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 THE END OF A NATURAL MONOPOLY:

DEREGULATION AND COMPETITION IN THE

ELECTRIC POWER INDUSTRY
THE ECONOMICS OF LEGAL
RELATIONSHIPS
Series Editor: Nicholas Mercuro
Michigan State University
 THE ECONOMICS OF LEGAL RELATIONSHIPS
VOLUME 7

THE END OF A NATURAL

MONOPOLY:
DEREGULATION AND COMPETITION IN THE
ELECTRIC POWER INDUSTRY
EDITED BY

PETER Z.GROSSMAN

Efroymson Chair in Economics, Butler University, USA

DANIEL H.COLE

M.Dale Palmer Professor of Law, Indiana University,

USA
2003
 JAI
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 CONTENTS

LIST OF CONTRIBUTORS viii

STATEMENT OF SCOPE x

1. INTRODUCTION 1
Peter Z.Grossman and Daniel H.Cole
2. IS ANYTHING NATURALLY A MONOPOLY? 9
Peter Z.Grossman
3. THE ORIGINS AND DEVELOPMENT OF ELECTRIC POWER 39
REGULATION
Robert L.Bradley, Jr.
4. THE “REGULATORY CONTRACT” 71
Daniel H.Cole
5. THE ZENITH OF THE NATURAL MONOPOLY SYSTEM 83
Peter Z.Grossman
6. WHITHER NATURAL MONOPOLY? THE CASE OF ELECTRICITY 104
Joseph P.Tomain
7. UNIVERSAL SERVICE IN COMPETITIVE RETAIL ELECTRIC 132
MARKETS: REFIN(ANC)ING THE DUTY TO SERVE FOR A POST-
NATURAL MONOPOLY ERA
Jim Rossi
8. STRANDED BENEFITS VERSUS STRANDED COSTS IN UTILITY 158
DEREGULATION
Reed W.Cearley and Daniel H.Cole
9. WHY THE MUSIC IS OFF-KEY WHEN LAWYERS SING FROM 182
ECONOMISTS’ SONGBOOKS OR WHY PUBLIC UTILITY
DEREGULATION WILL FAIL
Andrew P.Morriss
10. DOES THE END OF A NATURAL MONOPOLY MEAN 202
DEREGULATION?
Peter Z.Grossman
 LIST OF CONTRIBUTORS

Robert L.Bradley, Jr. Institute for Energy Research, University of Houston,

USA
Reed W.Cearley Mullett & Associates, Attorneys, USA
Daniel H.Cole Indiana University, USA
Peter Z.Grossman Butler University, USA
Andrew P.Morriss Case Western Reserve University, USA
Jim Rossi University Of North Carolina, USA
Joseph P.Tomain University Of Cincinnati, USA
 THE ECONOMICS OF LEGAL
RELATIONSHIPS

STATEMENT OF SCOPE

The Economics of Legal Relationships monograph series is dedicated to publishing

original scholarly contributions that systematically analyze legal-economic issues. As
with other monograph series, each monograph can take a variety of forms:

(1) Each monograph may be comprised of a collection of original articles devoted to a

single theme, edited by a guest volume editor.
(2) A monograph may be a collection of refereed articles derived from the Series Editor’s
“call for papers” on a particular legal-economic topic.
(3) An individual may wish to author an entire monograph.

Each monograph is published in hardback, approximately 250 pages in length and is

dedicated to:

• Formulate and/or critique alternative theories of law and economics-including—the

new law and economics, the economics of property rights, institutionalist and
neoinstitutionalist law and economics, and public choice theory.
• Analyze a variety of public policy issues related to the interface between judicial
decisions and/or statutory law and the economy.
• Explore the economic impact of political and legal changes brought on by new
technologies and/or environmental concerns.
• Examine the broad array of legal/economic issues surrounding the deregulation-
reregulation phenomena.
• Analyze the systematic effects of legal change on incentives and economic
performance.
 1.
INTRODUCTION
Peter Z.Grossman and Daniel H.Cole

For a hundred years, economists, other scholars, and government officials understood, or
thought they did, the electric power industry. Electric power, based on a single, large
service provider, connected by wires to all of its customers, was thought to be an industry
that could only operate efficiently as a monopoly; indeed it was something called a
“natural monopoly.” Since it had to be a monopoly, with all the attendant inefficiencies
and potential market abuses monopoly entails, there was no question about the propriety
of government regulation (Lowry, 1973).
These basic assumptions, which at times seemed to conflict with observed facts during
the first decades of the industry’s existence at the turn of the twentieth century, remained
largely unquestioned for the better part of 75 years. Then, changing institutional and
technological circumstances led economists (e.g Demsetz, 1968, Primeaux, 1986) to
question the basis in fact of the theory of natural monopoly, and the regulatory system it
entailed. As other industries, previously deemed natural monopolies, such as
telecommunications, adjusted to the new reality of post-natural monopoly theory, the
electric power industry and government regulators remained reluctant to concede that
anything fundamental had changed. Movement toward a deregulated electric power
system did not occur until the last decade of the twentieth century, and then it was
undertaken haltingly and piecemeal.
While the U.S. electric power industry and government regulators dithered, their
counterparts in other countries, notably the U.K., were, by the late 1980s, embracing
more completely a competitive market-oriented model of electric power generation and,
to a lesser extent, distribution (Ruff, 1989; Lester, 1991). In the U.S., the public-policy
debate over marketization and other deregulatory policies aimed at the American electric
power industry continued on through the decade, and only gradually did states began to
make policy changes. These were intended ostensibly to deregulate the electric power
industry and foster competitive markets, but the changes varied from state to state
reflecting the peculiarity of the American regulatory system for electric power, which
endows individual states with the bulk of regulatory responsibility. Consequently,
regulatory proposals and changes varied widely from minor regulatory amendments to
major overhauls of the system. However, few states instituted changes that could
legitimately be described as “deregulatory.” The process was largely one of re-regulation
rather than deregulation.
 The end of a natural monopoly 2
The result of this crazy quilt of regulations, re-regulations, and deregulatory proposals
has resulted in more costs than benefits for the regulated industry, consumers, and the
economy as a whole. Indeed, because of the most infamous case of California’s
regulatory miasma, which will be examined in Chapter 10, the entire enterprise of
regulatory change has been called into question. The process of de- or re-regulation in
several other states has ground to a halt because of fear of repeating California’s mistakes
(e.g. Banerjee, 2002). And many observers have raised California as a cautionary tale,
from which they extrapolate that deregulation is bad policy. In their view, the California
experience proves that electric power production and distribution remain a natural
monopoly, which must be heavily regulated by government (e.g. Bradley, 2001). As one
energy consultant was quoted as saying, “I don’t think one can have a deregulated
electricity system if one wants reliable power” (Francis, 2001). These arguments are
based, however, on the presumption that California had truly deregulated its electric
power industry. As we will argue in Chapter 10, there was no actual “deregulation” of
electric power in California. In fact, nothing that happened in California bears on the
arguments about the necessity or desirability of monopoly electric power systems.
This book addresses some of the fundamental issues underlying the debate over
electric power regulation and deregulation. Only by understanding these questions and
exploring a variety of possible answers to them can we hope to move the debate over the
proper structure of the electric power industry in the United States. This requires a
comparative institutional and organizational analysis of alternative structures of
electricity production and distribution. Note that we are not promoting a completely
laissez-faire conception of electric power production and distribution, devoid of
government oversight. In our economy, legal boundaries are necessary for the any
market, including the power market, to operate efficiently (Eggertsson, 1989). However,
the huge and unwieldy structure of the old natural monopoly approach to electric power
production and distribution is plainly obsolete (if it ever did make sense). Its institutional
and organizational structures are out of tune with both contemporary economic theory
and the economic and technological realities of the twenty-first century.
Here are some of the questions this book will address in attempting to determine the
proper institutional and organizational structure of electric power production and
distribution. First, what is meant by a natural monopoly, and is there really any such
thing? If you pick up any textbook on the principles of economics, and look in the index,
you will find a reference to natural monopoly. Now flip to that page, and you will likely
find a very clear and concise definition of natural monopoly, perhaps including a graph
showing a single, downward-sloping average-cost curve. A firm with such a cost-curve,
the book will tell you, is a natural monopoly. 1
But just what kind of firm has this
structure? The example in the book is based on nothing but a “production function,” a
kind of economic black box with only hypothetical, not actual, inputs or outputs. It bears
at best a stylized resemblance to any real firm operating in the real world. The text will
often go on to say, however, that this kind of configuration will be determined by the
technological characteristics of an industry, that is, that industrial organization is merely
the inevitable outcome of scientific realities. 2
 Introduction 3
Then the textbooks will go on to say that real-life examples of the phenomenon they’ve
labeled natural monopolies include electric power producers, telecommunications
companies, and transportation providers, particularly railroads (for example, O’Sullivan
& Sheffrin, 2001). In recent years, some authors have removed these examples,
recognizing that changing conceptions of industrial organization have raised serious
doubts about whether they are, or ever have been, natural monopolies (for example, Case
& Fair, 2002). Yet, the electric power industry remains firmly based on some conception
of this often elusive, ill-defined, and poorly understood concept. And serious arguments
continue to be put forward to the effect that electric power production, transmission and
distribution really are of such a nature that they require extensive government regulation
(see Chapter 10). In Chapter 2, we will explain what is meant by a natural monopoly, and
provide a frame of reference to assess the arguments about electric power deregulation.
A second issue addressed in this book concerns the institutional structure of electric
power regulation, and how that structure has evolved over time. It may seem to the casual
observer that electric power production has always been the province of a single,
monopolistic firm, controlling the market in its particular region of the country, and
strictly regulated by state public utility commissions. For most people alive today,
regulated monopoly is the only system of power production and distribution they have
ever known. As we will discuss, however, the structure we take for granted did not
emerge fully formed with the birth of the industry. It is a creature both of deliberate,
economically and politically-motivated policy decisions and of historical contingencies
or accidents. In fact, the original state of affairs when the industry first emerged was
largely unregulated competition. The utilities themselves first argued in favor of
monopoly control mitigated by government regulation, to prevent “ruinous competition,”
ostensibly for the sake of consumers. However, as discussed in Chapters 3 and 4, the
utilities had other concerns besides consumer welfare, namely their own rents derived
from protection against competition. In sum, the utilities relied on the natural monopoly
theories of economists not to maximize social welfare but to maximize their private
profits.
Of course, it takes two to create a monopoly out of a competitive environment. The
utilities could not have obtained monopolistic control of electricity markets without the
active participation of, first, state and local governments, and, later, the federal
government. Why did governments agree to this structure? Chapter 3 will explore this
question, and explain what governments had to gain from agreeing to what came to be
called the “regulatory contract.” Whatever the explanation, the fact of the matter is that
the so-called “natural” monopoly of power production and distribution did not arise
naturally, but was deliberately instituted by political agreement between governments and
utilities.
The next question, addressed in Chapter 4, is what constituted the precise nature of the
“regulatory contract” between electric utilities and state governments? Was this contract
really designed to enhance the welfare of consumers, as some scholars have argued
(Sidak & Spulber, 1997)? Historical research suggests that this was not the case. Rather,
the regulatory contract appears to have been created predominantly for the benefit of
 The end of a natural monopoly 4
certain, powerful utilities and local politicians they supported. No matter who was
intended to benefit from the regulatory contract at the time it was created, the nature and
composition of that contract remains a highly charged issue because of its implications
for proposed changes to the regulatory system, which would, in effect, alter the terms of
the “contract.” Alterations to the terms of the contract -redistributing rights and duties as
between utilities and governments—could give rise, in some circumstances, to legal
liability. One provision of the regulatory contract is the so-called “duty to serve”—the
requirement that utilities, as a quid pro quo for their regional monopolies, must serve the
entire region, regardless of the marginal costs of providing service to outlying customers.
The implications of this requirement are considered by Jim Rossi in Chapter 7. Another
provision of the regulatory contract entitles utilities to a fair return on prudent and
productive investments. If deregulation (or reregulation) terminates current “rate-of-
return” regulation, and the competitive market “undervalues” earlier investments, the
question arises whether utilities have been deprived of the benefit of past bargains. In
other words, must utilities be guaranteed recovery of costs for investments undertaken
under the old regulatory regime, but which become uneconomic in the new competitive
market system? Reed Cearley and Daniel Cole take up this issue in Chapter 8.
If it is true, as this book will argue, that natural monopoly is not natural, and that
monopoly arose through an agreement of industry and government, then the question
becomes: why did that system last as long as it did? Once the natural monopoly
regulatory approach was institutionalized beginning in the early years of the 1900s and
codified fully in the 1930s, it persisted more or less unquestioned until the 1960s. Why
did it remain largely unchallenged for more than 50 years? These questions are
considered in Chapter 5. The key to the answer lies in the functionality of the natural
monopoly conception. As Chapter 2 explains, the most efficient form of organization for
any industry is highly contingent on a variety of technological and institutional factors.
There is no reason why an industry cannot temporarily be better off, or at least as well
off, as a single firm, and ostensibly have some of the characteristics of a “natural”
monopoly. And given the state of the electric industry and technology generally, the form
of single firm, regional monopolists was, if not ideal, at least serviceable especially
during the period after World War II. The regulatory system, though never capable of
actually monitoring and analyzing the details of the industry it supervised, nonetheless
allowed for expansion and development of the electric system that served a rapidly
growing U.S. economy. In other words, the basic institutional form was for a time at least
a stable equilibrium. However, Chapter 5 shows that early on there were reasons to doubt
the long-term efficacy of such a system and the assumptions on which it was based. The
fact that so many in industry and government had invested in the natural monopoly
system, however, guaranteed that it would prove resistant to change.
What finally led to a reexamination of the economic model and the underlying legal
structure that supported it? This is an issue that Joseph Tomain takes up in Chapter 6. As
he points out, regulation inevitably goes through a “life cycle,” so change, be it
evolutionary or revolutionary, is inevitable in any regulatory process. But the changes in
perceptions about electric power also developed from exogenous forces in the larger
 Introduction 5
economy. The energy crisis of the 1970s in particular led government and industry
officials to reexamine some of their beliefs relating to the organization of the power
industry. This, in turn, led directly to new policies that in very real ways undermined
claims that monopoly was a necessary form of organization for the socially efficient
production and distribution of electricity. Failures within the industry, for example the
catastrophic cost overruns in power plant construction, led to tension between
government and industry, and inevitably disturbed the fragile coalition supporting natural
monopoly. With each change, critics argued, there were more and more reasons to doubt
the assumptions of the model of a regulated natural monopoly.
Changes in industry structure and the overlying regulatory system have been numerous
but incomplete. Often, they have involved the application of piecemeal reforms in
response to specific, local issues or isolated problems. Only rarely, at least until the
1990s, did regulators and the regulated community contemplate wholesale changes to
industry structure. Nevertheless, some of these changes have had important impacts, not
all of them positive by any stretch of the imagination. Still, the changes have led to
important rearrangements of political forces, legal structures, and industrial organization.
These changes and their effects, which are best viewed as reregulatory rather than
deregulatory, are examined in Chapters 6 through 10. For example, as discussed in
Chapter 8, efforts to address utility demands for recovery of so-called “stranded costs”—
unrecov-ered costs of investments undertaken under the old regulatory system—have led
regulators to propose market prices on the one hand but guaranteed profits on the other.
In other cases, state governments have loosened the single, vertical monopoly structure of
utilities by forcing separation between production and distribution units. However, often
the terms on which this separation has been affected require at least as much government
oversight and intervention as the previous regulatory system required. For the most part,
states have not proposed, let alone implemented, policies that would truly deregulate the
electric power industry. In a few states, wholesale and retail electricity prices are now
more or less determined in competitive markets, and consumers in those states can
choose between power providers. But in most states, electric power production remains
highly, if differently, regulated. In Chapter 9, Andrew Morriss explains why, for the most
part, electric power production has been reregulated rather than deregulated, and he
considers the outlook for the future of the American electric power industry. His view is
pessimistic, based on his perception that public choice pressures are likely to impede true
deregulation. In Chapter 10, Peter Grossman offers an alternative, and somewhat more
optimistic, vision of the power industry’s future, this despite his dour analysis of
California’s disastrous experience with regulatory reform. Like Morriss, Grossman
appreciates the institutional difficulties of real deregulation; but unlike Morriss, he sees at
least the possibility that efficiency-enhancing change will emerge in the long run.
Still, we do not doubt the basic difficulty that institutional change entails. As Nobel-
laureate Douglass C.North (1990) has explained, institutional change is a problematic,
haphazard, and usually incremental process. The result is sometimes less socially
efficient than the pre-existing situation those changes were designed to improve upon. In
North’s work, institutions are defined strictly as “the humanly designed constraints
 The end of a natural monopoly 6
imposed on human interactions,” (North 1991). That is, institutions are the formal laws,
cultural norms and the mechanisms of enforcement of both formal and informal rules that
bound, structure and focus social interaction. 3 All societies by definition are bound by
sets of rules (“rules of the game,” to North) since human interaction requires structure.
These rules create and determine political and economic incentives, reduce uncertainty
for everyone in society and channel social forces in specific directions. As North points
out, if a society values piracy, it will structure institutions to reward that activity and
produce people adept at piracy.
But while institutions play a part in controlling human behavior, they are alterable and
indeed, economic and political actors in any society might see the potential for a more
favorable distribution of costs and benefits by changing the institutional framework to
their own benefit. There is likely to be a tension in a social system whereby some forces
act for preservation of existing institutions and others act for their change. In general the
force for institutional change will predominate when there are increases in uncertainty or
in the cost of transacting, arising from changes in technology, ideology and other
dynamic factors confronting society. As change occurs, there are changes in relative costs
and benefits, which lead to an examination of existing rules and the distribution of social
and economic benefits.
But the demand for change and in fact actual change in the institutional structure does
not guarantee greater efficiency of the result. Social actors may see a need for a reduction
of uncertainty and hence change in the institutional structure. But uncertainty may be
reduced at the expense of efficiency. So for example, free markets may be more efficient
in the long run but the dislocation that is produced as a consequence of their creation may
lead in turn to inefficient, but more certain, kinds of rules, for instance totalitarian
dictatorship and/or centrally planned economic systems. There are many examples in
human history—the Russian Revolution comes to mind—where institutional change was
demanded and change affected, but the result was highly inefficient, producing a decline
in living standards or long-run stagnation. In other cases, the result embodied
compromises among groups for the distribution of benefits and costs such that while
greater efficiency was achieved in one social or economic dimension, it was offset only
by the implementation of inefficient rules elsewhere.
This picture of institutional change is certainly pertinent with respect to the electric
power industry. First, at the start of the twentieth century, monopoly organization and
regulation developed in response to changes in technology and the distribution of costs
and benefits that the new technology presented. The organizations devised under these
institutional arrangements—the monopoly utilities and the regulatory bodies that oversaw
them—had a vested interest: first, in maintaining (or maximizing) the benefits that they
received from those institutional and organizational arrangements, and minimizing (or
externalizing) the costs; and second, in seeing that any changes in the institutional and
organizational structures would yield them further net benefits. They would
understandably resist efforts to alter the institutional structure in ways that might reduce
their net benefits. Even as technological innovations and changing political and economic
circumstances altered the conditions of electric power production and distribution, a
 Introduction 7
strong status quo bias remained.
Utilities that benefited from the existing regulatory system opposed changes that, they
perceived, would threaten their monopoly status. Meanwhile, however, other firms that
did not benefit from the existing system, but which perceived economic opportunities
from deregulation, pushed strongly for change. In addition, electricity consumers and
state regulators pursued what they perceived to be their own interests, which were often
at odds with both entrenched power suppliers and their would-be competitors. The
multilateral, inherently political contest that ensued virtually ensured that institutional
change would be contested at every step and, ultimately, incomplete.
Nothing has happened so far that would lead us to question this supposition. The
implications for the future of electric power deregulation are that, at the very least, the
outcome of efforts to reform the power industry are uncertain at best. It is possible, but by
no means guaranteed, that the outcome will be a more efficient system. That said, the
very fact that this economic, legal, and political battle is being waged indicates that the
basic assumptions underlying natural monopoly theory, and the system constructed upon
that theory, are obsolete. We are witnessing the end of natural monopoly. What comes
next?

NOTES

1. As Baumol et al. (1988) have demonstrated, this description of a natural monopoly

is exceedingly over-simplified.
2. Milton Friedman (1962), for example, has referred to natural monopoly as “a
technical monopoly.”
3. Institutions are distinct from organizations, which are groups of individuals that
form to take advantage of the institutional structure of society (North, 1990).

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online at: http://www.nytimes.com
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Market Structures, Revised . San Diego: Harcourt Brace Jovanovich.
Bradley, W. (2001). Power to the People. The American Prospect , 12(11) (June 25),
online at: http://www.prospect.org
Case, K., & Fair, R. (2002). Principles of Economics . Upper Saddle River, NJ:
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Demsetz, H. (1968). Why Regulate Utilities? Journal of Law & Economics , 77, 55–65.
Eggertsson, T. (1990). Economic Behavior and Institutions . Cambridge: Cambridge
University Press.
Francis, D. (2001). Cooling to Electricity Deregulation. Christian Science Monitor ,
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(April 3), online at: http://www.csmonitor.com
Friedman, M. (1962). Capitalism and Freedom . Chicago: University of Chicago Press.
Lester, T. (1991). Regions Plug Into the Market. Management Today , (March), 102.
Lowry, E. (1973). Justification for Regulation: The Case for Natural Monopoly. Public
Utilities Fortnightly , (November 8), 17–23.
North, D. (1990). Institutions, Institutional Change and Economic Performance .
Cambridge: Cambridge University Press.
North, D. (1991). Institutional Change: A Framework of Analysis. Manuscript.
Washington University: St. Louis.
O’Sullivan, A., & Sheffrin, S. (2001). Economics: Principles and Tools . Upper Saddle
River, NJ: Prentice Hall.
Primeaux, W. (1986). Direct Electric Utility Competition: The Natural Monopoly Myth .
New York: Praeger.
Ruff, L. (1989). Electricity Restructuring in Two Nations: Different Paths to a
Competitive Future. Public Utilities Fortnightly , (June 22), 13–17.
Sidak, J., & Spulber, D. (1997). Deregulatory Takings and the Regulatory Contract: The
Competitive Transformation of Network Industries in the United States . Cambridge:
Cambridge University Press.
 2.
IS ANYTHING NATURALLY A MONOPOLY?
Peter Z.Grossman

…public utilities such as water and electric power companies are

examples of natural monopolies.
-from Exploring Economics, an introductory textbook by Robert
L.Sexton (1999, p. 267). The definition is illustrated with a large
picture of an electric light bulb.

INTRODUCTION

The title of this book refers to the economic concept of a “natural” monopoly, and as the
quote above suggests, electric power has usually been considered an exemplar of this
type of firm and industry structure. The importance of this concept to the development of
electric power industry and government regulation in the U.S. cannot be overstated.
Because electric power companies have been considered natural monopolies, it has been
believed that such companies cannot be competitive, that they must be monopolies, and
that they must be regulated by government agencies. Indeed, it is fair to say that the
economic theory of natural monopoly has provided the foundation for: the establishment
of monopoly power systems in the U.S.; the legal structure that exists with respect to
electric power; and the regulatory system established by local, state and federal
government bodies to control electric power production, distribution and consumption.
The early development of the electric power system in the U.S. will be examined in the
next chapter. This chapter will consider the concept of natural monopoly itself, and what
happens in a market if a firm actually displays characteristics of a natural monopoly. As
we will see, if an industry is identified as an actual natural monopoly, government
regulation becomes desirable and probably inevitable.
The problem, however, as this chapter will discuss, is that it is not clear that any
industry is “naturally” a particular form of industrial organization. When an industry is
typed-based on some supposed characteristics, usually technical, typology will likely
obscure the subtleties of organization and technology, as well as market and government
behavior. Of course, it is easier for government to identify types and regulate an industry
(or not) according to some general criteria or technical characteristics. But once such a
 The end of a natural monopoly 10
regime is established, it is very difficult to change or to permit exceptions. And as this
chapter will argue, the form any industry would take in the absence of regulation, will be
highly contingent to various circumstances that would lead to different industry structures
in different places, as well as to different forms of industry organization in the same place
at different times.
To understand this, we will, first, examine the standard version of natural monopoly
theory, and the assumptions on which it is based. Then we will propose an alternative
version that it will be argued more accurately reflects the nature of a firm in a dynamic
technological and institutional environment. Finally, we will review the history of how
this concept evolved and was applied to utilities in general and electric power in
particular.

WHAT IS A NATURAL MONOPOLY?

Most introductory economics textbooks begin (and some end with) a very simple
definition of natural monopoly. It goes something like this:

A natural monopoly exists when “a single firm can supply a good or a service to
an entire market at a smaller cost than could two or more firms (Mankiw 1998,
p. 306).

To expand on this more completely: if one firm has lower costs than any other firm or
combination of firms in producing a good or service at the full level of market demand,
then the industry, operating in a free market, will become a monopoly because the one
firm can always profitably underprice entrants and drive them out of business.
This definition is undoubtedly true; indeed it is so simplified as to be a truism. But
mostly it begs the question: how does such a situation arise? Or perhaps even more
fundamentally, does such a situation arise and when?
It is generally argued in the literature that a natural monopoly condition arises from
persistent economies of scale, which cause average costs to fall over the entire range of
market demand. This is illustrated in Fig. 1. This figure is the starting point for most
discussions of natural monopoly. Consider the demand curve (solid line on the graph, D)
to represent the market demand for a given commodity X. What price the product will
sell at in a free market will usually be determined by the intersection of supply and
demand. But here we depict not supply, but the average cost curve (AC) for the entire
industry, which slopes downward (and bows inwards) even at the point where it intersects
the demand curve. 1 Since average costs—at least long run average costs—represent the
cost to firms per unit of output (including the firm’s normal rate of return), then if any
one firm can produce the quantity at the lowest point of the AC curve it can underprice its
competition. Here, since the AC curve is still downward sloping at the point of
intersection with market demand (point y), one firm producing y will be able to produce
for the entire market and will drive out competition.
 Is anything naturally a monopoly? 11
To illustrate, say that there are two firms, both of which can produce half of market
demand. But in that case their share of the market intersects average costs at a point
above y (in Fig. 1), and so they both produce a lower quantity than y (point y-a), and
must both receive a price of at least P1—if they are to in fact cover their costs of
production. But now one firm expands and in so doing can drive down the price until at
y, where output is sufficient to satisfy the entire market, the price is at P2. Clearly, the
other firm producing at y-a will be unable to compete. The expanding firm will have the
advantage, which will be unassailable—unless another firm is in some way able to lower
This is socially wasteful. The amount that should be produced—that is where resources
are efficiently employed and producers still make a profit—is at y, at price P1 But
instead, production is set at {a} by the monopolist, at price P3’ the point that would
maximize the firm’s profits. As a result, too little is produced, and it is sold at too high a
price. The shaded area on the graph represents the social loss this entails, referred to as a
“deadweight” loss from monopoly. In economics, this is an example of a market failure
since the market acting on its own does not produce the socially optimal quantity of the
good.

Fig. 1 . Standard Textbook Illustration of Natural Monopoly.

Notes: Average costs are declining through the entire range of demand. The
firm that supplies the entire market can sell as p2, while the one
serving less than the market must charge more {p1}.
 The end of a natural monopoly 12
its costs even further say through technological innovation and subsequently take over the
market. Barring that, the expanding firm captures the entire market gaining a monopoly
that cannot be overcome by competition.
Of course, as theory tells us, the monopoly firm, once it has gained an unassailable (or
“natural)” monopoly does not set the price at the average cost. Rather it chooses a price
that maximizes profits, which will be at the point where marginal costs equal marginal
revenues, as shown in Fig. 2. 2

Fig. 2.

Notes: A monopolist produces where MC=MR, and charges p3. There is a

loss to social welfare as a result (shaded area).

It might be thought that at this point another firm can enter the market and sell the
product at some point below P3, since now there seems to be an opportunity to capture a
share of the market. But the monopolist can always ramp up production and lower prices
back to P,—where it will still be profitable for the one firm to produce, but not for an
entrant. Assuming entry has costs, the second firm won’t enter and so the incumbent firm
retains the monopoly.
Given the inability of competitive forces to curtail the firm’s monopoly power and the
social loss that this theoretically entails, government regulation of natural monopoly
 Is anything naturally a monopoly? 13
would seem highly desirable. Of course, government could choose to force a competitive
market by decreeing a size limit to firms, but that—if natural monopoly in fact exists in
that particular industry—would mean that each would be producing at too high a cost and
so prices would have to be too high (so firms could make a profit); some social losses
would still result. Moreover, if a single firm is the natural state of things, so the argument
has gone for more than a century, better that the government enfranchise one firm, grant
it monopoly power, but reduce its ability to employ monopolistic pricing power. This
basic idea has been an article of faith for those who accept that some industries are indeed
natural monopolies.
It should be noted that falling costs for the entire range of output are not strictly
necessary for even this simple picture of natural monopoly. Figure 3 shows the case
where average costs fall to a certain point but then before the entire range of market
demand is satisfied, they begin to rise. (This would result when the marginal cost of
production begins to exceed average costs.)
This case in an unregulated market would still lead to a monopoly outcome. While it is
true that minimum cost is reached where output is at c, not y, no one can beat price P*,
the price the monopolist could charge at an acceptable profit, and still satisfy market
demand. No entrant can enter and capture the small portion of output where average costs
have begun to rise (the portion from c to y), because to gear up its production processes
the entrant would be starting at the upper end of the average cost curve. The price it
would need to charge for its output would be well above P*. Consequently, the market
situation illustrated in Fig. 3 still represents a natural monopoly.

Fig. 3.
 The end of a natural monopoly 14
Note: In this case, firms would charge marginal cost; otherwise all sales
above qc would be at a loss. Still, this is subaddictive since any entrant would
have to charge more that p*.

Sources of Falling Costs

The source of falling costs, and hence natural monopoly, is generally assumed to be
pervasive “economies of scale” (Schiller, 2003, p. 76) This concept—scale economies—
is even confused in the economic literature (e.g. Dranove, 1998; Train, 1991). Economies
of scale are said to exist when at given set of input prices, 3 a percentage quantity
increase of inputs leads to a greater percentage increase in output. In other words,
economies of scale mean that by expanding production a firm can increase output more
than proportionally to its input requirements. This kind of outcome can be the result of
technological innovation, or it can result from, as Michael Porter (1985) notes, from
greater “efficiencies in the actual operation of an activity at higher scales as well as from
less than proportional increases in the infrastructure or overhead needed to support the
activity as it grows.” Economies of scale are not equal to, but nevertheless require, that
production show “increasing returns to scale” (Truett & Truett, 1990), and that only with
increasing returns will genuine scale economies emerge. 4
There are some obvious cases of technological economies of scale: if the cylindrical
area of a water pipe is increased, the volume of water the pipe can carry increases by a
greater percentage than the percentage increase in materials needed to construct the pipe.
In electric power, it was the case especially in the early years of the industry that a
generator could be increased in size and produce proportionally more units of
electricity—in kilowatt hours—than the increase in inputs of capital, labor and materials
needed to generate them.
Since technological economies of scale are known to exist and since they can be a
source of falling average costs, the argument has often been that a natural monopoly is
entirely a technological phenomenon. Indeed, Friedman (1962, pp. 28–29) has explicitly
referred to natural monopoly as a “technical” monopoly that could, by its nature, justify
government regulation. Posner (1969, p. 8) similarly has argued that natural monopoly
refers to the “relationship between demand and the technology of supply.”
There is no doubt that scale economies from technology can lead to decreased long-run
costs, but there needs to be some caution with regards to just how determinant technical
characteristics actually are. Economies of scale are present in nearly all forms of
production. The average cost curve even for a small competitive firm will have a range
over which average costs fall (and so the curve will be u-shaped, showing economies of
scale over some range and diseconomies over another). It is only in their pervasiveness
that these determine a single-firm industry structure that would be considered a natural
monopoly. And then it must also be the case that costs are so overwhelmingly a technical
phenomenon that nothing else really matters. Or alternatively, the market must be small
enough so that it only can accommodate one firm. 5
The technological issue has a further, and important, implication: if a technology is
 Is anything naturally a monopoly? 15
deemed a natural monopoly, then it follows that whenever the technology is adopted the
form of industry organization must follow. This may well ignore local conditions that
change the nature of costs, so that even when a single firm is demonstrably efficient in
one instance, it will be notably inefficient in another. Moreover, it will be argued later in
this chapter that technology alone is seldom—if ever—so overwhelmingly determinate as
to proscribe all but one form or organization.
Even in many technical arguments relative to natural monopoly, the sources of scale
economies are not accurately identified. Or more exactly, the literature often has
misidentified (and inaccurately defined) scale economies and thus the rationale for
natural monopoly.

The Source of Scale Economies

The mistake most often made is to believe that economies of scale derive from high fixed
costs, and that by having a larger output the costs are reduced on average across that
output. As Train (1991, p. 6) puts it: “The most prevalent source of economies of scale
are fixed costs…. When output expands, the fixed costs (in this case the costs of the
[electric generating] plant) are spread over more units, such that average cost declines.”
There are important—albeit commonly held—errors in this statement. Most crucially,
from a long run perspective there are no fixed costs, and so this comment is by definition
false. Capital costs—the costs of plant and equipment—are not fixed in the long run since
most capital can be sold or put to alternative uses; capital, like labor, then varies and can
be considered over time as a variable rental price. In the long run, the amount of capital
can be adjusted to reflect the output that is demanded from it. If output is too great, then
capital can be reduced to the appropriate level; if it is insufficient, new capital can be
employed. Thus, there should be no long run impact of such costs on average costs
generally. That is, no matter what the short run fixed costs are, the long run average cost
should be unchanged. Of course as a practical matter, there are mis-forecasts or imperfect
capital markets that lead to too much or too little capital and so short run constraints that
may lead to excessive or insufficient capital for the needed output. But this result is not
the same as arguing that fixed costs are a present condition that determines economies of
scale.
Train (1991) is apparently mistaking fixed costs for sunk costs. Costs are sunk when
they cannot be recouped through alternative use. In other words, if capital can not resold
or leased then expenditure would entail the potential for loss in the long as well as the
short run. Sunk costs may well present a barrier to entry that will keep others out of a
market, but that would be true whether average costs are increasing or decreasing. 6
Even if we were to allow fixed costs in the long term, the basic premise of Train’s
statement is still inaccurate, because it identifies economies of scale with the spreading of
fixed costs. In fact, it confuses scale economies with capacity utilization, which again is a
confusion of short run constraints for long run conditions. It must be emphasized that
economies of scale involve the long run. If average costs are not falling in the long run as
production expands, where there is merely the spreading of fixed costs, then scale
 The end of a natural monopoly 16
economies are not demonstrably present.
To illustrate, consider a case where a factory with one machine is constructed. In all
cases, the output from the machine will be expected to pay the cost of that capital as well
as more obviously variable costs of labor and raw materials of production. If the machine
runs at half capacity, but the full capital cost must be born anyway, then it is true that in
the short run the average cost will fall as output expands toward capacity. But now let’s
say capacity is reached. If there are pervasive economies of scale in this industry then
when output capacity is expanded (a second machine is added), average costs must
continue to fall. If, however, what is achieved is mere capacity utilization, then they will
not fall. Indeed, adding a second machine may require the same capital and labor and
materials as the first machine. 7 The average cost will in that case never fall below the
level achieved at capacity from the production by one machine. This would mean that in
fact the increased capacity utilization did not reflect continuing economies of scale in the
industry, and that the production process had in the long-run constant, not increasing,
returns to scale.
Now consider what this implies with respect to a natural monopoly argument. For the
technological argument to be the case, the production of a particular good—and thus far
we have examined the case of a single good—would be a natural monopoly only if as
output were expanded to meet the entire market demand, one machine or one plant or, for
some reason, one dispersed firm would have to be able to achieve reduced average long
term costs. That is, costs would have to be lower per unit at higher and higher levels of
output. Of course, as we noted in Figure 2, it is possible for the argument to hold even if a
point is reached before full market demand is satisfied where diseconomies raise average
costs slightly. But even in that case, relative to market demand scale economies would
have to be pervasive enough so that entry by another firm using the same technology
would be futile.
A further technological point: this monopoly might still be only temporary, unless for
some reason no technological innovation were possible—a hardly tenable position—or,
more possibly, one firm had absolute control of the technology. 8 Otherwise, as long as
the monopoly depended on technical characteristics alone any innovation that would
lower costs including ones of organizational process would mean that an entrant could
come in acquire the necessary capital and take over the entire market by underpricing the
original monopolist. The prospect of long-term monopoly rents should make this a very
attractive proposition. However, if a firm has a government-provided monopoly franchise
this kind of outcome will not occur since an entry is barred by statute. But then we could
hardly consider it a “natural” monopoly.

Subadditivity and Contestability

There are a number of features of the simple natural monopoly concept that are not
reflective of the real world. The most important of these is that few firms produce only
one good; joint production of two or more goods is far more common. This may not seem
so obvious at first glance: an electric company produces electric power, a cable tv
 Is anything naturally a monopoly? 17
company (also often identified as a natural monopoly) distributes television programs,
and so on. But in fact, these and other firms have a measure, often a large measure, of
vertical integration.
An electric company—of the type that has generally been seen in the U.S. and most
other countries, a franchised (or government-owned) monopoly—is vertically integrated
across a number of “outputs.” First, it produces electric power. Then it distributes the
power. It markets the power directly to consumers, and it also services distribution access
points. The list can go on, but the point is straightforward: most firms identified as
natural monopolies have more than one output so the simple model of the previous
sections is clearly too simple.
In a classic work that is the starting point for much of modern theory relating to natural
monopoly, Baumol, Panzar and Willig (1988) argued that both the single output and
multi-output cases could be explored by abandoning the pure economies of scale
definition and using instead the concept of “subadditivity.” Essentially for any natural
monopoly, costs in the industry must be strictly subadditive. That is, the costs of single
firm must be less than the sum of the costs of all possible combinations of firms.
Mathematically, for a single output, x, and cost function C(x):

C(x)<C(x1)+...+C(xi), where the sum of all outputs of firms 1…i, (x1…xi)=x.

This general approach can be extended to a multi-output case. Indeed, it can be argued
that without the general concept of subadditivity, it is not possible to examine coherently
the multi-product case. It is in fact possible to show that two or more outputs can have
increasing returns and yet there would be no gain by having them both produced by one
firm (Sharkey, 1982). 9 Thus when there is a multi-product example, which in fact
encompasses most industries identified as natural monopolies, including electric power,
economies of scale through the range of production are not sufficient to justify a natural
monopoly. At the same time, it is perfectly plausible that production in a range may not
exhibit economies of scale, or that throughout the range one product may not display
increasing returns, and yet strict subadditivity still obtain. Put a bit differently, it may be
the case that the cost of production of two outputs may be lower if performed by one firm
than any alternative arrangement, because the joint cost of production is lower than the
cost of producing the products separately (Baumol et al., 1988). 10
This would result from economies not of scale but of scope; in fact, that is how
economies of scope are defined. Mathematically, economies of scope case can be
illustrated for outputs x and y, by the expression:

C(x,y) < C(x)+C(y)

It is not difficult to think of examples of where joint production of two goods may be
cheaper than producing the goods separately. German dye-makers of the late nineteenth
century were able to use the same capital, labor and raw materials to make a variety of
 The end of a natural monopoly 18
different dyes and even pharmaceuticals (Chandler 1990). Modern “natural” monopolies
have also been able to utilize economies of scope. The old telephone monopoly provided
both long distance and local calling utilizing much of the same equipment, which was
believed to represent a cost savings (Train, 1991).
To summarize then, pervasive economies of scale are not sufficient to explain the
existence of natural monopoly once we look beyond the single output case to the more
realistic multi-product case. Here the literature looks to see if subadditivity obtains. But
even when an industry exhibits subadditivity, there can still be a question of whether a
natural monopoly exists or at least whether any firm can function as a monopolist
requiring government intervention to prevent consumer abuse and social deadweight loss.
Baumol et al. (1988) examine the problem by exploring whether or not a market is
“contestable.” A perfectly contestable market (also called “perfectly competitive)” is one
in which entry and exit are essentially costless. Thus there are no sunk—that is,
nonrecoverable—capital or other costs to enter, and anyone can enter whenever profit
opportunities appear and exit when those opportunities are gone. While this clearly
applies to competitive industries, even ones that are oligopolistic or monopolistic may
still be contestable. That is, the industry may have scale economies and a large firm may
dominate. But if entry and exit costs are low then the threat of entry is always present and
so the monopolist is always constrained in pricing (Demsetz, 1968). If prices rise above
average cost, then entry will immediately occur with the entrant offering the product (or
products) at a lower price. Thus the monopolist is forced to behave like a firm in a
competitive industry, and keep prices at the socially optimal average cost level.
Baumol et al. (1988) have been criticized for this formulation because it is clear that
most endeavors have at least some sunk costs, and, it has been argued, that this may well
negate many contestability claims (Weiztman, 1983; Schwartz & Reynolds, 1983). But it
can be argued that even when there are sunk costs, and there are ways for entrants to
secure contracts with customers (in the event of price increases by the monopolist) the
monopolist will be constrained regardless of whether there is actually ongoing
competition for the market itself (Demsetz, 1968). The market will be “almost
contestable,” at least sufficient to keep the monopolist from exercising substantial market
power.
Though pricing power may be lacking, a subadditive cost function will lead to what
Baumol et al. (1988) refer to as a sustainable natural monopoly configuration. In the
presence of high sunk costs that firm may also be able to exercise monopoly power. It is
at least implied that public utilities were (and in some instances still are) considered
natural monopolies of this sort—industries with high sunk costs and subadditive cost
functions. However, as we will see later in this chapter and in the next, there has always
been some lack of clarity and contradiction in the arguments presented to support this
natural monopoly conclusion with respect to electric power.
The theory of contestability is a highly sophisticated view of markets and firms, and
underlies much of current scholarly discussion with respect to industrial organization
generally. But it is important to note that Baumol et al. have not departed very
substantially from a basic technological paradigm, a view of what causes natural
 Is anything naturally a monopoly? 19
monopoly that is not much different from that found in the simpler form of the theory.
Actually, this is not always so apparent. When Baumol et al. state conditions of
production functions, they seem to make them general enough to be inclusive of all costs
of production. There is no reason on the face of it that these cannot include the costs of
contracting, measurement, enforcement, and so on. But when the authors seek to
operationalize the concept of contestable markets, it is clear that they fall into the
technologically determined view. For example, in a footnote (1988, p. 152), they observe
that certain institutional factors in developing countries might result in firms that are too
small, or as they put it, there must exist “strong ‘impediments’ to large enterprise that are
unrelated to either absolute or relative input prices.” Since the prices of inputs determine
cost, the translation of this is that institutional factors can lead to distortions of the “true”
costs of production and limits on the true size of the firm, which must be the same,
presumably, whenever the given technology is applied. 11
As will be argued in the next
section, that idea, as a practical matter, is incorrect except in an ideal world of perfect
information and no transaction costs. And most especially, it is devoid of meaningful
application in the real world.

A TRANSACTION-COST APPROACH TO NATURAL MONOPOLY 12

In his groundbreaking 1937 article, “The Nature of the Firm,” Ronald Coase asked the
simple question: why do we have firms? From the standpoint of neoclassical economic
theory it was not at all clear that they should exist. Consider a world in which there is
complete information by all economic agents, entry and exit to any industry is free, and
transacting is costless. These are assumptions of a neoclassical model of perfectly
competitive markets. If they were true there would be no particular reason for firms. Let’s
say an individual wanted to make cloth. He or she could contract with a supplier of raw
materials; contract with a transportation specialist to carry the materials; contract with a
spinner to turn it into thread; contract with an owner of capital to rent a machine and a
space to turn the thread into cloth; contract with a dyer or other finisher; contract with
someone who would market the cloth; and so on. Each of these transactions would be
costless: The cost of drawing up the contracts is zero and the prices for the services
reflect competitive market equilibria of supply and demand, and the behavior of agents—
contracting parties—is known in advance with certainty. Consequently, there would be
no benefit to the creation of a firm. Market transactions could efficiently substitute for
transactions that go on within the firm, and all people would be independent contractors
since they would achieve no gains through another form of organization.
But of course we do have firms, and Coase argued that the reason is that transaction
costs are not zero and information is not complete. It is costly to bargain around, write,
and enforce contracts; costly to monitor agents; costly to measure performance; costly to
search for information on all prices. Therefore, it must sometimes be cost effective to
internalize some transactions, organizing and coordinating them within a hierarchical
 The end of a natural monopoly 20
firm. Of course many activities are still more efficiently transacted in markets. The
decision of when to use a market and when to organize a firm is determined by which
form of organization is lowest cost. Put another way, it is not technology that determines
the boundaries of the firm, but the cost of transacting.
As indicated by the example of an ideal neoclassical world without firms above, one
way to conceptualize transaction costs for firms is to think of all functions within a firm
as a set of contracts. Some scholars in the Coasean tradition have in fact defined the firm
itself as a “nexus of contractual relationships” (Jensen & Meckling, 1976). The point is
that every facet of a firm’s operation could be seen as an explicit or implicit contract
between the firm’s owner and separate owners of capital, labor, services, materials, etc,
with many terms of measurement and enforcement spelled out or inferred. The firm then
is an organization that consolidates some of the contracts into a single defined unit as a
means to lowering the cost of organization and coordination of production.
While Coase focused on the rationale for the existence of firms, his work also had
important implications about firm size and organization generally. As some scholars have
argued (for example, Cheung, 1983; Liu & Yang, 2000) that to talk of a particular firm
size as appropriate to a particular technology, is meaningless or “irrelevant.” In their
view, it is entirely contingent on the degree of specialization within and between firms as
well as the cost of contracting (Williamson 1979). Clearly, this same kind of analysis can
be applied to natural monopoly in general and electric power in particular.

The Organization of Electric Power Systems

In the nineteenth century, the English scientist Michael Faraday demonstrated the basic
principles by which electricity is produced. Faraday showed that if a coil of wires is
rotated through a magnetic field (or if the field is rotated within a coil of wires) a
continuous electric current is induced. The current travels at close to the speed of light
and can be utilized instantaneously for various tasks provided the electric generator (and
coils and the magnetic field) produces enough energy (measured in watts or more
typically kilowatts or megawatts—a thousand watts and a million watts respectively) to
do the job. If the generator stops turning, the current ceases instantaneously and any and
all things connected to the generator cease to function as well.
Generators since the late nineteenth century have operated primarily by creating high-
pressure steam in a boiler and using it to turn the blades of a turbine, which in turn spins
the generator. Alternatively, moving water has been used for the same basic purpose. 13
Individual generators are capable of an electric output in some cases large enough to
provide electric energy for entire cities.
Any individual can in theory provide her own electricity by acquiring all elements of
power production including generation equipment. But in the 1880s, Thomas A. Edison
demonstrated that one large generator connected to customers through a system of wires
could in fact provide energy to a neighborhood and more. Customers joined the power
network first for light, then for the various other benefits that electric devices provided.
Initially, consumers paid only for the light fixtures, which were also provided by the
 Is anything naturally a monopoly? 21
electricity provider; later billing was on a metered use-of-energy basis.
Over time, many electric generators became interconnected so that power could be
distributed over high voltage lines from community to community. This allowed
companies to trade electric power and to move it instantaneously to meet fluctuations in
demand—day to day, hour to hour. Though some electricity providers maintained
independence from larger power grids, the electric power system today is a vast
collection of interconnected generators of various sizes and primary energy sources; long
distance high voltage lines; distribution nodes; and plugged-in end-use consumers. As the
next chapter will detail, most electricity providers have been legal regulated monopolies,
and to many, “natural” monopolies because of their technical characteristics, especially
perceived economies of scale in power production and distribution.

The Source of Monopoly: A Coasean Thought Experiment

To get an idea of how problematic it is to claim that an industry is a natural monopoly on
technical grounds alone, consider the following Coasean scenario:
There is a world in which there are some economies of scale in electric power
production and distribution, and (as the neoclassical model of competitive markets
assumes) information is complete and contracting is costless. An owner of an electric
generator, a very large one that captures whatever technical scale economies are present
in power production, contracts with the owner of a factory space to rent a portion of it to
install the generator. He then contracts with an owner of a steam turbine to drive the
generator, who in turn contracts with the owner of coal resources and with coal
transporters to provide the raw materials for the process to make steam to turn the
generator. Our generator-owner then contracts with someone who owns wires to
distribute the electricity and with the customers who ultimately use the power. Since all
of this contracting and coordination is costless, all contract terms specified, and no cost
for information on performance or price, there is no reason why these independent
producers need to be organized as a separate hierarchical entity that would resemble a
firm. They would not need, especially, to be so vertically integrated to encompass all of
the functions noted above in one commonly owned, hierarchically-managed monopolistic
entity.
Of course, the picture above is not complete. With electric power, there would be a far
greater network of independent contractors. One generator would not suffice. There
would be a large generator for a general level of need (called “base load”). There would
also have to be a smaller second generator to provide extra power for highest demand
times of the day (called “peak load”) and spare generating capacity of some kind for
times when there would be maintenance problems with the primary generator. There
would also need to be a service contractor, and so on. It would be a large web of
contractual relationships to be sure, but this does not change the basic idea. That is, there
is not any reason why, in a world of zero transaction costs, we would need vertically
integrated electric power companies at all, much less monopoly providers. Contracting
could achieve the same result without losing the scale economies of a large generator or
 The end of a natural monopoly 22
any other technical scale economies. In this world, there would not be anything called a
“natural” monopoly.
Needless to say, this ideal world doesn’t and cannot exist, and in the real world of
positive transactions costs, there are and will be firms because they economize over
market alternatives. But when, if ever, will there be “natural” monopolies? Indeed, from a
transaction cost approach, what does “natural monopoly” mean?

A Theoretical Analysis
To begin the analysis, firms are assumed to be cost minimizers, but consider what is
meant in economics by “cost.” A cost function, the representation of cost, has been given
thus far by the simple: C(x); that is, cost is functionally related to the quantity of output
(x) that is produced. But while the cost function is typically given in terms of output, this
is really a decomposition of a larger function composed of a vector of factor prices w
(w1-n) and x, or:

C=C(w1,…,wn; x).

Given factors of production, capital, labor, etc. (z1), cost is commonly assumed to be
linear, where C=z1w1+z2w2+…+znwn, and where each w is determined in competitive
factor markets and x is constrained by the technology, given as a production function, x
=f(z1-n). 14 Average costs then are the sum of the cost components, which must be
assumed to be a large string of factor costs, divided by x. It is assumed that, in natural
monopoly, as output increases, new factors are added and total costs rise, but at a rate
relative to output that leads to a decline in average costs. As noted before, and this point
should be stressed, the basic model assumes that factor prices do not change with
expanded output and that indeed they are set competitively and solely in factor markets.
So then for example, the cost of labor is entirely the wage rate that is set by forces of
supply and demand in the labor market.
Now consider a firm—any firm—as a nexus of contractual relationships in which
contracting is costly (in other words transaction costs are non-zero, as in fact they are in
the real world). This firm will still be assumed to minimize costs. A monopoly will exist
if a single firm can minimize the overall cost of its contractual relationships such that it
has a lower cost per unit of output than that achieved by any alternative arrangement of
firms. Or more to the point by any alternative arrangement of contracts. Cost overall is
based on the ability of the firm to contract (that is write, measure and enforce a contract)
both internally and externally, with all factors of production as well as all customers, at
the lowest average cost. Many contracts with factors of production are internalized within
the firm, precisely to minimize cost over market alternatives.
But the cost function in this alternative approach must be conceived differently from
that of the standard model. Indeed, the standard model, where cost is functionally related
to output and factor wages, is oversimplified in important respects.
 Is anything naturally a monopoly? 23
Most crucially costs depend on more than factor wages. There are costs of creating,
measuring and enforcing the terms of each contract with all factors of production and
coordinating their operations; there are also contracts and their attendant costs with
customers of the firm. While it may seem that the only change then would be a different
variable in the cost function, (e.g. C=C(x, t), where t is some measure of transaction
costs) in fact the introduction of transaction costs alters the behavior of the function in a
few important ways. First, the overall cost of a factor will not be identical to the wage (or
market price) of the factor. In other words, a wage rate for labor may be determined in a
competitive factor market, but the cost of contracting with the labor force may be
determined by the legal and social structure, by the technology of information and
enforcement, by the size of the firm itself, and by other transactional factors. The cost of
a factor is thus both exogenously and endogenously determined. While a wage rate may
be constant for any class of workers, transaction costs may not be constant and indeed
may be a functional argument in the cost function subject to a set of constraints apart
from those imposed by the production function. In other words, while the average cost of
physical production may fall because of scale, costs of transactions with factors may rise
precisely because of scale, or may rise (or fall) because of constraints placed by
government on firm behavior or because of the technology involved in carrying through a
contract. Consequently, the price of all factors may rise with scale even where the firm is
able to acquire factors in largely competitive markets and is producing where there are
technical economies of scale in production.
Second, a transactional analysis of a cost function reveals important interdependencies
among the components of that function that do not appear in the standard model. In the
standard neoclassical model, there are also interdependencies; the quantities of factors
will change when there are changes in relative prices, provided some alteration in
production methods is possible with a given technology. In other words, it is understood
that if the relative price of capital rises, assuming input ratios are not fixed in production,
then a firm will add more labor or raw materials to substitute for more expensive capital.
In a transaction cost analysis interdependencies are deeper. The most important
consequence of looking at the transactional side is that not only do prices affect quantities
of factors, but that quantities can now be shown to affect prices. The point is this: even if
we include a transactional term in the price of each factor, the quantities of factors impact
the prices of other factors. For example, a firm hires supervisory personnel. The point of
these factors is at least partly to monitor compliance with contractual terms on the part of
labor. If the monitors fail to perform their jobs adequately or are constrained by
informational barriers or other transactional problems, there is a higher probability of
labor’s failure to adhere to contractual terms. Shirking rises and productivity diminishes;
as a result, the effective price of the labor that is to be monitored rises (and the costs to
the firm go up). 15
To see this a bit more concretely, consider the following illustration: A firm that is
deemed a natural monopoly needs to hire factors of production to produce a particular
level (any level) of output. The factors are purchased in competitive factor markets.
Assume also from a technical standpoint the production process exhibits increasing
 The end of a natural monopoly 24
returns to scale as output is increased. Is the cost of monitoring, supervision and
enforcement also declining with scale? There is no reason to assume so, and indeed
evidence suggests that hierarchical inefficiencies will lead to diseconomies. (The Soviet
Union was of course the great exemplar of scale inefficiencies.) It may be that as inputs
are decreased proportionately to capture technical economies of scale, the amount of
monitoring and enforcement personnel and capital must increase disproportionately to
prevent the price of labor and capital used in the production process from rising. It is not
unreasonable to assume for transactions a rising, flat or u-shaped curve that shows
diseconomies soon after some level of scale benefits are reached (see Fig. 4.)

Fig. 4.Source: Train, p. 6, Fig. 1.2.

Now assume that the firm vertically integrates because it is deemed that there are
economies of scope, thus (it is hoped) achieving subadditivity, and it contracts with a new
group of factors. Additionally, it incurs costs of coordination between the two types of
production within the vertically integrated firm. These stem from new needs for
monitoring, measuring and enforcing implicit and explicit contract terms across the
various factors, and types of production. Subadditivity obtains if this new system of
coordination is actually less costly than the alternative. But again, these costs will depend
on the relationship between factors, and the technology and cost of contract measurement
 Is anything naturally a monopoly? 25
and enforcement. This will inevitably vary with institutional and market circumstances
(as well as technological advance), and there may well be decreasing returns to the
transactions side of the firm. Thus, in one circumstance vertical integration may lower
costs; in another raise them. But in all cases, the cost of individual factors will depend on
the quantities of other factors, the technology of information about those factors, and the
institutional circumstances that provide the setting in which contracting for factors takes
place. The efficient size of the firm will result from a comparison of the various costs of
internal contracting vs. market alternatives.
To summarize: how then might we define a natural monopoly from a transaction cost
perspective? Subadditivity in principles still obtains, but for any one firm, total cost is a
complex of factor costs (and the contractual relationships for them) that are
interdependent with one another. If we add to this picture external contracts (also costs to
the firm), we have an even larger string of cost components that in sum must be smaller
than any alternative arrangement. Or put another way, for any “natural” monopoly, at any
given time, the preponderance of costs must be lowest with a single firm configuration
over all other possible arrangements. But this must be highly contingent. It is unlikely to
hold true in all institutional settings, all demand conditions, and all market conditions.
Rather than a technologically determined fact of life, it may more accurately be said to be
accidental. That is, for total costs to be less in one vertically integrated firm, like electric
power monopolies, than in any alternative arrangement, there must be some problem with
market contracting and some unusual benefit to hierarchical coordination to make it so.
There is no reason why the problems will be identical or even largely similar from one
institutional setting to another. As Crocker and Masten (1996, p. 35) have observed, “The
fundamental lesson provided by transaction cost economics is that organization form
matters and that, depending on the specifics of the environment, some modes of
governance will be preferred to others.”
While this analysis has been static (as is most analysis of natural monopoly), there are
also important dynamic considerations. We noted above that changes in technology can
alter the picture for an industry’s organizational characteristics. But changes in
transactional constraints—technological or institutional—will also alter cost curves. Each
individual cost curve may be subjected to differing conditions that may shift them
upward (or downward) over time. For example, changes in laws may affect the cost of
contracting, or changes in certain technologies may affect the cost of transacting.
Inevitably, some costs will not continue to fall with expanded output even if technical
characteristics of production lead to greater efficiency at higher levels of output. Others,
over time, will rise (or fall) regardless of the quantity of output that is produced. In fact,
costs will rise (or fall) independently of whether production increases, decreases or
remains constant.
These considerations are based largely on exogenous changes. But if an industry is to
be designated a “natural” monopoly a priori, then some thought must be given to the
question: under what conditions will it remain one? This is especially important where
government assumes that regulation is necessary (and a single firm industry must be
enfranchised) because it has perceived that a “natural monopoly” exists. If such a
 The end of a natural monopoly 26
monopoly is determined solely by technology, then institutional change does not matter.
But if it is only a temporary condition due to particular contingent circumstances, then
the industry should perhaps be allowed to assume whatever form is appropriate to those
circumstances. But if an industry is designated by a broad technological typology, this
often cannot happen because of path dependence, government inertia, the vested interests
of the monopolists, or simply a failure of information about how changes affect the
industry. This failure may be due precisely because competitive markets are unable to
point to efficiency gains since such markets are not permitted to exist.
Given that institutional settings differ (and that they are subject to change), the lowest
cost industry configuration—the minimum size for firm efficiency—will not necessarily
be the same either across settings or over time. Average costs, in fact, will not ever be the
same unless socio-political factors are identical and change identically. Where costs of
internal contacting are high, it is doubtful that a monopoly will actually exist or be
sustained without government help. Ironically, as we will explore later in this book, it is
often the case that so-called natural monopolies are industries where government
regulation prevents a competitive industry—not where it protects consumers from
monopoly pricing.

What Does it Actually Mean to Call the Electric Power Industry a Natural
Monopoly?
Given the argument above, we can now consider just what it must mean if it is to be
claimed that electric power production and distribution is a “natural monopoly.”
First, it means that the electric production and distribution is functionally subadditive;
that is, a single firm produces electricity in a given market at lower cost than any
alternative organization of the industry. This must be true by definition.
Second, a single provider of electricity production needs to vertically integrate for all
products and services related to electric power because all functions together are
subadditive. This cannot be due solely to scale economies in production or distribution.
Consider again the zero transactions cost model: even if there are great economies from
one big generator than from several small ones, it is never the case that one big generator
alone can most efficiently provide a community with all of its power. As noted, there will
be many of various sizes; and there may well be links to other power companies to
arrange power purchase arrangements and affect transmission and distribution. Without
significant transaction costs, there is no reason why generators must be part of a single
firm, or that one company will most efficiently handle all functions of power production
and distribution and so must contain all functions in a single vertically-linked enterprise.
In fact, there must be a coordination problem that prevents these functions from efficient
operation competitively or separately.
Put more generally, even if there are economies with respect to power production,
these do not necessarily mean there are benefits to linking in one hierarchical firm
production with distribution or transmission much less service or marketing. Indeed, it is
clear that they should be linked only in the event that there are high coordination costs to
 Is anything naturally a monopoly? 27
market transactions among firms at different stages of production and consumption.
These are conditions that must be met to say that a power provider has a natural
monopoly over all phases of electric power.
Third, given that all phases of electric power production and distribution are
subadditive, without regulation, the industry will necessarily resolve into a single firm
monopoly since any other type of organization is unsustainable. Entry into a market
occupied by an incumbent firm, unless the entrant has some new cost advantage (either
transactional or productive) that is unavailable or hidden to the incumbent, is not just
unwise, it is economically irrational. Entry might be observed in an early stage of
industry development as firms vie for a stream of long run monopoly rents, but it is
unlikely to persist. Initially there might be merger among early entrants; later there would
be simple destruction of entrants since the incumbent firm, by dint of subadditivity, can
always underprice newcomers.
In fact, the electric industry did become a network primarily of vertically integrated
regional electric monopolies that provided all functions of electric production and
service, with rates regulated by the government. 16
This would suggest one of two
possibilities: either that the above conditions were in fact observed in the early years of
the electric power industry, or that the companies were able to use the power of
government to force monopolization where none was warranted.
For the former to be true, of course, means that natural monopoly was applied to
electric power because clear evidence of a subadditive cost structure was evident. Was
this the case? In fact, historically the above conditions were not clearly observed (see
Chapter 3). Rather than demonstrated empirically, natural monopoly was mainly asserted
by its proponents as the condition of the electric industry. Indeed, there has been little
clear cut evidence that the industry even has had for much of its history pervasive
economies of scale. In general this has merely been assumed.
In fairness, it must be admitted that there is no way to prove or disprove the
proposition that at some times in the past and in some places in the U.S., the lowest cost
form of organization for a regional electric system was a monopoly. 17 For technical
and/or institutional reasons, internal coordination and contracting costs in a vertically
integrated electric power system may have been lower than any alternative, and thus, the
single firm’s costs were at those times in those places, subadditive. In such instances,
government enfranchisement and regulation might have seemed the best alternative to
prevent market failure from monopoly pricing.
But without much evidence, there is no reason to assume that electric power is or ever
was by some definition or typology, naturally anything. Moreover, the requirements for
subadditivity in a vertically integrated company listed above are quite stringent and it is
doubtful that it applies universally to any industry. In any case, none of the conditions
listed above seemed to apply in the early years of the electric industry. Indeed the main
argument for much of the monopoly formation process and the regulatory apparatus that
governed it, seems not to have been based on subadditivity at all. Rather it was argued
that competition was bad because it “ruinous” to existing electric providers. That is,
prices in competition were “too low.” Not too low to drive all providers out of business,
 The end of a natural monopoly 28
or necessarily to disadvantage customers, but presumably to drive down profits to level
that distressed company executives. 18
It was argued that that this ruinous competition would hurt the industry and would,
somehow, lead to monopoly in the long run. But this argument is tenuous at best and not
at all identical to, or even consistent with, the model of natural monopoly in the
economics literature. Finally, to cast further doubt on natural monopoly as an inherent
technological characteristic of the electric power industry, it has been shown that
competitive power production continued in some localities throughout the twentieth
century with little loss to the consumer or total destruction of the competing firms
(Primeaux, 1986).

“NATURAL MONOPOLY” THEORY AND PUBLIC UTILITIES

As the foregoing discussion suggests, the theory behind natural monopoly was not very
solidly grounded when it was applied to the electric power industry. Yet it has been so
applied, and not just by rent-seeking firms. Many economists and legal scholars have
supported this idea for quite some time—supported not just the theory in the abstract but
its application specifically to public utilities like electric power systems.
Some scholars (for example, Hovenkamp, 1984) accord the genesis of the idea of
natural monopoly to English Lord Chief Justice Mathew Hale who in the seventeenth
century noted that some that some seaport facilities were strategically located and
“affected with the publick interest.” 19 Hale and later Blackstone, who also commented
on the legal status of businesses that had implications for public welfare, were interested
mainly in specifying the nature of ventures that should face public regulation, not to
specify a condition for a monopolistic outcome (Hovenkamp, 1984).
John Stuart Mill appears to be the first to have elaborated the possible benefits of
regulated monopoly enterprises in the provision of public utilities. Indeed, Mill observed
that local gas and water companies, if organized as legal monopolies could achieve scale
economies and “make lower charges” while at the same time obtaining the then current
level of profit (Mill, 1965 [1848])-the benefits of a falling average-cost curve discussed
earlier. It should be noted that monopolies did exist in Mill’s time, but most monopolies
persisted primarily by royal or state charter. These charters were granted for various
purposes, for example, like the Hudson Bay Company to invest in colonial development,
but not because of perceived economic characteristics of production.
In any case, the main impetus to natural monopoly theory came in the second half of
the nineteenth century. At the time, economists were grappling with the remarkable
technical advances of the Second Industrial Revolution. These seemed to indicate: first,
the potential for enterprises that could be efficient on a vast scale; second, the potential
for predatory behavior and monopoly pricing by those enterprises; and third, corruption
and social problems that such enterprises could create by virtue of their sheer size and
wealth.
Economist Richard Ely (1887), one of the founders of the American Economic
 Is anything naturally a monopoly? 29
Association, specifically used the term “natural monopoly” to describe vast enterprises
that in particular, to use Lord Hale’s phrase, were “affected with the public interest.”
These businesses did not include electric companies but did pertain to communications,
transportation, as well as utilities supplying water and gas (Hazlett, 1985). 20 The key
point for Ely was that efficiency gains from the size of enterprises were socially
beneficial but that the utilities and transportation companies by virtue of their importance
to society were notable “for the abuse of corporate power.” (Ely, 1887). Thus they were
from a technical standpoint destined to be (and best left as) a monopoly, but they needed
to be regulated by the state on behalf of the public interest.
As DiLorenzo (1996) points out, Ely could be ambiguous even about how to identify a
natural monopoly since, in Ely’s view, vast scale alone was an insufficient criterion. But
it is nevertheless true that Ely has continued to be cited well into the twentieth century
(Lowry, 1973) as the first theorist to legitimize the concept of government-regulated
natural monopoly. As Ely (1887) argued, “It is not true that that private corporations are a
bad form of industrial organization; it is true that their sphere has been unduly extended.”
Henry Carter Adams, writing at about the same time as Ely, elaborated the theory of
natural monopoly and most explicitly focused on the importance of high fixed costs,
increasing returns to scale, and a declining average cost curve. Industries with these
characteristics could not, according to Adams, be regulated by market forces since
increasing returns permitted a single firm monopoly that would inevitably be
“administered for personal profit” if left to its own devices. Instead, the answer had to be
government regulation to prevent monopoly abuses (Adams, 1954 [1887]). As Hazlett
(1985, p. 10) notes Adams was engaged mainly in an “ad hominem attack on corporate
capitalism” rather than an explication of natural monopoly theory. But Adams’s basic
formulation provided the underpinnings of the traditional natural monopoly argument that
persisted well into the 20th century. Indeed, its basic construction is still found in
introductory economics textbooks today.
In fairness to Adams, while the increasing returns argument for natural monopoly is at
best overly simplified, it is the case that if a firm that can meet all of market demand at a
point where average costs are decreasing, it should be able to capture the entire market.
And since most production processes have some degree scale economies there may be a
point at which any business can achieve a monopoly, at least in a local market. Thus we
see only one (a local monopoly) general store in a small town, one gas station, one
barbershop, 21
where demand is low and producers can gain the limited scale economies
that are available to them. Such businesses will stay monopolies if: demand is static; they
become more efficient and move to a lower average cost curve; and/or lower cost
substitutes do not materialize. But they are also constrained in their ability to exploit their
monopoly position as long as there is the potential for entry or innovations in other areas
(such as transportation) that might make substitutes more desirable.
But as noted earlier, average cost curves for any industry are likely to be U-shaped.
That is, over a certain range they will be decreasing; over another range they will be
constant; and then they will rise as the scale of operation increases. Natural monopoly
theory based on decreasing average costs implied that scale economies not only existed
 The end of a natural monopoly 30
but that they were somehow inherent for a technology at any level of output. Further,
demand could never rise to the point of appreciable decreasing returns; and finally that no
substitutes could exist and so no one could ever enter the market and offer an alternative
product.
Now it is undoubtedly the case that in the nineteenth century, economists observed that
as some technologies advanced, average costs fell. Firms could operate at
unprecedentedly large scale and still be on a declining portion of their average cost
curves. This may have influenced some of the thinking at the time. Or alternatively, for
something like the provision of water, a good “affected with the public interest,” demand
intersected a declining cost curve far from any recognizable minimum efficient scale and
so it was pointless for competitors to attempt entry and contest a given market. Thus de
facto monopolies were the norm and seemed likely to remain so for a long time.
But economists at the time did not empirically test the model or examine its long run
implications. As in the case of Adams, much of the discussion was ideological rather than
economic. And while theorists applied the basic theory widely to cover all industries in
transportation, communication and public services, in fact as has been argued above, the
implications of the model were so stringent few if any industries probably fit.
Some economists in the second half of the twentieth century began to point out the
shortcomings in the theory of natural monopoly and a few questioned the existence, or
even the idea, of natural monopoly altogether (e.g. DiLorenzo, 1996) and particularly its
application to electric power (e.g. Hammond, 1986). Probably the most notable critique
of natural monopoly came from economist Harold Demsetz in a classic article, “Why
Regulate Utilities.” Demsetz questioned whether a firm, regardless of its size and its
domination of a market, could actually exercise monopoly market power given the
potential for entry or for opportunities to contract around a large firm’s market position.
But this piece did not appear until 1968. By then, electric power companies as well as
gas, water and telephone companies were franchised as local, regional or even national
monopolies and regulated as if the natural monopoly model were true. 22
Whether
competition was actually impossible, whether monopoly abuses were actually inevitable,
whether substitutes really were unavailable were all beside the point. 23 That’s the way
the industry was treated and the common wisdom, natural monopoly theory, continued to
support it. 24

CONCLUSION

The rationale for a single firm has often been broader than that given by the common
definition of natural monopoly. Many in politics, industry, and even public consumer
advocacy claim that social welfare was and is improved by the presence of a regulated
monopoly system—regardless of any justification in economic theory. This seems on the
face of it self-contradictory. In economics, it can be shown that the best—socially
optimal—uses of resources are most clearly determined in competitive markets. And if
competition in electric power would exist in the absence of government regulation, then
 Is anything naturally a monopoly? 31
why would it be socially more desirable to have a regulated monopoly than a relatively
unregulated competitive market? 25 The implication is that a competitive market in
electric power would be notably prone to market failure but as the next chapter suggests
there is little reason to believe that that was or would be the case.
And for the purposes of this book, the key question is this: even if it once seemed
correct, is there still greater efficiency in a single firm than in competition for electric
power—or any part of that industry? Few would argue generally that electric power is
now a natural monopoly, whatever it once was. But given that natural monopoly is at best
contingent and must be held highly unlikely in most circumstances, it seems that the
concept was largely empty of real empirical content. The better question (discussed later
in this book) then is: how why did it take so long for such a concept to unravel?

NOTES

1. Mathematically, the derivative of average costs is negative.

2. Marginal revenue declines as the monopolist expands production, and it is always
less than or equal to price, because of the downward sloping demand curve. Say, for
example, the monopolist sells one unit for $10. Then that is the marginal revenue.
Now to sell two units, the monopolist must reduce prices to $9 each. Thus total
revenue is $18, but the marginal revenue is $8—less than the price. The monopolist
gains additional profits so long as MR ≥ MC.
3. This is important. Any consideration of economies of scale assumes constant input
prices; this issue will be explored in greater detail later in this chapter.
4. Mathematically, economies of scale can be represented in terms of its effects on
costs by: C(λq) < λC(q) for all X, where 1 ≤ X. ≤ 1+a, where a is a positive number.
The key point here is that at the output is increased by X, costs rise by less than
when costs themselves are increased by X. It can be easily shown from this that
average costs are less as well (Sharkey, 1982).
5. In some sense virtually any firm can be a monopoly given a small enough market
for their product. See the discussion on page 36.
6. This issue will be considered later with respect to contestability of markets and
subadditivity.
7. And indeed it may involve higher management and oversight costs raising average
costs, not lowering them.
8. Note that all of the figures represent a static picture, but all parts of these graphs are
potentially dynamic: demand as well as the costs of production change over time.
9. Sharkey (1982) uses a cost function with the form for outputs x and y: C(x,y) = x½+
y½+(xy)½. This function exhibits economies of scale (as multiplying through by X
would show), but it is also possible to demonstrate for some values of x and y, the
function is not subadditive.
10. Baumol et al. view a composite good as a bundle with fixed output proportions to
avoid the problem of aggregating two different kinds of goods varying in quantity.
 The end of a natural monopoly 32
11. Of course there would be differences from the costs of transportation, as the “law
of one price” would dictate.
12. For an overview of transaction cost economics with respect to regulated industries
see Crocker and Masten (1996).
13. Wind is also capable of turning a turbine as is a diesel or other internal combustion
engine and a gas-powered turbine like that found in jet aircraft. Solar energy may be
used either to heat water for steam or to produce power directly through a process
called photovoltaics (Cassedy & Grossman, 1998).
14. If the factor market is monopsonistic then purchases by the firm affect market
prices, whereas in a competitive market all participants are assumed to be price
takers.
15. Principal-agent literature is quite extensive (see for example, Grossman & Hart,
1983).
16. Some municipalities and various agencies of states and the federal government
have in some cases taken full control and ownership of electric power production
and distribution. The movement toward municipalization of power is discussed in
Chapter 3.
17. Since this proposition seems to defy falsification, it calls into question whether
“natural monopoly” should be considered a scientific concept.
18. There is a public policy justification against competition; that is, that competing
capital investment is inherently “wasteful” because it is unnecessarily duplicative.
Therefore there should be only one firm. But that is not obviously the case unless
there is only one unit of capital.
19. Cited in Hovenkamp, 1984, p. 1282.
20. Some of the earliest claims for some kind of natural monopoly status were
accorded to the gas-light industry in the period just after the Civil War (Platt, 1991,
p. 310).
21. Mill, in fact, was pleased to see the scale of enterprise increase since it meant that
many of the former local monopolists were being replaced by lower cost national
producers (Hazlett, 1985).
22. An important line of argument has come from the Public Choice school of
economic thought. In this view, public regulation of utilities was largely an effort on
the part of the businesses themselves to seek rents through government intervention
(Mueller, 1979).
23. Experimental work by Coursey et al. (1984) suggested strongly that Demsetz was
correct. As the authors of the former study wrote (p. 111), “It is simply not true that
monopoly pricing is a ‘natural’ result of a market merely because firms in the
market exhibit decreasing costs and demand is sufficient to support no more than a
single firm.”
24. There are those who argue that natural monopoly still should be applied to electric
power transmission. This point will be considered further in later chapters,
especially Chapter 6.
25. Of course, there is no market that is without some degree of government role.
 Is anything naturally a monopoly? 33
Indeed, the more sophisticated the economy, the more it depends on basic rules of
contract and property law and their (relatively) impartial enforcement. But regulated
monopolies also entail government price setting and other features that make it quite
apart from those industries that rely on market price setting and contracting. See also
Chapter 6.
 The end of a natural monopoly 34

REFERENCES

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Jurisprudence (two essays) . New York: Columbia University Press [1954 reprint].
Baumol, W., Panzar, J., & Willig, R. (1988). Contestable Markets and the Theory of
Market Structures (Revised). San Diego: Harcourt Brace Jovanovich.
Cassedy, E., & Grossman, P. (1998). Introduction to Energy (2nd ed.). Cambridge:
Cambridge University Press.
Chandler, A. (1990). Scale and Scope: The Dynamics of Industrial
Capitalism .Cambridge, MA: Belknap Press.
Cheung, S. (1983). The Contractual Nature of the Firm. Journal of Law and Economics ,
26 , 1–21.
Coase, R. (1937). The Nature of the Firm. Economica , 4 , 386–405.
Coursey, D., Issac, R., & Smith, V. (1984). Natural Monopoly and Contested Markets:
Some Experimental Results. Journal of Law & Economics , 27 , 91–113.
Crocker, K., & Masten, S. (1996). Regulation and Administered Contracts
Revisited:Lessons from Transaction-Cost Economics for Public Utility Regulation.
Journal of Regulatory Economics , 9 , 5–39.
Demsetz, H. (1968). Why Regulate Utilities. Journal of Law and Economics , 11 , 55–65.
DiLorenzo, T. (1996). The Myth of Natural Monopoly. Review of Austrian Economics , 9
(2), 43–58.
Dranove, D. (1998). Economies of Scale in Non-Revenue Producing Cost
Centers:Implications for Hospital Mergers. Journal of Health Economics , 17 , 69–83.
Ely, R. (1887). The Growth of Corporations. Harper’s , (June), 71–79.
Friedman, M. (1962). Capitalism and Freedom , Chicago: University of Chicago Press.
Grossman, S., & Hart, O. (1983). An Analysis of the Principal-Agent Problem.
Econometrica , 51 , 7–45.
Hammond, C. (1986). An Overview of Electricity Regulation. In: J.Moorhouse (Ed.),
Electric Power: Deregulation and the Public Interest (pp. 31–61). San Francisco:
Pacific Research Institute for Public Policy.
Hazlett, T. (1985). The Curious Evolution of Natural Monopoly Theory. In: R.Poole
(Ed.), Unnatural Monopolies: The Case for Deregulating Public Utilities (pp. 1–26).
Lexington, MA: Lexington Books.
Hovenkamp, H. (1984). Technology, Politics and Regulated Monopoly: An American
Historical Perspective. Texas Law Review , 62 , 1263–1312.
Jensen, M., & Meckling, W. (1976). Theory of the Firm: Managerial Behavior, Agency
Costs, and Capital Structure. Journal of Financial Economics , 3 , 305–360.
Liu, P.-W., & Yang, X. (2000). The Theory of Irrelevance of the Size of the Firm.
Journal of Economic Behavior and Organization , 42 , 145–165.
Lowry, E. (1973). Justification for Regulation: The Case for Natural Monopoly. Public
Utilities Fortnightly , (November 8), 17–23.
Mankiw, N. (1998). Principles of Economics . Ft. Worth: Dryden.
Mill, J. (1965[1848]). Principles of Political Economy . New York: A.M.Kelley.
Platt, H. (1991). The Electric City Chicago: Chicago University Press.
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Porter, M. (1985). Competitive Advantage: Creating and Sustaining Competitive
Performance . New York: The Free Press.
Posner, R. (1969). Natural Monopoly and its Regulation. Stanford Law Review , 21 ,
548–643.
Primeaux, W. (1986). Direct Electric Utility Competition: The Natural Monopoly Myth .
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Sexton, R. (1999). Exploring Economics . Ft. Worth: Dryden Press.
Shiller, B. (2003). The Micro Economy Today (9th ed.). New York: McGraw-Hill.
Sharkey, W. (1982). The Theory of Natural Monopoly . Cambridge: Cambridge
University Press.
Schwartz, M., & Reynolds, R. (1983). Contestable Markets: An Uprising in the Theory of
Industry Structure. American Economic Review , 73 , 488–90.
Train, K. (1991). Optimal Regulation: The Economic Theory of Natural Monopoly .
Cambridge, MA: MIT Press.
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Economies Scale: Further Considerations. Journal of Economic Education , 21(4),
411–419.
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Relations. Journal of Law and Economics , 22(2), 233–262.
 EDITORS’ FOREWORD TO CHAPTER 3

If, as the previous chapter has argued, a “natural” monopoly is at best accidental and
contingent, then how is it that the electric power industry came to be identified as one?
There would seem to be two possibilities. First, contingencies at the time the industry was
founded made it a natural monopoly, in which one firm truly would have been the
outcome of market competition. The second alternative is that political and/or business
interests wanted to create the industry as a set of government-regulated monopolies,
regardless of whether institutional, technological, and economic circumstances justified
such a structure.
Well into the 1970s and 1980s, representatives of the electric power industry argued
that it was, and in fact had always been, a real natural monopoly (Lowry, 1973). To
explain how the system of regulated monopoly firms came into being, the industry
offered two different, and not entirely consistent, “creation myths,” both of which
incorporated aspects of natural monopoly theory.
The first story is one of natural evolution from a competitive industry towards self-
regulated monopoly. The industry, according to this story, was heading towards a
monopoly structure before the government ever got involved. Subsequent government
regulation was intended to prevent the inevitable monopoly providers from exercising too
much market power to the detriment of consumers. In this story, the government acted,
after the reality of monopoly became both apparent and desirable, strictly to protect the
public interest. The utilities at first worked with “unvarying consistency and
stubbornness” using “all their political influence to oppose the establishment of
regulatory bodies and later the extension of powers of such bodies” (Mosher & Crawford,
1933, p. 551). That is to say, the utilities wanted freedom from government regulation.
But once it was clear that regulation was coming because government would not relent in
its assault on free enterprise, industry firms and organizations used their influence to
minimize its effects, so that the market would rule to the greatest extent possible.
According to the second “creation myth,” utilities began competitively but, because of
the industry’s natural monopoly characteristics, competition became “ruinous.” 1 In any
case, on this account, it was not just the utilities that suffered from “ruinous competition,”
but the public. Multiple providers, with their layers upon layers of duplicate wires, were
defacing cities and confusing consumers. Already poor service grew increasingly
irregular as competition intensified. At this point, so the story goes, government joined
together with industry, in the spirit of public interest, to bring order to the market. They
agreed that a regulated monopoly structure, towards which the industry was naturally
heading anyway, was preferable to current situation of too much competition. Whether
anyone actually believed this nonsense is beside the point of the second “creation myth,”
 The end of a natural monopoly 38
which was to justify the monopoly status of electric power production and distribution.
One other problematic aspect of the creation stories is also noteworthy: If the industry
was truly a natural monopoly, then didn’t that justify “municipalization,” where the
government became owner, provider of electric power? This was a fear and a justification
for monopoly in itself. Regulated monopoly often became, according to the stories, the
preferred alternative given that the natural monopoly characteristics of the industry meant
either that either a single private monopoly firm or a government-owned entity were the
only possible outcomes.
As Robert Bradley, Jr. explains in this chapter, the actual history of the electric power
industry and the imposition of regulated monopolies followed a path rather different from
what the popular creation myths would lead one to believe.

NOTE

1. This argument starts from a theoretically untenable premise, for reasons cited in the
preceding chapter: if the industry truly had natural monopoly characteristics,
competition should not have been “ruinous,” but should have led in due course to
consolidation of the industry into a single provider.

REFERENCES

Lowry, E.D. (1973). Justification for Regulation: The Case for Natural Monopoly. Public
Utilities Fortnightly , (November 8), 17–23.
Mosher, W.E., & Crawford, F. (1933). Public Utility Regulation . New York: Harper.
 3.
THE ORIGINS AND DEVELOPMENT OF
ELECTRIC POWER REGULATION 1
Robert L.Bradley, Jr.

INTRODUCTION

The current debate over restructuring the electric industry makes a look back at the
origins of political electricity relevant. The thesis of this chapter—government
intervention into electric markets was not the result of market failures but business and
political opportunism—suggests that the intellectual and empirical case for market-
oriented reform is even stronger than would otherwise be the case.
A major theme of applied political economy is the dynamics of government
intervention in the marketplace. Because interventions are often related, an analytical
distinction can be made between basis point intervention and cumulative intervention
(Bradley, 1996). Basis point regulation, taxation, or subsidization is the opening
government intervention into a market setting; cumulative intervention is further
regulation, taxation, or subsidization that is attributable to the effects of prior (basis point
or cumulative) intervention. The origins and maturation of political electricity are
interpretable through this theoretical framework.

A NEW INDUSTRY
The commercialization of electric lighting in the U.S., successfully competing against gas
lamps, kerosene lamps, and wax candles, required affordable generation, long distance
transmission capabilities, and satisfactory illumination equipment. All three converged
beginning in the 1870s, the most remembered being Thomas Edison’s invention of the
incandescent electric light bulb in 1878.
Beginning in 1879, electricity was used to light streets and selected buildings in major
cities. The firms providing the new service, like the manufactured gas companies that had
inaugurated lighting service several decades before, had to receive corporate charters and
franchises, which often meant providing city fathers with “some kind of personal,
extralegal arrangement” (McDonald, 1962). 2 This was particularly true given the prior
Another random document with
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"posted and blazed all the way." She sang, between their lusty roll-ons, of
the "great round-up," where cowboys, like doggies, were gathered to be
marked by the Riders of Judgment, and on to the final warning:

"They say He will never forget you,

That He knows every action and look;
So, for safety you'd better get branded,
Have your name in the great Tally Book."

Several other ranch songs followed, but somehow the usual zest of their
not unusual chorus exercise was lacking. She halted them for false harmony
on "Poor Lonesome Cowboy" and when they began to twit Dick Murdock
for his scowl and his refusal to sing, she gave them "The Dreary, Dreary
Life" which generally marked the end of the chuck-room concert. This well
known range lament, calculated to bring tears to the strongest eyes, ran:

"A cowboy's life is a dreary, dreary life,

Some say it's free from care;
Rounding up the cattle from morning till night
In the middle of the prairie so bare."

After complaining of "the wolves and owls with their terrifying howls"
the cowboy of the song envies the farmer and the man who stays home with
wife and child. And the last "yowl" gives all the glad part to the cook, thus:

"Half-past-four the noisy cook will roar,

'Hurrah, boys, she's breakin' day!'
Slowly we will rise and wipe our sleepy eyes
The sweet, dreamy night passed away."

Flame suited action to the word of the song, pushing back her chair and
rising to a pair of tired feet. "It's the sweet dreamy for me, boys," she said.
"Come on, dad."

Although Smiling Dick Murdock concentrated his gaze upon her, the
girl spared him no look. Not so easily was he to get back into favor after
such an attack as he had made upon Jack Childress, that different sort of
man.

No word passed during the brief walk from the chuck-house to the
owner's cabin. The father, having missed none of the wordless tilt between
his daughter and the handsome range boss, was wondering what it was all
about.

"Out roaming the range this afternoon, Firecracker, you missed a caller,"
said Gallegher when they had settled on either side of the reading lamp in
the plain but comfortably-furnished living-room. "Serves you right."

"I knew I'd missed something while stabling my beastie," returned the
girl. "But it will be news if you tell me what you did to our neighbor that he
should leave the pride of his heart, Mr. Silver, stabled with us. I hope there
wasn't any rough stuff?"

"Rough stuff? Over what?"

"You know as well as I do the cloud of rustling suspicion that hangs

over him. This outfit's not inclined to be pulling on silk gloves where he's
concerned. Again let me say that I hope there was no rough treatment."

The father smiled tolerantly. "If I'd known you were so deeply
interested, girl o' mine, I'd have kept him by hook or crook or invitation to
dinner until you loped in. He rode over with a led saddler, and asked us to
keep his silver horse while he's away on some particular business the exact
nature of which was left to our imagination. Said his one man, an Irishman
named Mahaffy, I believe, would have all he could do looking after the
stock—his breeding band—and he did not want to risk Silver while he was
gone. I could not refuse such a neighborly request, and I didn't ask any
questions. There are times when I don't like to answer. You can have the
thrill of exercising the beauty beast if you like."
 "He's going away—where?" The girl scarcely realized that she had put a
question. She flushed with embarrassment when her father laughed at her.

"Seems to me that some one is strangely interested in one rustler

suspect," he commented unfeelingly. "What's friend Dick Murdock going to
think and say. I can tell you, though, where the attractive neighbor is going
—at least where he said he was going. He has some important business to
transact down in Montana."

The girl said no more, but busied herself with a bulky catalogue just
received from Eaton's, the Winnipeg department store, a volume that has
been called "the next-to-Bible of the West Canada housewife." She made
out a sizable order, tossed it across the table for her father's approval, and
decided she was tired enough to "dint the feathers."

Flame took refuge of her own room, the size of which was such that it
served as bedroom, boudoir and shower-bath—this last an unusual ranch
luxury, thanks to the immediate presence of the lake and a windmill which,
aided by a lofty tank attachment, gave the entire home ranch a considerable
and unfailing water pressure. Hers was a dainty room, done in white and
hung with blue draperies. At once it was characteristic and yet it wasn't.
Had one seen the young mistress only in saddle clothes, which were waist,
breeches and boots, with no compromise of skirt, this blue-and-white—
almost Dresden—effect must have seemed somewhat incongruous. But the
room was sacred to Flame, the only woman on the ranch. None ever entered
it except the China-boy who "made it up and down," as he put it. There, in
the mirror of her dresser, she scowled at the freckles that persisted to bridge
her nose, but as always decided not to amputate them. Had a pimple
appeared—— But fair as was Flame's skin there never had been a prairie
draft so hot as to burn her.

This night she put on the flimsiest of the things she had learned to wear
in her few years at a Montreal convent—the few years of an education cut
short by the death of her mother and a feeling that Dad-Sam would "go
wild" did she not return and take care of him. Before she tucked herself in
under the silken blue spread that concealed a couple of blankets—
provincial nights are cold at this early season—she studied herself in the
glass and was not ashamed to preen a trifle. What would he think of her
could he see her now and in so different a costume than the rough range
ones in which she most often had greeted him? What would he think? And
why—why was she worried, or even interested, over what he'd think, if,
indeed, he'd think at all?

With the windows particularly open to-night, that she might hear and
get into the fray should any attack be made upon the silver horse of
suspicion, she pulled the brocaded coverlet up to her chin, and repeated
words to herself.

"You fool go to sleep!"

That was the order repeated over and over, at first verbally, then in
thought. "Go to sleep—you're tired! Go to sleep!" But for once the order
was not obeyed.

Flame found herself pondering over what might be this mission in

Montana from which he might not speedily return. There was something
weirdly strange about his leaving Silver with another ranch outfit. Suppose
that a raid on their stock took place while he was absent from his "baby"
ranch in the basin, presumably on business in Montana? Was not that State
the base from which the rustlers worked; the haven to which they drove
their loot for brand blotting and hurried sales farther south? Would she,
then, still be able to cling to her persistent belief that Childress was a
gentleman and not the scoundrel that so many believed him? This last
question she did not answer, except to breathe a fervent hope that there
would be no raid.

Then she slipped from her bed, put pink toes into purple "mules,"
walked to her dressing-table and, for the first time in more than a year, set a
small alarm-clock. Usually she could waken at any hour on which she set
her mind; but to-night her mind did not seem to be entirely under control.
And there was something she must know—something that meant getting up
with the Chink cook and riding hard until she knew. Her father had been too
courteous to ask questions, but she need not be. The newcomer called her
Flame and she called him Jack when they were alone.
 Why was Jack going down into Montana on an inferior mount, his own
prize left to the care of a man he scarcely knew? Why? But particularly why
—why was she losing sleep over the fact?

CHAPTER XX.

POOR BRANDED MAN!

Flame's clock did not fail her. Next morning she was up with the cook
who, at that season of the year, was not perpetrating any of the half-past-
four roars. She slipped out of silken "nighterie" and into the rougher clothes
of the range. Without disturbing her father in his quarters across the living-
room, she crossed the quadrangle and entered the chuck-shack to the
unblinking surprise of Chan.

"Coffee and cakes, Chan," she ordered with a grin as cheerful as though
she had slept the clock around instead of only a quarter of it. "And you
needn't say that I had so early a breakfast should any one ask for figures."

"Cheerio—I mean righteo," returned the Chinaman. To him these white

ranch people were a queer lot, but Gallegher a good boss, and the young
lady less troublesome than the housewives for whom he had worked in
several towns. "Chan keep sleclet much better 'an Mister Murdock."

She gave him a quick look, followed by sharp demand: "Just exactly
what do you mean by that, you heathen."

Chan grinned broadly, as he always did when she called him "heathen."
She had been the object of his most respectful worship from the time of a
near tragedy of the winter before. The cook had returned from a vacation in
Strathconna, which boasted a considerable Chinatown. There he had
acquired a new idol or joss, a dreadful-looking dragon figure, which he
enshrined upon a shelf in the dining compartment of the chuck-house.
Rusty, the buster, came in for supper, saw the new decoration and
proceeded to ring it with his sombrero instead of using the regular hat-and-
gun rack. At the very moment the Stetson settled over the emblem of
Buddhism, Chan appeared in the doorway of the kitchen partition, in hand
the carving knife with which he was about to slice roast beef. He saw the
desecration, and seeing, saw red. With a yell that would have done credit to
the most supernatural banshee, he started after the bow-legged horseman,
brandishing the knife in religious frenzy. When almost within reach of the
thoroughly frightened Rust, who had entered upon a life-or-death marathon
around the long table, not daring to pause to open the door for the refuge of
the yard, Flame had entered. Taking in the tense situation at a glance, she
tripped the knife-man for a heavy fall.

After forcing Rust to remove his hat from the Celestial's sacred object,
and insisting that he apologize to the cook, she had convinced Chan that her
ready tripping probably had saved his life. The outfit undoubtedly would
have "eaten him alive" had the carving knife reached its mark. Thereafter
Chan swore by her, and for her, but never at her.

"Murdock, he clazy about Missie Flame—so much clazy he can kepp

that sleclet away from nobody but she—you."

"Well," she returned after a moment of pondering on the Chink's sage

observation, "you'll keep my early departure this morning a 'sleclet' from all
hands or I'll—I'll feed you to the buzzards!"

Still grinning, Chan went about the cooking of a hurried breakfast, sorry
that there were so few culinary touches that might be added to an early
morning meal that was calculated particularly to "stick to the ribs."

Breakfast finished, she leathered her own particular black; paused a

moment to stroke the cold muzzle of Silver, the strange visitor; then she
mounted and was off in an easterly direction at a pace calculated for long
distance travel. She congratulated herself that she was up and away before
any of the outfit was stirring. Even on ordinary occasions she was adverse
to answering questions about her proposed movements, but never had been
able to persuade her father and the older busters of the fact; moreover, this
was no ordinary occasion.

To herself, Flame did not apologize for the unwonted interest she was
taking in the affairs of a comparative stranger. No more did she try to
explain this interest. The fact that it came from the heart, not the brain, did
not alarm her. There had been so little heart interest in her life thus far that
she found a sort of thrill toying with this one.

Her chief concern, as her horse brushed through the fire weed and over
the stretches of rising grass, was whether or not she could pick the pass he
would take on his ride into Montana and, picking it, would she arrive before
he had gone through. Admittedly she was worried about what had happened
on or about the home ranch. Childress' leaving of the silver stallion was a
queer proceeding at least. She did not doubt her father's statement that their
big neighbor had brought the horse over and ridden away toward his one-
section ranch on a led animal. But the general demeanor of the boys,
particularly of Smiling Dick Murdock, had alarmed her as to what might
have happened when Childress had rounded the lake and ridden beyond the
vision range of Sam Gallegher. It was more to satisfy herself on this point
than to attempt to pry into the big ranchman's affairs that had led her afield
so early.

And if she were lucky enough to encounter him jogging southward into
the State of Trouble, what should she say to him, what ask, how explain her
early-morning presence so far from home? With the thrill of a school girl
engaged on some momentous undertaking in behalf of love's young dream,
she asked herself, answered herself—then discarded her answers.

In case Jack—Mr. Childress proved entirely unmolested, in good health

and in his right mind, riding about his own private business, Flame realized
she would need to take care lest she make herself and her impulsive action
seem ridiculous. That would be simply insupportable! He might think of her
worse than the situation really warranted—that she was in love with him;
when, of course, she was but "mildly interested." Yes, she would need to
take care, unless—and she almost hoped that something in the way of mild
discipline had been administered. What a chance that would give for her to
show sisterly interest and sympathy!
 Meantime her mount had been throwing the miles behind fleet heels.
They had reached a point on the range where she must choose her pass for
the "hold-up." Would he take the narrow, rocky one that gave way across
"Medicine Line" directly south of his own place, or would he swing around
to the valley farther east. She decided that all depended on where in the
States he was headed. As she was totally without information on this point,
she accepted the first chance that offered and eased her black down into a
rocky defile that afforded a direct gateway to Crow's Nest, a settlement of
ill-repute, as well as to law-abiding towns farther south.

Once on the trail she dismounted and examined it closely for traces of
any recent passage. Two nights before there had been a downpour which
washed clean the earthy portions of the road. She could see no hoof marks
and was satisfied that none had passed in either direction since the rain. If
the owner of the Open A intended to use that gap to the States, she was in
time.

Around a sharp bend, she halted her horse in mid-trail, having thought
of a subterfuge that might lessen his suspicion that she was laying in wait
for him. Loosening the cinch on her cow-saddle, she waited with the
patience of a feminine Job. And presently she was rewarded. The scrape of
an iron shoe upon a rock came to her ears from beyond the pinnacle that hid
her presence. At once she busied herself with the saddle straps, and so Jack
Childress found her, engaged in a commonplace operation of the trail.

Flame did not look up until he was almost upon her, and then with well
feigned surprise. This changed quickly to real anxiety when she saw the
peep of a white bandage beneath the brim of his hat. She took full
advantage of the moment afforded her for speculation. Something, then, had
happened to him the day before—some injury that required the use of a
gauze dressing! Noting the position of the injury, she recalled that other
morning when she had discovered Dick Murdock, Roper and Rust about to
do a dreadful thing with a red hot running-iron. It required no great strain
on her lively imagination to figure out what had happened.

Not for a second did she doubt her father. Samuel Gallagher never had
lied to her, and she did not believe that he would begin in this twilight stage
of their close acquaintance. This thing that had been done to Childress had
been perpetrated after he had deposited the silver stallion and started back
to his own little ranch. For just a second she was disappointed in him that
he should have permitted a second attack to succeed. A man as upstanding
as he seemed to be should not have been caught napping twice, should at
least have left his mark upon the enemy. She had seen no trace of conflict
upon any of the outfit about the home-ranch board the night before. They
must have sprung some new-fangled surprise upon him. She could not bring
herself to believe that Jack—her Jack as she whispered to herself—was a
man afraid to fight. Should he prove to be that sort, of course, her interest
must end; but he would not! She knew he would not.

By this time he was upon her, pulling his mount to a halt in a state of
surprise, the genuineness of which could not be doubted.

"Our trails do cross, Flame of Fire Weed!" he exclaimed gladly.

"Although yesterday, when I did not find you in your own corral, I feared
my luck was slipping."

He had pulled off his hat, in utter disregard of the bandage about his
forehead.

"What—what has happened to you, Jack Childress?" she cried,

sweeping a hand in gesture across her own fair forehead.

"Nothing worth worrying about," he assured her. "Are you going far and
headed my way? Can I help you with that saddle?"

She stamped her foot. "I'll not be put off with polite chatter. Those
roughnecks that dad calls an outfit got you and branded you after you'd left
Silver with us as a hostage of your good behavior. Dick Murdock, the
smiling fiend, will answer to me for every inch of the burn. Does it hurt
terribly and have you done everything possible for the wound?"

Childress grinned reassuringly, pleased beyond measure at her snap-of-

the-hammer sympathy. "I've done everything possible," he said. "The
wound don't hurt. Probably there will be no permanent scar. But above all
else, let me absolve Murdock and his men. They had nothing to do with
this. I did not see any of them yesterday. I doubt if they knew I had been to
the ranch until they found Silver in your home stable."

"Then it must have been that shifty widow's outfit that got you," she
flared, after a long inquiring look that convinced her he was not absolving
his enemies who rode the Gallegher brand just to save her trouble. "You'll
have to spin an iron-clad excuse, Jack, before I'll forgive you for letting any
of that Rafter bunch catch you napping." She paused a moment—a pause he
did not interrupt, being entirely too busy identifying the emotions that
played across her face. "Strange," she went on, more to herself than to him,
"strange they should hit on the same ordeal that our busters had. That Tom
Fitzrapp must have been talking to Murdock. Will you climb down off that
horse, brother, and let a woman have a look at what has happened? Men are
worse than babies when it comes to looking after their wounds."

Sergt. Childress obeyed, already convinced that in the end he would

make a clean breast of exactly what had happened.

"Be careful," he admonished as she started to unwind the bandage.

She frowned at him. "You're worse than a child with a cut finger," she
chided. "I'm not going to hurt you, son."

"I meant be careful with the bandage—it's all I've got with me."

"I'll take care of that," she assured him and went on removing clumsily
fixed pins, each of which she saved in the sleeve of her shirt, as though in a
pincushion.

At last the bandage was off and she stood back to observe the havoc
wrought his brow. She stared a moment; then transferred her gaze to the
bandage.

"Didn't you have any salve—any ointment?" she demanded.

"Would that have been good for—for what ails me?" he answered with a
cheerful question of his own. "Does the horseshoe effect meet with your
artistic approval?"
 Obviously she was puzzled. Who wouldn't have been? The idea of
jesting over as deep a disgrace as can come to a man on the range—a living
degradation than which many would have preferred a merciful death!

"What's the idea, Jack?" she demanded after a moment. "For a poor
branded man you don't seem as concerned as might be, and if I was going to
put the horse thief brand on any misguided freebooter, I'd burn deeper than
your decorator seems to have done. I don't get this smear any more than I
do your attitude toward it. Suppose you come across clean."

"Sorry, Flame, that you don't like my artistry with the brush," he
laughed. "I hadn't time to ride over to the Rafter A and show it to our
dashing widow friend."

Shy as a beautiful, speckled trout, she refused to take the bait of Ethel
Andress' mention; but she was quick to demand further information
regarding the brand.

"Your artistry, what do you mean? And what had a brush to do with it?"

"Recall, if you please, that day not so terribly long ago when you
arrived in the nick o' time to save a certain roped ranchman from the
decorative efforts of Messrs. Rust and Roper, doubtless members of the
impressionistic school and deep burners with the running-iron."

The girl nodded actively and the sergeant went on, changing to the
personal form.

"Perhaps you don't remember that I said as we were riding to your home
ranch something about a valuable idea that had come to me from the
frustrated attempt. This masterpiece of forehead decoration is the working
out of that idea. I sent to Strathconna for a tube of blister paste and a brush
with which to lay it on. I worked hard to paint an artistic horseshoe and if
the effect isn't what it should be, blame the zig-zag crack which Paddy
Mahaffy put in my only mirror when he dropped it the other day—seven
years' bad luck to him! I didn't put any brand within the shoe, as it is not
necessary that the folks I'm going to visit should know exactly where I
acquired the mark of the thief. It will be enough that they should think me
what I am not—a rustler of horses."

"Then you're going down into Montana on a visit?" she asked, more to
gain time in which to ponder the madness of a man who, without
compulsion of any sort, would so disfigure himself.

There ensued momentary digression, for he asked her to oblige him by

replacing the bandage. He wanted the blistered horseshoe to become well
set, and he did not care to exhibit it until he reached his destination.

"This visit?" she reminded him, when she had performed a first-aid
effect that would have been a credit to an army nurse.

"I haven't lost any animals yet from this popular out-door sport of
rustling in Fire Weed," he returned readily. "But then I haven't many and I
haven't been here long. I am tired, though, of the suspicion that hangs over
me and my silver horse. I owe at least one of the gang a toasting for that
day he marooned me on that ledge and forced me to chin myself out of
difficulty on the wriggliest length of hemlock I ever hope to tie to.
Moreover, we see nothing of that scarlet patrol that we asked of the
Commissioner of the Royal Mounted. Something must be done, and
without any fuss, I'm going to attempt to do it."

Sergeant Jack was sorry as soon as he had spoken that he had mentioned
the Mounties. That was his one slip into direct prevarication, and it did not
come easy from him to lie to Flame of Fire Weed. He tried to excuse
himself to himself by the fact that he had used the uniform color scheme in
his statement, but realized the evasive poverty of such an excuse. As long as
he confessed so much of his plans, why didn't he go the whole way and tell
her that Mahaffy and he were the scarlet patrol—very much without the
scarlet? He had trusted her with much, trusting without exacting even a nod
of promise that she would not reveal his plan; then why not tell her
everything? But something tied his tongue on the big secret. He was not
sure just what this was, but argued mentally that there would be time
enough for disclosures when he had accomplished something on this special
detail.
 Flame had listened to his revelation with widening lids. These now
narrowed as she weighed the proposition.

"Then you're going——"

"To Crow's Nest first, possibly farther into Montana—wherever the trail
leads."

"Don't go to Crow's Nest," she begged. "They'll kill you!"

"They're more likely to enfold me like a brother." He raised a hand in

mock salute to the forehead bandage.

"It's the hell-hole of the West," Flame continued to voice objection. "I
wouldn't send my worst enemy into it. What are a few stolen horses and
lifted hides to——"

He was pleased beyond measure at her interest, the thought of which

would ride with him no matter what the danger. But he realized that the
morning was slipping away. An after-dark entry into the Nest for a stranger
was a foolhardy undertaking. Pleasant as it was to tarry here on the safe side
of "Medicine Line," studying emotions as portrayed on what was becoming
to him the fairest face he had ever seen, regardless of freckles and flare of
hair, Childress realized that he must ride on.

"Nothing's likely to happen to a branded man," he reassured her. "By

night my forehead will wear what seems to the casual observer to be a real
scar."

"But the Crow's Nest!" she cried. "I wish you weren't going into that
brimming cup of iniquity alone. Suppose we ride back to the ranch and tell
your plan to dad. He'll send Murdock or one of our trusty busters to back
you up."

Childress grinned. "My dear——" He caught his breath at the daring

phrase of endearment which had popped out so unexpectedly; but she
seemed not to have noticed. "Flame, I wouldn't ride into hell brushing
stirrups with Murdock. If you'll let me adjust that saddle for you—fix
whatever's wrong with the leather, I'll be on the way along the primrose
path."

"There's nothing wrong with the saddle, Jack." Her turn for confession
had come and she met it gallantly—without a blush. "I slipped a cinch just
to have an excuse for laying in wait for you, hoping you'd come this way."

Almost at this moment did he tell her something that he was beginning
to feel sure eventually and inevitably would be told; but he held his tongue.

"You guessed the right pass," he parried the danger point. "Take good
care of Silver, won't you, Flame?" He swung into the saddle and cantered
down into the draw where soon he would leave the land of the beaver for
that of the eagle.

"Crow's Nest," Flame murmured almost in a wail. "Crow's Nest! Why

did he wish such a task on himself?"

CHAPTER XXI.

THE NEST OF THE CROW.

In the heart of the bad lands, where the Bitter Root Mountain range
begins, lies the nest of the crow, one of the few remaining hide-outs which
the taming West affords. It is easy of access once you know the trail
whether you come from the prosperous Montana towns to the south or from
the Canadian province to the north. And it is safe enough to all who have
won their spurs at outlawry in either direction. A single road leads to it;
although there are several trails away from it, available to those who are "in
the know" and forced to make a sudden get-away.

At the entrance gulch, through which the only wagon road winds its
way into the dreary upland, so well called "bad," there dwells a small
rancher who finds it worth while to keep within the law. His chief source of
income, on which he pays no tax, is to signal the approach of strangers,
particularly officers of the State or Federal government. A flag which he can
raise or lower without leaving his front porch sends the alarm to the outlaw
nest. The system may be old-fashioned, but it has not yet been discarded
either for the telephone or the radio. Telephone wires can be cut by a posse
that really is in earnest about paying the Nest a surprise visit and radio
communication is, as yet, too much of a mystery to interest these border
folk as a safeguard.

It was nearly four o'clock in the afternoon when Sergeant Jack rode up
to the out-guard ranch house. From his previous visit to Montana he had
learned enough about Crow's Nest to understand the method of safe
approach. The bandage had disappeared from his forehead; written there in
lines of fire was the horseshoe brand of disgrace.

Lounging, as was his wont, in a sway-backed chair built by stretching

an undressed hide upon a proper arrangement of saplings, loafed the
outguard—a long-nosed, lanky, unshaven mountaineer. At his feet, in half
slumber, lay a couple of nondescript hounds, reputed to be efficient
guardians, so far as alarm was concerned, of the entrance gulch at night. In
the scraggly front yard a boy of nine or ten years was playing as best he
might with no mate to make up a real game. In the open door of the shack a
slovenly woman appeared, evidently the wife and mother, drawn from some
household task by the noise of the horse's approach.

"Greetings and salutations, friend," was the sergeant's opening. "Is

everything sitting pretty up at the Nest?" His hat was tilted low over his
forehead, concealing the informative scar.

"That there all depends on who yuh are and what yuh want," returned
the man on the porch without moving a muscle of his elongated frame. "I'm
Doc Chase, ranchman and honest. I don't pay no attention what goes on up
there. Who're yuh?"

Childress removed his Stetson, disclosing the tell-tale wound which

already was beginning to look like a scar.
 Chase started up in his chair, then sank back again, as though the effort
was painful.

"They got yuh, eh?" he remarked. "Wonder they let yuh get away,
Childress, with just a brand, considering the Strathconna Breeders has put
an alive-or-dead on you."

"How did you know my name?" the sergeant demanded.

"Don't know your real name—only the one you've borrowed from
somebody in the Mounted. Recognized yuh from the description on the bill
and the picture. What was the matter with your gun that yuh let 'em treat
yuh like a maverick?"

"They got me when I wasn't looking and I guess they didn't know about
the reward. You don't seem interested in collecting it."

Doc Chase sniffed loftily. "Blood money ain't no good to no one

stranger. I reckon you'll be welcome up to the Nest. Tommie!" This last was
called to the boy who came quickly from his play. "Tommie, run up the
flag."

"The stripes or the white one?" asked the lad.

"The white, you young idiot. Can't yuh recognize a friend when yuh see
one?"

So Childress rode on into the rough country, confident that no pot-shot

would be taken at him from the abundant cover on either side of the trail.
Had the stars and stripes fluttered from the signal mast on the hill behind
Doc Chase's cabin, he probably would not have been allowed to cover the
first of the two miles that intervened without being made a target. As the
flag was white, he rode safely and unchallenged into the small mountain
park which so surprisingly decorated the region of mountainous
despoliation.

Years before Bart Crowe, a potential outlaw, had found refuge there,
liked the semi-forested location, and had taken up a homestead. Once the
property was his and his debt to the law squared by the statute of
limitations, he had built a log hotel and passed the word among his hard-
riding, careless friends that at Crow's Nest was a sure refuge in the time of
storm. The arrangement with Doc Chase had come later and was
particularly designed against Prohibition raiders, since Montana sheriffs and
their deputies preferred to wait until men they desired had left the "nest."

With the law's repression closing in on the better known and more
respectable resorts of the state, Crowe's business had increased. A supply of
liquor always available through his rum runners from the North, he had
built up quite a trade with loggers from the camps in the Bitter Root forests.
They could get in if they looked right to Doc Chase and stay until they had
spent their earnings. If there was a tougher place in the United States than
Crow's Nest—he had dropped the "e" of his own name for that of the
glossy-black carrion birds which were at home among the cedars—Bart
Crowe would have wondered "how come."

Before the main structure of the small settlement—a log building of

considerable size—Childress dropped rein on his cayuse and entered.
Beyond the open door he found a long bar, its wood unpolished and with no
brass rail for impatient feet, at which half a dozen men were drinking. Two
wore the vividly-colored Mackinaws of lumberjacks and the calk studded
boots that went with the same; two were in riding clothes of balloon-
trousered cut; a fifth was dressed in the height of Helena fashion and the
sixth he recognized from description as Bart Crowe himself. Behind the
rough bar, a pasty youth with plastered hair was polishing glasses. The only
difference between him and the bartenders of the pre-Volstead era was the
fact that he wore a flannel shirt instead of a white jacket, but under the
collar of that shirt blazed a crimson tie with a more-or-less diamond
accompaniment.

No one paid particular attention to the newcomer, although seven covert

glances certainly were directed his way. They had known that someone was
coming, as reported by the flag. It was up to him to make the first overture.

Childress glanced at the group, as though seeking a familiar face, and he

nodded to the man so easily recognized as the proprietor. He still wore his
hat, pulled down over his eyes.
 Then he crossed to as strange a bulletin board as ever an outlaw camp
boasted. The freshest and most prominent "Wanted" placard held his entire
attention, as it was the first time he had seen it since he had ordered a few
of them printed and privately and particularly distributed by his friend the
sheriff of Bison County, Montana. Below a reasonably good likeness of
himself appeared with the usual flare of the small-town printer:

$1,000 REWARD

DEAD or ALIVE

This amount will be paid by the

undersigned for the capture in any
form of

JACK CHILDRESS

wanted for horse stealing. Has

taken name of Mounted Police
officer and may wear uniform.

And there followed a description that was more or less accurate.

Childress spent several minutes studying this poster; then he crossed to

the bar.

"Pen and ink," he requested.

The bartender looked startled; the drinkers glanced up.

"Don't serve 'em usually; would you have 'em with or without?"

Childress started a long reach over the bar, which the drink-mixer
avoided. Then, evidently, he got a glance-of-eye order from Bart Crowe; set
out a bottle of ink and a scratchy pen. "We don't cash no checks up here,
mister," he asserted, not to be denied a last fling.
 The sergeant took the bottle in one hand, the pen in the other and
crossed to the board. There he traced a horseshoe on the brow of the half-
tone presentment of himself. When he had finished and returned the pen
and ink, he swept off his hat and addressed the group at the bar.

"Now, gents, that poster looks something like me," he said casually. "If
anyone of you needs a thousand dollars reward——"

He waited. The others stared—stared most fixedly at the horseshoe scar

upon his forehead, in that outlaw camp a royal badge.

"Be yourself, son!" The admonition came from Bart Crowe. "Step up
and name your poison—one's as bad as the other."

"You don't mind the brand, then?" Childress demanded.

"Hell, no!" said Crowe.

With that the sergeant walked over to the bulletin board and pulled
down the poster which he had arranged to have posted against himself.
"That's a go," he said. "What'll you all have."

While they were having—mostly "another of the same"—Childress

stepped to the swinging door of the back room where a tin-piano and a
"fiddle" were making music for some sort of a dance. Several women were
there—best not described. They rented cabins from Crowe for a profession
that is older than the oldest. The two-piece orchestra blared, and the two
couples on the floor seemed to dance until one of the women, a brunette
slightly beyond the life she obviously was leading, caught sight of the
stranger in the doorway. At once she let go the big lumberjack who was
trying to follow her through the steps of a waltz.

"Here's my man at last!" she cried and quit her rough-shod partner cold.

"Not me," said Childress, trying to back out.

But he was not quick enough. The woman insisted that he dance with
her, insisted even to the point of laying violent hands upon him. The group
at the bar saw the attack and applauded.

"Better give in afore you offend the lady," advised one of his newly
made acquaintances—the one with the pegleg. "Delores Doleroso drives a
wicked knife and gen'ally gits what she thinks she wants."

"Come on, you big, beautiful horse thief," urged Delores. "I just love to
waltz with a man what's wanted dead-or-alive." She turned to the two-piece
"orchestra." "Start that number over!" she commanded.

None of them paid any particular attention to the Swede logger who had
been ditched in the midst of a dance for which he already had paid. The
mackinaw-clad giant stood mid-floor, rocking his huge frame backward and
forward on the calks that studded the soles of his boots. The while he
clawed at a blond-bushed chin, his sky-blue eyes shooting dangerous fires.

Although not in the least interested in the dark-eyed dance hall girl who
had drafted him as partner, Childress could not be rough with a woman.
Since she would not be shaken off gently, there seemed nothing to do but to
dance with her. A skillful "stepper," despite infrequent indulgence, he
swung her out upon the floor from which all but the deserted logger had
retired.

From the Swede came a snarl. "You tank you can steal my girl—Sven
Larsen's girl!" was his shout in bellicose basso. "I finish you now—once for
sure."

On top of the threat came swift advance which left Childress no doubt
that he was in for a fight.

CHAPTER XXII.

THREAT OF SPIKES.
 The music broke off in the middle of a run. The group at the bar pressed
forward, all eager to see how this strange outlaw, who had dared them to
collect the price on his head, would acquit himself against a whisky-crazed
lumberjack. Delores, her interest really captured by the upstanding figure of
the newcomer and clinched by that livid horseshoe scar upon his high
forehead, made faltering effort to halt the trouble she had started.

"Back to your kennel, you yellow dog!" she ordered. "I'll dance with
you when you pull off them spiked boots. Be yourself and show some
sense."

She tried to throw herself in front of Childress and take the brunt of the
jealous rush. But Childress swept her to one side and behind him.

The first blow of the contest momentarily stopped the adversary who
had thundered forward with huge hands outstretched in the obvious intent to
grip the sergeant's throat.

Slightly taller than Childress and much heavier, the Swede shook
himself. For a second his close-set, turquoise eyes blazed downward. Then,
with lowered head, he rushed again.

That Childress had not been in the path of the human steam roller, that
he had side-stepped and was urging Sven Larsen to wait a minute and have
his girl returned to him, appeared only to increase the logger's fury. In the
next few minutes the sergeant had no thoughts to spare from his blows and
footwork.

Larsen abandoned his futile rushing tactics and tried to connect with
mallet-like swings. Had one of them landed true, the innocent cause of his
jealous rage must have gone to sleep for an uncertain length of time.
Although strictly an amateur in all his sports, Childress had developed
considerable boxing skill in his barrack days at Regina and by way of
exercise in lonely posts from the Yukon to the Arctic; yet, clumsy as was
the woodsman's attack, its weight taxed him to avoid being knocked out.

That Larsen shed his return attack as though it were from feather
pillows instead of reasonably seasoned fists was disconcerting. The skin of
the logger's face was doubtless tough as leather from years of outdoor work
in all sorts of weather; moreover, it was heavily bearded and, as yet, showed
no mark. Childress was already bleeding in a couple of places from
scraping blows which he had not been able altogether to avoid.

The sergeant had no "war" with the Swede. Could he have ended the
futile contest by clinching and crying enough, he would have been tempted
to do so for the sake of his mission. But, remembering Larsen's threat to
finish him, he dared not risk putting himself under such disadvantage.

In the early days of his service with the Scarlet, when on detachment
assignment with the end-of-rail crews that were building the Grand Trunk
Pacific through the forests of British Columbia, he had witnessed rough-
and-tumble bouts in logging camps, although this was his most active
participation in one. Always the uniform had prevented his entry, even if he
had been so inclined. Generally the crowd stepped in before the last breath
had been crushed from the vanquished, and when the onlookers held back
he had ordered festivities to cease. Twice within his knowledge, when he
had been elsewhere, the crowd had waited too long and murder was the
ugly result. In this rough-shod mill, he could not interfere.

His best chance seemed to lie in wearing down the self-crazed giant,
then driving home a blow to chin or temple that would force a respite in
which he might explain that the black-eyed Delores was nothing of interest
in his clam-shell life. Childress began to spar with caution, playing for the
logger's wind whenever he was within reach, but chiefly engaging himself
in keeping out of the way.

As the minutes passed with no call of time, the sergeant's plan of

campaign seemed to be succeeding. Larsen's breathing sounded like the
wheeze of a bellows. If he knew anything of reserve, the logger was too
angry to apply the knowledge. Evidently feeling the pace telling on him, he
tore at the neck of his shirt with one hand, ripping off the buttons until there
was exposed a chest as hairy as that of an ape. Then he rushed the harder.
Long since he had abandoned the invective of his adopted English for what
were probably more weighty curses in his mother tongue.
 The sentiment of the onlookers at first had been with the Swede, but this
now showed division. The loggers, pressed against the wall of the dance
room that the fighters might have all the room they needed, were still with
Larsen. But the stranger's game battle against odds of height, reach and
weight was winning him supporters among the outlaw group at the open
doorway. They did not hesitate to ejaculate pithy advice and
encouragement.

Then suddenly, Larsen showed himself still capable of thought. Having

edged toward the on-lookers, he lurched and seized a stool which had been
vacated to give room. This he spun along the floor, torn and splintered by
the spikes of countless boots, toward his advancing opponent. Catching
Childress at the knees, it tripped him to a heavy fall. Lunging toward him
came the Swede.

Objection from the outlaw spectators showed in a forward press, gasped

invective and Bart Crowe's shouted warning:

"Look out there, he means to calk you!"

Already the angry jack's purpose showed in the lift of one spiked, heavy
boot. Childress realized that there was not a second to spare.

Larsen meant to calk him—the most dreaded punishment of the West

woods! In the thought flashes that come in moments of stress, he
remembered men who had suffered the torture and lived through its years of
after horror, with cheeks and forehead pitted as from disease, noses
flattened, lips punctured—even with eyes gouged out.

The spiked boot was above his head now, about to be ground down into
his face. He never had thought much of his looks, but he couldn't endure to
be a horror to all who, perforce, should have to notice him.

There entered in a determining thought-flash. Flame of Fire Weed was

the whole of it. All of a sudden he realized that he loved the ranch girl. For
her, whether he won or lost her, he must save such personal appearance as
he had. Thank Heaven that he had a gun—that, although loath to draw it,
never had he been beaten in point of time thereto, once his mind was made
up. It was now—for Flame!

All in the same flash with his realizations, his gun hand had gone to his
hip, his fair warning had been lifted.

"Take care, boozo—I've got you covered!"

The pause gained by his boast was only the length of a breath, of a look.
His hand was empty—had failed to find the trusty Colt where it should have
been stalled in his hip holster!

A rasped curse from the Swede sounded like the breath of an Arctic
winter storm, the sort of storm he had become familiar with on his last long
detail in the North.

The boot studded with calks descended, and the end—the unspeakable
end—was near.

But in the fraction of the last second a fury of denial moved the
seemingly helpless man upon the splintered floor. The vivid remembrance
of Flame Gallegher, freckled nose, fiery hair, had something to do with it.

"Not me; not me!" shrieked his primal appetence—his will to live.

With all the power conserved in him by years of trouble service, he

threw up the arm that had reached in vain for his gun and took the Swede's
tread square, without a whimper, although the pain was beyond experience.

The spikes cut into his forearm, snagging the flesh to the bone.
Borrowing strength from the very torture forced upon himself, he gave an
upward heave that forced him to a sitting posture and toppled Larsen to a
fall.

How long Childress lay in a faint he never knew, for he forgot to ask.
The only detail that mattered when he at last came to was that his agonizing
effort had ended the fight. In falling backward, the logger had crashed his
head against a corner of the "tin" piano and already had been carried out to
sleep it off under the trees.

"And if he never comes out of it—the trance," said Crowe, "there won't
be any crepe hanging on the front door of the Nest."

"You said some words, brother!" This from Delores, who had been
ministering to the sadly punctured forearm. "I'll take him to my cabin for I
guess I won him."

"What the hell did you do?" demanded the peg-leg crook.

Childress awoke—otherwise returned to consciousness. He took a look

at his arm before they put upon it an antiseptic salve that any road house,
used to spearing fights, keeps behind the bar. Then he did shudder at what
he had escaped. Would Flame, little Flame with the delicious freckles across
her nose—would she ever have looked at him again had he come back to
her with the logger's mark all over his face? Of course, she would have
scorned him!

Came forward then the violinist of the two-piece orchestra. He held out
something that Childress had missed at a vital moment.

"Didn't it fall out of your holster when he tripped you with that stool?"
asked the dope artist. "When you were heeled with all of that, me friend,
why didn't you pull it sooner?"

"Never draw unless necessary," said Childress, wondering how the gun
had torn loose.

"And then," declared the pasty-faced musician, "necessity ain't what it

used to be!"

The sergeant was himself again. The arm still pained, but he was inured
to pain. But there was a new sort of trouble in the immediate offing—
Delores.
 "You'll come to my cabin," she said, as if with authority. "I know what's
good for all that's happened to you, horse thief."

"Horse thief?" he asked, forgetting for the moment.

"Your forehead!" exclaimed the dark-eyed sister of trouble. "I don't

mind. My only husband was one and they strung him up down Missoula
way. You come with me."

Childress had no intention of going with the girl, either to her cabin or
to any other. Even had he not been a clean-living soul there must have
intervened that early-morning meeting with Flame Gallegher.

"It can't be done, sister," he said, offering a smile for her interest.

"But it was my fault—I got you into the mess," she protested.

"And I got out of it with small damage," he returned cheerfully. "You'd

better see what you can do for our logger friend. That crack he gave his
head when I threw him might well mean more than a headache to-morrow."

"To hell with——"

Having listened to the colloquy, and realizing from the text thereof that
the stranger was no ordinary philanderer, Bart Crowe stepped in with all the
authority that is rested in the proprietor of an outlaw joint.

"Here you, Delores, take your damn logger to your own cabin," he said
harshly. "You've made trouble enough for one afternoon. Mr. Childress is
going to be my guest until he decides what he wants to do, who, with and
when. Did you get that?" And he called her a name which is too descriptive
for the printed page, no matter how much she may have deserved it.

Thus Sergt. Childress of the "Royal" won his spurs in the most
notorious outlaw camp which the States still permits. After a supper with
the "bunch," about the board at which he was freely toasted over his escape
from the "logger's curse," he rented a cabin of his own and took possession,
accepted fully as a horse rustler and a man who could take care of himself
whatever the odds.

CHAPTER XXIII.

COMING A CROPPER.

Clothes, summer clothes—or rather the lack of them had taken Ethel
Andress to Strathconna a few days after Childress departed on his Montana
visit. Her uncle, the devoted old major, had gone with her, leaving Tom
Fitzrapp in charge of the ranch and outfit. None of them knew of their
neighbor's departure, or they might not have been so confident that rustling
had been halted for a time, at least.

But before Ethel was through with her dressmaker a strange foreboding
of range trouble harassed her. Not that any disturbing news had come from
Fitzrapp, as should have been the case in the event of any unwonted
happening at the ranch. Major MacDonald tried to argue against a hurried
return to the Rafter A. Hadn't the horse bands been driven to the upper
ranges, where they must be safe? But the fair owner's whim persisted. After
they had arrived at the nearest railroad station and retrieved their buckboard
team from the livery barn, she had crowded the horses over the home trail.

Old Man Cuss alone greeted the returning owner and her nearest
relative when the team finally had covered the prairie miles. His face was
always gloomy, so his expression told nothing.

"Everything all right on the range, Darned?" asked the widow as she
unbuckled the reins and flung one to either side.

"Mostly," returned the home guard.

"Where is Mr. Fitzrapp?" she inquired.

 "Up to the house, nursin' a hurt arm."

Both Mrs. Andress and the major knew Cuss's disinclination to waste
any more language than was absolutely necessary. Leaving the steaming
team to his mercies, they hastened their steps toward the ranch house. There
they found the handsome manager stretched out on a couch in the living-
room, his left arm in a sling. Ethel hurried to him anxiously.

"What in the world has happened to you, Tom?" she asked in a voice
replete with sympathy.

"I came a bad cropper, Ethel, and, of course, at a decidedly inconvenient

moment," returned Fitzrapp gloomily. "I'm more worried about the loss to
you than about anything physical that has happened to me. I ought to be
fired for the mess I've made of things."

Woman-like, she scorned interest in her own misfortune until she had
satisfied herself about his physical one. "Arm broken?" she asked.

The major had thrown off his coat and now approached with the semi-
professional air of one skilled by long practice in the crude surgery of the
plains, where operations from bringing children into the crowded world to
necessary amputations generally are conducted without aid of an M.D.

"Oh, don't make such a fuss over me," said Fitzrapp, gesturing lightly
with his free arm. "The wing's only sprained, I guess; I can move my
fingers."

The major made a hurried but thorough examination, proving to his

satisfaction that no bones were broken, and deciding, from the absence of
inflammation, that the injury was trifling.

"That arm needs a good rubbing more than a sling," was the
unprofessional verdict delivered, but not unkindly. "Shook you up some
when you lit, I reckon. How came it?"

"Yes, how came it, Tom—and what's the new loss? I had a hunch up in
'Conna that I was in for one."
 "I've been an awful fool, folks," said Fitzrapp, his face showing a
disinclination to recite the details. "If you want to kick me out for this
blunder you won't hear a whimper, for I deserve it."

The explosion which the younger man seemed to fear from this forecast
of disaster and failure did not follow. With a control that was at variance to
past bursts of temper, MacDonald drew up a chair, and his niece, the real
loser, still worried over the super-employee's physical condition, stood near
by.

"It'll never be a case of kick-out, Tom," said the widow, who never was
more attractive than when smiling under difficulties. "How many did they
get this go?"

"Thirty-odd of the two-year-olds," murmured Fitzrapp.

"The racing stock," grunted the major. "Damn them!"

"Almost out of our front yard, too. The nerve of them! Did they leave
Mrs. Cuss the kitchen stove, or was it too hot to move?" This came from
Ethel, at last aroused to anger.

But Fitzrapp had more in the way of news. "And—and they stole
Canada, Ethel!" He called out this startling addendum with an agony of
voice that reflected his great affection for the splendid black stallion.

For a moment both Ethel and her uncle sat speechless. The fleet-footed
Canada was Fitzrapp's personal property, but that did not lessen their keen
regret. They fairly boiled with indignation at this crowning outrage, for the
horse must have been taken from his box stall in the stable behind the ranch
house.

"Wonder they didn't take the porch chairs while they were about it,"
blazed the major. "Let's have the whole story, Tom."

"If I hadn't been a blooming, blasted idiot," was Fitzrapp's halting start;
"if Duncan O'Hara hadn't been in league with the cut-throat band from the
States——"
 "Dunc O'Hara!" interrupted the major. "Where in hell is that rascal? He
didn't show up at the stables when we drove in."

"O'Hara is gone, Major—departed with Canada and the two-year-olds!"

Ethel took this shock stoically; asked Fitzrapp to begin at the beginning
and forget the if's.

Fitzrapp pulled himself up on the couch, as though to brace himself for

a distressing ordeal, and obeyed.

After the departure of Mrs. Andress and her uncle there had been
several quiet days, according to Fitzrapp's account. Then O'Hara had come
to him with a report that Childress had left his small ranch on the silver
stallion, leaving his man, the silent Mahaffy, in charge. O'Hara had
interviewed the Irishman that afternoon and reported him about as
communicative as a clam. After dinner that evening, Fitzrapp had discussed
the rustling with the head buster; had outlined Ethel's plan of baiting the
lower range and then falling upon the thieves in force sufficient to crush
them.

Then it was that Duncan O'Hara had broached a daring plan. He had
reminded Fitzrapp that they were both more or less in the fair owner's bad
graces for their failure at the ford. The disgrace of that could be wiped out
and their characters restored for the future by baiting the lower range
themselves and cutting down the raiders from ambush. In case any escaped
their pot shots they would have their speediest mounts in reserve and go
after them for a fight to the death. O'Hara had declared that he would rather
be dead than live under a cloud of cowardice.

Fitzrapp mentioned his own chagrin over his previous failures, and said
that the plausible buster had finally convinced him that they could turn the
trick. They had then cut out between thirty and forty of the best two-year-
olds and driven them to the lower range with the aid of a couple of Indian
herders. To be certain that there could be no escape, Fitzrapp had ridden
Canada as the fastest horse on the ranch. Duncan O'Hara had seemed
content with the star-faced half-breed that was his regular mount.