Lecture 7 – Regulation Flashcards
What are the characteristics of a natural monopoly?
• “A natural monopoly is a monopoly created and sustained by economies of scale over the relevant range of output for the industry”
• If industry profits are strictly positive with one firm operating and strictly negative with two firms the industry is a natural monopoly
• Arises when producing the goods involves large fixed costs and relatively small variable costs, due to the resulting economies of scale
➢ It is most efficient to concentrate production in a single firm
What price is the welfare optimal?
p = MC (Marginal cost)
What is minimum efficient scale (MES)?
• The minimum efficient scale (MES) is an indication for the likelihood of monopolistic industry structure arising
• The MES is the smallest amount of production a company can achieve while still taking full advantage of economies of scale with regards to supplies and costs.
• The MES is equal to the output level which minimizes the average cost
How to know if a a market is monopolistic or not based on the MES?
• MES is much smaller than demand at minimum AC
➢ Market is able to support a large number of competitors
• MES is comparable to demand at minimum AC
➢Market cannot support two profitable competitors
What are the different ways/ policy options to deal with natural monopolies?
- Socialization
- Average cost pricing (“Second-best”)
- Licensing
- „Let it be“
Describe socialization as a method to deal with natural monopolies?
• Regulation that sets p = MC: welfare-optimal
• Losses are covered by subsidy
Long-term cost-efficiency and innovation may be seriously crippled (bureaucrats)
Describe Average cost pricing (“Second-best”) as a method to deal with natural monopolies?
• Operate at p = AC (Average Cost): higher than welfare- optimal price
• Firm breaks even, no subsidy required
• Firm benefits from short-term cost savings
Complicated and non-transparent rate negotiation process to determine AC (information asymmetry)
Describe licensing as a method to deal with natural monopolies?
• Operate at p = MR (Marginal Revenue): higher than AC (Average Cost)
• Society profits from monopoly rent in the form of license payments
• Incentives for operational efficiency are preserved
Inefficient price and output choice can create substantial welfare loss; long-term licensee can dominate licensing process (self-fulfilling prophecy)
Describe „let it be“ as a method to deal with natural monopolies?
• Operate at p = MR (marginal revenue)
• Incentives for both entrepreneurial activity and operational efficiency are preserved
Inefficient price and output choice can create substantial welfare loss; society does not profit from
Would you characterise power generation as a natural monopoly and why?
• High fixed costs for conventional power plants, but still there is no limit to just one profitable company
• Lower fixed costs for renewables
• Few entry barriers
• MES is much smaller than the demand at minimum average cost ➢ Competitive market
Would you characterise power distribution as a natural monopoly and why?
• Distribution activity boils down to marketing, which has few entry barriers ➢ Competitive market
Would you characterise grid operation as a natural monopoly and why?
• High fixed costs, low marginal costs of serving the customer
• Only one grid can capture the economies of scale in a given region
• MES is close to demand ➢ Natural monopoly
What is the typical choice for public service industries (e.g. power grids) to deal with natural monopolies?
Average cost pricing (“second-best”)
What is the typical choice in innovative and dynamic industries (e.g. software) to deal with natural monopolies?
“Let it be”
What is market power?
• A firm exercises market power when it reduces its output or raises the minimum price at which it is willing to sell output (its offer price) in order to change the market price
− Firm risks to sell less, but raises price
− Profitable because the gain in profit by selling all the output (after the market price is
increased), is greater than the loss it faces by selling fewer units (if that occurs)
