Capital investment in natural monopolies under uncertainty with alternative allocation rules

Abstract

This dissertation investigates the impact of the recently proposed 'competitive rules' on investment in the petroleum pipeline industry. Specifically this study investigates the impact of the second competitive rule, commonly referred to as the expansion rule on investment behavior. The expansion rule provides that all shippers may request an expansion on pipeline capacity after construction. It has been argued that the impact of the expansion rule will be to inhibit investment at the initial stage of pipeline construction. The study investigates the effects on pipeline capacity theoretically and experimentally. A model is presented for two vertically integrated firms jointly investing in a single pipeline which have independent random demands for pipeline capacity. Marginal revenue from investing in pipeline capacity is found to be zero under an expansion rule. However, under an expansion rule a firm is also uncertain about its capacity costs, unlike the unregulated case where a firm knows its capacity cost with certainty. Hence, the effect of the expansion rule is indeterminate theoretically. The effects of the expansion rule on pipeline size were also investigated experimentally. Subjects, recruited from the student population at Texas A&M, were placed in a market setting designed to test the impact of the expansion rule on investment in pipeline capacity. Subjects were placed in a market where they were a firm in a two-firm industry. The other firm was another student or a computer which made random capacity decisions. The subjects in the experiments knew the capacity choice made by the other firm in the market before their choice was final. The results of these experiments indicate a strong tendency for firms to reduce their capacity choice in the presence of an expansion rule.