Much of society's resource allocation takes place within organizations. With some important exceptions such as agriculture, organizations are the prevailing structure where there is profit-oriented productive activity, both in free market economies and in economies that are controlled in varying degrees; in most industries it has become unusual for individual producers to deal autonomously with markets. Virtually all of every economy's governmental and private nonprofit enterprises take place within organizations. Consequently, when economic analysis of exchanges among organizations is not concerned with economic behavior within organizations, it overlooks a large part of society's resource allocation.

If employees competed on the basis of the external market forces of demands for the organization's outputs and supplies of its inputs, neglect of resource allocation within organizations could be unimportant. However, if economic forces that act independently of these external forces are generated within the organization, neglect of economic behavior within organizations could result in incomplete and perhaps incorrect conclusions about resource allocation.

This book presents a positive economic theory of resource allocation within organizations. Based on recent developments in the economic theory of information, the theory extends to individuals within an organization the received theory of firm and industry supply. In the theory presented here, information costs lead employers to delegate discretion over an organization's resource allocation to employees. Employees take advantage of this discretion by pursuing their own objectives at the expense of their employers' objectives.

Since 1974 local authorities in England and Wales have been under increasing fiscal pressure for two reasons. Firstly, reliance upon a property tax, rates, for raising tax revenue makes local authorities especially vulnerable to the effects of inflation. The property tax is not buoyant, since the assessed value of property is not raised annually in keeping with inflation. Thus, rates produce the same revenue yield each year unless the level of taxation, i.e. the rate per pound of assessed value, is altered. During a period of high inflation, such as Britain has experienced since 1974, local authorities inevitably face acute fiscal pressure, because inflation pushes up costs without increasing revenue (Sharpe 1981).

The second cause of fiscal pressure, of greater concern here, arises from the interconnection of central and local government fiscal measures. At Westminster successive governments have pursued policies of limiting public expenditure in order to combat inflation. Part of that macro-economic strategy has involved setting local government annual expenditure targets intended to reduce the growth of local spending, or even lower the volume of local services. The targets, although advisory and without the force of law, have been reinforced by reductions in grant support by central governments. A consequence of central government's policy has been to increase the financial difficulties already facing local authorities because of inflation by reducing the effective value of central government grants, which provide local authorities with almost half of their income.

The threat to local autonomy has been the subject of vigorous political debate in both the United Kingdom and the United States. Given the differences between the two countries, the terms in which the debate has been conducted have been surprisingly similar. In both countries the threat to local autonomy is seen to emanate primarily from intergovernmental fiscal relations, which are perceived as constraining local fiscal behaviour and rendering local government increasingly dependent on and controlled by national government.(1) This similarity in the terms of discussion and in the nature of the debate is striking in view of the substantial differences in the intergovernmental finance systems of the two countries and the widely held assumption that local autonomy – and local democracy in general – is much stronger and more vigorously valued and protected in the United States than in the United Kingdom.(2)

Unfortunately the political debate about the value of local autonomy and the extent to which it is threatened by changes over time in intergovernmental fiscal relations has suffered from substantial intellectual confusion in both countries. Frequently terms are not well defined, the logic of relationships is not specified, and empirical evidence about relationships is not brought to bear on the arguments. However, the similarity in the terms in which the debate is conducted in the two countries suggests that an analysis of local autonomy in a comparative context can serve to clarify our understanding of both.

Education now constitutes the most costly single service of local government, accounting for 36 per cent of its expenditure in England and Wales, claiming 41 per cent of current expenditure, and also 10 per cent of gross capital expenditure. Hence any developments affecting education will have considerable cost implications for overall local government expenditure.

The postwar period has seen educational expenditures rise as a result of both demographic push and increased spending per pupil. The total school population rose steadily until the late 1970s, reflecting the early post-war increase in the birth rate. Numbers in primary schools in England and Wales increased from 3.8 million in 1946 to a peak of 4.9 million in 1973, and secondary numbers from 1.2 million in 1946 to a peak of 4.1 million in 1979, including the effects of the raising of the school-leaving age in 1973. This growth entailed substantial and increasing levels of capital spending to meet basic need (i.e. the provision of more school places to cater for increases in the school population), and some attention was also given to the improvement of deteriorating facilities, such as old school buildings. Spending per pupil was increased, most notably by employing more teachers to reduce the pupil-teacher ratios (PTRs). By the early 1970s, current public expenditure on primary and secondary education amounted to 2.9 per cent of the Gross Domestic Product of the United Kingdom (OECD 1976).

In the last decade no spending authority has been insulated from pressure to cut expenditure. However, experience of that pressure and the reaction to it has varied between levels of government and between organisations within levels. Pressures on local government have been heavier and more continuous than those experienced by central government or other parts of the public sector. As a result, the level of local authority expenditure has declined both in real terms and as a proportion of total public expenditure. In 1975–6, local authority current and capital spending accounted for nearly one-third of total public expenditure; by 1980–1 that share was down to one-quarter. Moreover, in this period, total local authority expenditure declined by more than 16 per cent in real terms, with a further sharp fall in 1981–2.

Some of the pressures on local authorities to cut their spending result from change in the political control of local councils; other pressures arise from the inadequacy of local taxation in a period of high inflation. There are also pressures from central spending departments, like the Department of the Environment (DoE), the Department of Transport, and the Department of Education and Science, who themselves are subject to pressure from the Treasury and the former Civil Service Department (CSD). The pressures from Whitehall are particularly potent since Treasury grants form a large proportion of total local government income. In addition, the centre has enacted laws to strengthen its hand in central-local fiscal relations (see chapter 3).

The labour force is important in local government, most obviously because wages represent by far the largest cost which local authorities have to bear. Moreover, it is very difficult to reduce the labour force substantially by substituting capital, since in most local government services, such as education, social work and police, the activity of the labour force is the service to the public. Furthermore, local government is obligated to act as a good employer (Beaumont 1981); thus the 1946 charter for the local government service states that while local authorities should not take the lead in determining pay standards, they should be in the first flight of good employers. Finally, local government employees are usually significant within a city's total labour force, because they are highly unionised, a potentially cohesive bloc, and have a vested interest in local politics. Indeed, it is sometimes argued that in pursuing their own self-interest, local authority employees are potentially a distorting force in local democracy (Wellington and Winter 1971).

The legacy of the 1980s is far different from the relatively quiescent and peaceful relationships of the earlier post-war period. Labour problems in local government in the 1970s – the streams of ‘stop-go’ pay policies, the new militancy of local government employees and the foundering of the pay bargaining machinery – have largely remained unsolved. The Conservative government of Mrs Thatcher adopted policies that have exacerbated these problems.

To speak of controlling public expenditure is to assert what remains to be proven. For the Treasury to control public expenditure it would need to control not only the state of the economy as a whole but also spending and revenue-raising by central government, local authorities and nationalised industries. Insofar as this is difficult, the Treasury could maintain the appearance of control if it predicted what would happen to the fiscal system each year, and adopted these predictions as its own policy goals. As long as the outcome was as predicted, the correlation between what happened and what the Treasury proposed would be consistent with a claim of Treasury authority.

But in turbulent times predictability, the holy grail of social scientists, is easier sought than attained. Insofar as the chief determinants of a fiscal system cannot be predicted, then central as well as local governments must make fiscal decisions that are very uncertain of realisation. Instability can become a chronic condition rather than a merely transitory phase of public finance. The object of this chapter is to demonstrate that local government fiscal systems are now best described as chronically unstable rather than incremental in their principal financial characteristics, to explain why instability occurs when the desire for predictability is great, and to consider problems of coping with a fiscal system that cannot be controlled.

Fiscal stress is a symptom that something is wrong in our cities today, and that something should be done to relieve or remove the causes of stress. The problem is that there are more claims upon the public purse for services than there is money to meet these claims. Stress affects the everyday workings of local government, and creates friction in relations between town halls, responsible for delivering many public services, and Whitehall, responsible for many decisions about public spending and service priorities. Ordinary citizens are aware of fiscal stress, simultaneously facing annually escalating bills for local taxes and threats to cut back local services long taken for granted as desirable. Nor is fiscal stress unique to Britain; it is found in the United States and many European countries as well.

The problem of fiscal stress is not simply a dispute about cutting public expenditure or about the need to maintain local services. It is about achieving a balance between the costs and benefits of government. Fiscal stress is the dominant problem facing cities in the 1980s, if only as an unintended consequence of cities seeking to deal with other problems. Local government is a major provider of public policy benefits such as education, housing, roads, social services for the elderly, and police and fire protection. These are usually thought of as ‘good’ goods and services. But providing benefits costs money, lots of money. As the cost of government rises, its need for revenue increases.

Urban change and its costs are no novelty; it is almost exactly a century since Mearns (1883) published The Bitter Cry of Outcast London. Nor is the concern of governments with the costs of urban change new. Indeed, whenever governments have attempted to leave the cities to their own fates, as in the periods 1854–70 or 1921–9, the sheer pressure of events has eventually forced a renewal of intervention. It is already evident that the street disturbances of 1981 constitute a major challenge to present urban policy and it would be surprising if these disturbances did not produce some change of direction by central and local government.

Historically, questions of urban change have tended to dominate the agenda of central-local relations in Britain. But the urban problems of the 1980s are quite unlike those of the 1880s. Victorian urban problems arose from industrialisation and urban growth, from a mismatch between population growth and the development of urban infrastructure, from shifts in the arrangement of the space economy, in particular labour and capital, in favour of cities. The problems of social and fiscal stress in the 1980s arise from the obverse of these developments: urban disinvestment and decline. There is something new about recent urban change, something that is caught by the terms counterurbanisation or the post–City age. There is something new in national policy too, an arguably misplaced concern with economic regeneration to the virtual exclusion of ameliorative social measures.

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.

The term “destructive competition” has been widely used, and much abused, in the nontechnical and popular literature on natural monopoly and regulated industries. This chapter will investigate the possible merits of the proposition that competition is at times destructive by setting out a formal economic model based on the theory of cooperative games.

In many respects this chapter is a continuation of the work that was begun in Chapter 5. For example, the game theoretic approach to market stability is the same as that used in Section 5.3, although now it will be developed on a more formal and rigorous level. In addition, a nonsustainable natural monopoly may be correctly viewed as a particular example of a market in which competition is destructive. In Chapter 5 it was argued that although the theory of sustainability of natural monopoly is highly intuitive and useful, it is by no means a total theory of entry or competitive behavior in a natural monopoly industry. The results of this chapter may be seen as an attempt, from the point of view of cooperative game theory, to construct a model of competitive behavior in a market that is a natural monopoly or natural oligopoly. As will be seen later, it is convenient to build a cooperative theory of market stability on the demand side of the model.

As previously mentioned, the theory of natural monopoly has a long history. Before proceeding to set out in mathematical terms the conditions for that theory, I will survey part of that history in Section 2.1. The purpose of such a survey is twofold. First, it will enable readers to place the present effort in the proper context. Although the theory to be developed in this book is more formal and mathematical than work that has preceded it, many of the important ideas were originally suggested by earlier writers. Second, the literature survey will help those readers who are unfamiliar with the mathematical approach used throughout the volume to understand the most significant concepts.

In addition to the survey, this chapter contains, in Section 2.2, an examination of some recent empirical work that has attempted to test for natural monopoly conditions — primarily economies of scale — in the railroad industry. The major implication of these studies is that the railroad industry is inherently a multiple output industry and that simple measures such as economies of scale are not adequate to answer the relevant policy questions. Much of the complexity in later chapters is due to the need to develop a theory of natural monopoly that is relevant to multiple output firms and markets.

Finally, I will briefly discuss in Section 2.3 the interrelationship between the theory of natural monopoly and the possibility of destructive competition.

Chapter 4 was concerned with the technological conditions for the existence of natural monopoly. This and the following three chapters will deal with some of the economic issues associated with natural monopoly. Perhaps the most important one to be addressed is the role that competition by rival firms should play in an industry that is considered a natural monopoly. That is, should there be open and unrestricted entry into some or all of the natural monopolist's markets?

Given the discussion in Chapter 4, it may seem strange to pose the preceding question, for a natural monopolist is by definition more efficient than any collection of firms that could result from effective entry by rival firms. However, it should be remembered that the condition of cost subadditivity, although easy to state, is by no means simple to verify in practice. By the very nature of subadditivity, which requires comparison of a single firm's costs with an infinity of alternatives, no regulator can be entirely certain that the firm that it regulates is a natural monopoly. Potential rivals will not generally accept the monopolist's claims of subadditivity if they perceive that there is profit to be made upon entry into the industry. Even monopolists cannot be entirely sure that their position is a natural monopoly.

The purpose of this chapter will be to point out some surprising and potentially serious consequences of a policy of free entry into natural monopoly markets.

Although most of the theory to be developed in Chapters 4 through 8 is of recent origin, the concept of natural monopoly is not new. In this chapter I will review some of the tools that have traditionally been available to economists who studied natural monopoly. The first two sections describe the basic methodology common to almost all of microeconomic theory. The reader who is unfamiliar with this presentation may wish to review a standard economics text such as Samuelson (1980). The remaining sections describe more specialized results that will be used, or assumed, elsewhere in the book. References will be given when appropriate for a more detailed discussion of these conclusions. The primary function in collecting these results is to define a basic set of ideas upon which the remainder of the book will be built, rather than to teach the reader who is totally unacquainted with the material that is presented in this chapter.

Competitive equilibrium and monopoly equilibrium

One of the earliest formal models of competitive equilibrium is the analysis of supply and demand, due to Alfred Marshall (1927). Suppose that there are a large number of both potential buyers and potential sellers for a single well-defined product. On the supply side, each seller is assumed to have a cost curve defining the marginal cost of all possible units of output. Marginal cost for each seller is assumed to be an upward-sloping function of output.