6- Regulatory Economics, Natural Monopoly

Question 1

Define Regulation

Answer 1

Government imposed limitation on the behaviour of individuals or organizations

Question 2

What are the 2 major classes of regulatory tools?

Answer 2

-Cost of service/Rate of return (RoR) regulation
-Incentive regulation

Question 3

Describe Cost of service/Rate of return regulation

Answer 3

Costs are always reimbursed. Historical, entrenches inefficiencies as firm has no incentive to reduce costs.

Question 4

What are the 3 main types of Incentive regulation?

Answer 4

-Sliding price caps
-Franchise bidding
-Yardstick competition

Question 5

Describe Sliding price caps

Answer 5

Price is fixed for a period, firm can increase profits by reducing cost, price is revised to reflect new (lower) cost, firm has an incentive to reduce costs again, etc

Question 6

Describe Franchise bidding

Answer 6

Firms bid for (monopoly) right to provide service. Firms know true potential cost, hence expected profits. If auction is competitive, they will bid the maximum for franchise, i.e. all their expected profits.

Question 7

Describe Yardstick competition

Answer 7

Use independent but comparable firms as benchmarks

Question 8

What is a Natural monopoly?

Answer 8

Market best served by a single firm: demand is small relative to minimum efficient scale, industry 𝐴𝐶
is minimized when single producer

Question 9

What is a Natural oligopoly?

Answer 9

An oligopoly structure minimizes industry 𝐴𝐶

Question 10

What typically constitutes Natural monopolies/oligopolies?

Answer 10

Industries with enormous fixed costs e.g. Telephone networks, Public transport

Question 11

What are Scale economies?

Answer 11

Producing more, firm can lower average cost

Question 12

What are Scope economies?

Answer 12

Firm produces two (or more) products cheaper than two (or more) firms

Question 13

What is a sufficient condition for Scale economies?

Answer 13

When AC is strictly decreasing one firm minimises costs instead of 2 firms each having demand intersecting higher up the curve

Question 14

What is a Necessary condition for Scale economies?

Answer 14

Subadditive in relevant part of cost function, AC may be increasing but is still a lower envelope than with 2 firms

Question 15

What state is the market in when q < qᵐᵉˢ?

Answer 15

Increasing returns, firm is a natural monopoly,
because two firms would produce same output at higher cost

Question 16

What state is the market in when qᵐᵉˢ < q < qᴺᴹ?

Answer 16

Subadditivity C(q₁ + q₂) < C(q₁) + C(q₂)

Question 17

What state is the market in when q > qᴺᴹ?

Answer 17

Natural duopoly

Question 18

What are the 2 dilemmas faced by social planners in a Natural Monopoly?

Answer 18

-Competition leads to cost inefficiency: natural monopoly is productive efficient (produces at lowest cost)
-Monopoly leads to allocative inefficiency: deadweight loss.

Question 19

What is the fundamental regulatory mission?

Answer 19

Cost and allocatively efficient outcomes

Question 20

What are 3 main difficulties in regulation?

Answer 20

-Welfare rankings can differ in theory and practice
-Asymmetric information between regulator and firms
-Difficult to provide incentives (e.g. for cost reduction)

Question 21

What is First best welfare ranking?

Answer 21

Maximises welfare, usually marginal cost pricing

Question 22

What is Second best welfare ranking?

Answer 22

“Next best”, i.e. maximises welfare, subject to some constraints. e.g. Ramsey pricing

Question 23

What is Ramsey pricing?

Answer 23

Regulator sets price such that it maximises total surplus subject to the firm breaking even

Question 24

How is First best outcome implemented in practice?

Answer 24

-Set price equal to marginal cost P*=MC
-Subsidise the firm to breakeven by taxing consumer surplus to compensate for loss F

Question 25

Why is total welfare greater under First best compared to Second best?

Answer 25

Firms make zero profits in both cases but consumers are better off under First best

Question 26

What is the main practical problem of First best?

Answer 26

Subsidy must be paid from taxes and taxing is often inefficient; transferring money from consumers to firms is not costless

Question 27

Briefly outline why Asymmetric information makes price control difficult to implement

Answer 27

Regulator must observe both demand and cost however the firm has an incentive to exaggerate its costs

Question 28

Briefly outline how mechanism design works

Answer 28

Regulator announces its mechanism asking firm to report its cost ĉ from which it can charge p(ĉ) and be subsidised s(ĉ)

Question 29

What are the 2 conditions regulators must meet to induce firms to report true cost?

Answer 29

-Incentive compatibility (IC)
-Participation constraint (PC)

Question 30

Describe Incentive compatibility (IC)

Answer 30

Regulator must choose price and subsidy such that firm has an incentive to report its true cost, when it’s a high-cost and when it’s a low-cost producer
π(ĉ; c) ≤ π(c; c)

Question 31

Describe Participation constraint (PC)

Answer 31

Firm must make at least non-negative profits
0 ≤ π(c; c)

Question 32

What are the 2 marginal costs firms may have?

Answer 32

Firms may have high marginal costs c̄ or low marginal costs ⊆

Question 33

What is the profit function of a firm in this model?

Answer 33

π(ĉ; c) = [p(ĉ) - c][a - p(ĉ)] + s(ĉ)

Question 34

What is the result for price of a mechanism satisfying IC & PC?

Answer 34

True costs are reported so price accurately reflects them:
p(ĉ = c̄) = c̄
p(ĉ = ⊆) = ⊆

Question 35

What is the result for subsidy for a mechanism satisfying IC & PC?

Answer 35

Efficient firm has higher subsidy s(⊆)>s(c̄)

Question 36

What is the intuition behind the range a subsidy can be?

Answer 36

Difference between subsidies cannot be too small otherwise efficient firms would exaggerate cost, cannot be too large otherwise inefficient firms would downplay cost

Question 37

What is the expression for a subsidy’s range?

Answer 37

(c̄ - ⊆)(a - c̄) ≤ s(⊆) - s(c̄) ≤ (c̄ - ⊆)(a - ⊆)

Question 38

Why does the mechanism not maximise consumer surplus?

Answer 38

Firm makes a profit from the subsidy (informational rent)