers determined by profit maximization (process of economic allocation)

Private Goods (Exclusive and divisible)
No externalities and a socially optimum level of production at an equilibrium price

Market equilibrium

determination of the supply curve under perfect competition

market equilibrium
Socially optimal level of output (production)
excess supply
excess demand
significance of the equilibrium

Performance of competitive markets

Technical efficiency
Technical efficiency is the effectiveness with which a given set of inputs is used to produce
an output. A firm is said to be technically efficient if a firm is producing the maximum output
from the minimum quantity of inputs, such as labor, capital and technology.
Economic efficiency
1. Allocative or Pareto efficiency: no one can be made better off without making
someone else worse off.
2. Productive efficiency: no additional output can be obtained without increasing the
amount of inputs, and production proceeds at the lowest possible average total cost.

Economic aspects of infrastructure

Market failures:
1. Public goods: If those who benefit from a public good are asked to contribute an
amount reflecting their valuations, an individual may decide to free ride on the
payments of others. The free rider problem.
2. Huge fixed cost
3. Economies of scale: When producing one more of a good leads to a lower average
cost of producing each good, production of the good has increasing economies of
scale.
a. Few or no firms can survive as producers in the market.
b. Will lead to monopoly production.
c. Increasing economies of scale may push all producers out of a market if none
can charge enough to cover costs.
d. Production ceases even if it benefits society. Hence, markets fail under
increasing economies of scale.
Networks:
1. Central coordination and dependencies
2. Network externalities: Value of the good grows if the number of users expands

Economic characteristics infrastructures

Market failures
Common pool resource, Public Goods, Toll Goods
=> problems with respect to access, capacity, efficient pricing and investments
Natural monopoly (i.e. economies of scale) => problems with respect to traditional
marginal cost pricing
Networks
Technical complementarity between nodes and links
=> Need for central-coordination
=> High degree of asset specificity
Network externalities
Merit wants
Infrastructures are perceived as public utilities' that inhibit considerable positive effects
on the economy and society.
=> in some cases: universal service obligations
=> economic efficiency is not always a dominant criterion.

How to cope with these characteristics?

Traditional approach: strong governmental involvement (regulation, public property rights
and decision rights)
Recent tendency towards liberalization, privatization, and re-regulation

How to deal with public services and national interests?

Political non market objectives like:
Sustainability
High degree of national dependence from imported primary energy sources (-> natural
gas)
Political preferences for or against certain primary energy sources
Access to transport, ITC, water?

Market versus regulation

Market structure:
A wholesale electricity market exists when competing generators offer their electricity output
to retailers. The retailers then re-price the electricity and take it to market.
Retail structure:
A retail electricity market exists when end-use customers can choose their supplier from
competing electricity retailers

Conclusion

Infrastructures inhibit distinctive features which makes than different from traditional
economic sectors
Infrastructure reform is not only a matter of introducing competition, but also of
public services and national interests
Technology is an important aspect determining the opportunities for liberalization
There is no ideal model for the liberalization of infrastructures