It was argued in Section 18.2 that, if taxes are distortionary, the best policy for regulating a natural monopoly has three components:

• If the monopoly incurs a loss, the government should collect extra tax revenue to cover the loss.

• If the monopoly earns a profit, the government should appropriate the profit and reduce the revenue raised through taxation by an equal amount.

• The pricing of the monopoly's output involves a trade-off. As the price rises above marginal cost, fewer units of the monopoly's good are purchased, and less consumer surplus is generated in the monopoly's market. However, the monopoly's profits rise, so less revenue needs to be raised through distortionary taxes. The decline in the welfare cost of the tax system means that more surplus is generated elsewhere in the economy. The regulator should choose the price that maximizes total surplus.

The model on which this policy was based neglects the role of management. Energetic and effective management will be reflected in lower costs, while lax management will result in higher costs. But if management is important, the policy described above is unlikely to be optimal. Why should the managers strive for greater profits, if profits are appropriated by the government? Why should they avoid losses, if losses are automatically covered by the government?

If the regulator can directly observe the managers' behaviour, the answer to these questions is easy: the regulator can induce the managers to work efficiently by punishing lax behaviour.