Chapter 2 – Economic Concepts of Regulation

• Public Utility – for-profit firm whose operations were strictly controlled so as to not jeopardize the public interest– Controlled by• Who enters/exits• Extent and quality of service• Prices charged• “obligation to serve” all customers

Chapter 2 – Economic Concepts of Regulation

• Who was controlled: • electricity• natural gas• grain elevators• railroads• stockyards• water suppliers• telephones• banks• airlines• dairy producers

• Controlled firms were guaranteed a certain rate-of-return on the cost of operating and investments

Theory of Regulation

• Mimic a competitive market outcome, even when the underlying market is not competitive.

• Reality is that regulators may have other goals– Environmental and renewable concerns– Providing service everywhere– Keeping transmission lines and generators from

locating in certain areas to keep property values high

Model of Perfect CompetitionP P

Q Q

P*

Individual Firm Competitive Market

AC1

MC1

QF QM

S=∑MC

D

Consumer and Producer SurplusP

Q

P*

Competitive Market

QM

CS

PS

S

D

V=CS+PS

Imperfect Markets

• Imperfect Markets occur because of– Natural monopoly– High barriers to entry

• Definition of a Natural Monopoly– Demand falls on decreasing AC curve– Economics of Scale– Economies of Scope

Natural MonopolyP

QQM

ACMC

D

Reasons for regulation

• Nature of natural monopoly (we want to capture economies of scale and scope)

• Competition difficult given that the nature of the industry requires the company to hold excess capacity most of the year

• High barriers to entry/exit– Large initial capital investments– Costs borne by new firms but not incumbent firm

2.1 Natural Monopoly in the Single-product Firm

Two concepts are fundamental for our understanding of single-product natural monopolies:

Decreasing Average Cost: unit costs fall with increases in output.

Subadditivity: A firm with rising unit costs is able to produce a given level of output at a lower total cost than multiple firms if its cost function is subadditive.

Decreasing Average Cost and Subadditivity

• A decreasing average cost for all positive output less than or equal to q can then be expressed as (2.1) C(qi)/qi < C(qj)/qj

for all qi and qj , where 0 < qj < qi ≤ q. - C(q) is the firm’s continuously differentiable cost function. - q is a measure of the firm’s output.

This condition is sufficient to ensure that production costs will be lowest when there is a single firm supplying the output, but not necessary.

• Subadditivity has a cost function at q if and only if (2.2)

for all quantities q1 ,………. qm such that ∑i=0m qi = q.

This condition is necessary and sufficient to ensure that costs will be lowest when there is a single supplier.

m

i

i

m

i

i qCqC11

)()(

Where 0 < qi <q, i= 1,….,m, and . In turn this can be written as

And summing both sides over all i yields

Which is the definition of strict subadditivity.

Equation (2.1) implies (2.2), however, (2.2) does not imply (2.1)

q

qC

q

qC

i

i )()(

qqm

i

i 1

)()( qCq

qqC

ii

)()()( 1

1

qCqCq

qqC

m

i

im

i

i

Total Cost

C(q)

q q′ qo o

A

B

Price setter vs. price taker P

QQM

DWLMC

D

MR

Q*

P*

PM

One Regulatory Solution: Average Cost Pricing

P

QQ*

ACMC

D

QM

MR

DWL

PM

QAC

PAC

P*

Definition of natural monopoly

• Strong natural monopoly satisfies (2.1)• Weak natural monopoly satisfies (2.2) but not

necessarily (2.1) over the relevant range of q

2.2 Regulation for the single-product firm• Social Planner Max W = CS + π q Where π = p(q)q – C(q) and p(q) is the inverse market-demand function.

The first order necessary condition from this maximization problem yields a price equal to marginal cost, or

p(qw) = C‘(qw)≡ MC(qw) The prime indicates a derivative, and qw is the output produced

and sold.

q

qqpdxxpCS0

)()(

• If the firm behaves as a profit-maximizer, then the monopolist will simply maximize the profit. The calculation will yield a price that satisfies

MR(qm)≡ p(qm ) + qmp‘(qm ) = C' (qm ) ≡ MC (qm )

where qm is the profit-maximizing output, and primes indicated derivatives. This process yields similar result that marginal revenue equals marginal cost.

Figure 2.2 The monopoly and the welfare-maximizing outcomes

$

p(q)

MRR

MC

AC

p(qm)

p(qw) y

b

a

q

c

qm qw

g

f d

e

x

Other Complicating Factors• Measuring actual costs• Firms produce multiple goods/services, which makes

pricing complex• Multiple goods in multiple markets (regulated and

unregulated)• Viewed as convenient wealth redistribution to give

lower rates to low income citizens, but this complicates the rate structure and who shares what burden of the cost

• RPS – changes the structure of cost curves• Reliability is a public good

Additional Issues

• High Upfront Capital Costs => who should pay the costs intergenerationally?

• To obtain investors, firms must be able to capture some return of their capital investments. Otherwise, there would be no incentive to invest

• Some argue that demand is on the increasing side of the AC curve

Monopoly Power

• Monopoly Power measured by– Market share– Contestability- the ease of entry/exit of other

firms in the market (for example, garbage collection has small contestability)

• The challenge of regulating the price of a natural monopoly is setting a price so the firm recovers cost, but also produces the competitive market amount

Alternative Regulatory Policies

• If regulation induced no inefficient response by firms in terms of input-mix distortions, the gains to regulation would depend on three factors:

1, The extend of the resource misallocation in the absence of intervention (often accompanied by large profit).

2, The existence of barriers to entry into the market.

3, whether the firm is a strong or weak natural monopoly.