What do you think is the biggest problem with regulating a natural monopoly?

First, let's understand what exactly a natural monopoly is. A monopoly refers to the situation where one firm controls an entire industry. A natural monopoly refers to a particular type of monopoly, one in where the larger the firm gets, the lower its average costs are. Economists call this "increasing economies of scale" or "increasing returns to scale". This means that as the natural monopolist grows, its costs per customer fall.

The most common example of a natural monopoly is the electric utility. Most cities only have one electric company - it doesn't make any economic sense for multiple electric companies to erect their own power poles and to wire up the city independently. It makes a lot more sense for one large company to maintain one grid so society doesn't have to pay the fixed cost of building the electric grid over and over across multiple competing electric companies. Further, once the grid is built, the cost of connecting one more home to the grid is minimal. This means that the bigger the electric company gets, the smaller is the role of the fixed cost of building the network, and the more profitable the electric company can be.

Natural monopolists, if left alone, are generally expected to exploit their market power by charging high prices and making correspondingly large profits, safe and secure in that their dominant size makes it impossible for competitors to challenge them. This calls for government regulation to protect the public interest, but this is very difficult. Generally, economists think the toughest issue in regulating monopolies is the government's inability to understand the monopoly's true potential.

For example, suppose the electric company says it wants to charge 15 cents per unit of electricity. The government may know this is too high - the electric company wants to make a big profit through its dominant market position. The government wants to set a lower price, one that keeps the electric company afloat, but doesn't let it make any more profit than it would in an industry where it faced competition. But how can the government know this number? The government may be able to observe the company's costs, but it cannot observe how the company's business and costs would change in competition. In a monopoly, without competitive pressure, the natural monopolist has little incentive to control costs, like it would in competition. Since the government cannot observe the "true" costs of the monopoly, it makes setting a price that is fair to consumers very difficult.