6- Regulatory Economics, Natural Monopoly Flashcards
Define Regulation
Government imposed limitation on the behaviour of individuals or organizations
What are the 2 major classes of regulatory tools?
-Cost of service/Rate of return (RoR) regulation
-Incentive regulation
Describe Cost of service/Rate of return regulation
Costs are always reimbursed. Historical, entrenches inefficiencies as firm has no incentive to reduce costs.
What are the 3 main types of Incentive regulation?
-Sliding price caps
-Franchise bidding
-Yardstick competition
Describe Sliding price caps
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
Describe Franchise bidding
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.
Describe Yardstick competition
Use independent but comparable firms as benchmarks
What is a Natural monopoly?
Market best served by a single firm: demand is small relative to minimum efficient scale, industry 𝐴𝐶
is minimized when single producer
What is a Natural oligopoly?
An oligopoly structure minimizes industry 𝐴𝐶
What typically constitutes Natural monopolies/oligopolies?
Industries with enormous fixed costs e.g. Telephone networks, Public transport
What are Scale economies?
Producing more, firm can lower average cost
What are Scope economies?
Firm produces two (or more) products cheaper than two (or more) firms
What is a sufficient condition for Scale economies?
When AC is strictly decreasing one firm minimises costs instead of 2 firms each having demand intersecting higher up the curve
What is a Necessary condition for Scale economies?
Subadditive in relevant part of cost function, AC may be increasing but is still a lower envelope than with 2 firms
What state is the market in when q < qᵐᵉˢ?
Increasing returns, firm is a natural monopoly,
because two firms would produce same output at higher cost
What state is the market in when qᵐᵉˢ < q < qᴺᴹ?
Subadditivity C(q₁ + q₂) < C(q₁) + C(q₂)
What state is the market in when q > qᴺᴹ?
Natural duopoly
What are the 2 dilemmas faced by social planners in a Natural Monopoly?
-Competition leads to cost inefficiency: natural monopoly is productive efficient (produces at lowest cost)
-Monopoly leads to allocative inefficiency: deadweight loss.
What is the fundamental regulatory mission?
Cost and allocatively efficient outcomes
What are 3 main difficulties in regulation?
-Welfare rankings can differ in theory and practice
-Asymmetric information between regulator and firms
-Difficult to provide incentives (e.g. for cost reduction)
What is First best welfare ranking?
Maximises welfare, usually marginal cost pricing
What is Second best welfare ranking?
“Next best”, i.e. maximises welfare, subject to some constraints. e.g. Ramsey pricing
What is Ramsey pricing?
Regulator sets price such that it maximises total surplus subject to the firm breaking even
How is First best outcome implemented in practice?
-Set price equal to marginal cost P*=MC
-Subsidise the firm to breakeven by taxing consumer surplus to compensate for loss F
Why is total welfare greater under First best compared to Second best?
Firms make zero profits in both cases but consumers are better off under First best
What is the main practical problem of First best?
Subsidy must be paid from taxes and taxing is often inefficient; transferring money from consumers to firms is not costless
Briefly outline why Asymmetric information makes price control difficult to implement
Regulator must observe both demand and cost however the firm has an incentive to exaggerate its costs
Briefly outline how mechanism design works
Regulator announces its mechanism asking firm to report its cost ĉ from which it can charge p(ĉ) and be subsidised s(ĉ)
What are the 2 conditions regulators must meet to induce firms to report true cost?
-Incentive compatibility (IC)
-Participation constraint (PC)
Describe Incentive compatibility (IC)
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)
Describe Participation constraint (PC)
Firm must make at least non-negative profits
0 ≤ π(c; c)
What are the 2 marginal costs firms may have?
Firms may have high marginal costs c̄ or low marginal costs ⊆
What is the profit function of a firm in this model?
π(ĉ; c) = [p(ĉ) - c][a - p(ĉ)] + s(ĉ)
What is the result for price of a mechanism satisfying IC & PC?
True costs are reported so price accurately reflects them:
p(ĉ = c̄) = c̄
p(ĉ = ⊆) = ⊆
What is the result for subsidy for a mechanism satisfying IC & PC?
Efficient firm has higher subsidy s(⊆)>s(c̄)
What is the intuition behind the range a subsidy can be?
Difference between subsidies cannot be too small otherwise efficient firms would exaggerate cost, cannot be too large otherwise inefficient firms would downplay cost
What is the expression for a subsidy’s range?
(c̄ - ⊆)(a - c̄) ≤ s(⊆) - s(c̄) ≤ (c̄ - ⊆)(a - ⊆)
Why does the mechanism not maximise consumer surplus?
Firm makes a profit from the subsidy (informational rent)
