 natural monopoly. A given industry is said to exhibit natural monopoly characteristics if the cost function derived from the underlying technology is subadditive, that is, if a single firm can supply the entire market at lower cost than could two or more firms. If the technology of local telephone service were to exhibit natural monopoly characteristics, then a single firm could construct and operate that network at a lower cost than could two or more firms. Multiproduct cost functions are said to exhibit natural monopoly characteristics if and only if the cost function derived from the underlying technology is subadditive across products. That is, cost functions exhibit natural monopoly characteristics when the costs incurred by a single firm producing the entire set of products are less than the costs that would result if the same production were divided between two firms. The existence of a natural monopoly does not necessarily preclude competitive entry, however. For example, even if a particular telecommunications technol- ogy were to exhibit natural monopoly characteristics, providers could still achieve efficient retail prices if they were required to compete through periodic auctions for the right to serve the market. 12 Moreover, proponents of contestability theory (introduced in Chapter 4) have demonstrated that SO long as entry and exit are easy, the potential for new entry can drive prices toward competitive levels even if 11 For our initial discussion of entry barriers, see Chapter 4. 12 Demsetz (1968); Posner (1972); Zupan (1989). But see Williamson (1976) challenging Posner's proposal. Pricing of Access to Networks the technology makes it most efficient for a single firm to serve the entire market (Baumol et al. 1982). Thus, even if the incumbent firm prices at cost, there will still be situations in which it cannot set a price that sustains its position against entry. Moreover, natural monopoly technology need not impede competition, because the technology of entrants can differ from that of incu