036- Public Good Aspects of TARGET: Natural Monopoly, Scale Economies, and Cost Allocation

DNB Working Papers
Date 29 April 2005
This paper discusses various theoretic concepts which play a role in assessing the public benefits of Target, the large value RTGS payment network operated by the Eurosystem. These concepts touch upon natural monopoly, network externalities, competition and contestability, as well as economies of scale and scope. Based on empirical results for the Federal Reserve’s payment system (Fedwire), it is argued that if Target decided to standardize its operating platforms and consolidate its processing sites into one or a few centers, it too could realize strong scale economy benefits and lower unit costs. The main thrust of the paper concerns natural monopoly and the possibility of lowering unit payment processing cost via economies of scale. The existence of a natural monopoly provides a rationale for a temporary partial or full subsidy in order for Target to achieve the ‘most efficient scale’ or apply the most efficient technology to lower unit costs. Such a subsidy could be implemented through temporary 'penetration' pricing (i.e., pricing at less than full current cost). When the lower costs are realized, the subsidy would be removed and full cost pricing implemented. Once users face the full costs of their payment decisions, they are better able to match benefits with actual costs and implement a more efficient allocation of payment resources than occurs today on Target. Key words: public good, natural monopoly, most efficient scale, partial subsidy JEL codes: G20, H41, L10