L24: Regulation

Question 1

why regulate?

Answer 1

allocative efficiency
- social marginal benefit of marginal unit = social marginal cost

rationing efficiency
- output distributed to consumers with highest WTP

cost efficiency
- output produced at the minimum feasible cost

efficient product selection
- set of products in the market is socially efficient, no inefficient entry

efficient cost reduction
- social marginal benefit of cost reducing investments = social marginal cost

Question 2

natural monopoly

Answer 2

industry is a natural monopoly if the cost function is subadditive
- cost of a single firm producing everything is smaller than the cost of smaller firms producing a portion of the output

result of EOS
- strong natural monopoly where EOS is not exhausted

Question 3

alternatives to regulation of monopolies

Answer 3

auction monopoly rights
- WTP will be monopoly rents

contestability
- hit-and-run entry limits rent
- sunk costs limit entry

Question 4

peak-load pricing

Answer 4

demand for public utilities often variable over short periods of time

dynamic pricing allows for welfare maximisation, taking into account that we have to pay for empty capacity off-peak

Question 5

how does peak-load pricing improve welfare?

Answer 5

lower off-peak price increases consumption relative to uniform price
- marginal units have lower marginal cost than WTP

higher peak price reduces consumption relative to uniform price
- marginal units have higher marginal capacity cost than WTP

Question 6

cost-of-service regulation

Answer 6

reimburses firm for costs + reasonable rate of return on investment
- essentially set price equal to AC+

Question 7

concerns with cost-of-service regulation

Answer 7

poor incentives for cost efficiency
- prices increase with costs so limited incentives for efficiency

insufficient incentives for new products and innovative services
- limited incentives to introduce cost-saving innovations

regulatory burden
- costly to gather information

Question 8

incentive regulation

Answer 8

response to shortcomings of cost of service regulation

leading example is price-cap regulation
- prices paid to the firm are capped and adjusted by formula

Question 9

concerns with incentive regulation

Answer 9

induces allocative inefficiency if there is cost uncertainty
- induces excess demand and rationing if price cap is too low

incentive to eliminate products and reduce service quality
- firm seeks to reduce costs, possibly at the expense of consumer welfare

threat of tightening cap may deter innovation
-discourages firms to increase efficiency