Regulation of Natural Monopolies, Self-Selection, and Optimal Taxation

It is well-known that the increasing returns-to-scale (IRS) property accounts for the presence of natural monopolies, which usually become public enterprises or are subject to regulations. This paper argues that public enterprises provide private goods not only for the IRS property, but also for relaxing the incentive problem of the tax system: they help relax the self-selection constraint of the optimal income tax problem through nonlinear pricing. The intuition is that when some private goods with IRS properties (e.g., public transportation) relative to other goods are more valuable to low-ability individuals than the high-ability counterparts in terms of the marginal rate of substitution (MRS), the high-ability individuals are discouraged to mimic low-ability ones. Our results provide theoretical underpinning for the low price of publicly provided private goods for low-income individuals, breaking the p = MC rule for efficient redistribution. The optimal nonlinear pricing allows low marginal tax rates for both types, leading to greater work incentives.