Externalities - University of Victoriaweb.uvic.ca/~pcourty/Chap12-15.pdfExternality: Benchmark...
Transcript of Externalities - University of Victoriaweb.uvic.ca/~pcourty/Chap12-15.pdfExternality: Benchmark...
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Externalities
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Shopping MallsShopping Malls
Anchor stores: average monthly rent $4.13 per square foot
Specialty stores: average monthly rent $29.37 per square foot
Why the disparity?
2(c) 1999-2007, I.P.L. Png & D.E. Lehman
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OutlineOutlineOutlineOutline
externality resolving externalitiesg network effects & externalities public goods public goods technology
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Externality: BenchmarkBenchmark
Definition: An externality is when one party directly conveys a benefit (positive) or cost (negative) to others
Economic efficiency: collective marginal benefit = collective marginal cost Presence of externality implies the relevant
market does not exist hencemarket does not exist, hence Collective marginal benefit not equal to
collective marginal cost
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collective marginal cost
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Externality:U.S. shopping malls
Store type Average monthly rent
Average monthly sales
(per sq. ft)y
(per sq. ft)Anchor stores $ 4.13 $185.34
Speciality stores $29.37 $317.68
Source: Gould Pashigian and Prendergast (2005)Source: Gould, Pashigian and Prendergast (2005)
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Externality:Silicon ValleySilicon Valley
Stanford University X P l Alt R h C t Xerox Palo Alto Research Center
Hewlett-Packard Ci S t Cisco Systems
3Com Y h ! Yahoo!
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OutlineOutlineOutlineOutline
externality resolving externalitiesg network effects & externalities public goods public goods technology
7(c) 1999-2007, I.P.L. Png & D.E. Lehman
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Resolving externalitiesResolving externalities
Economic inefficiency opportunity for profitNegative externality g y
Pay sources to reduceCollect fee from victims
Positive externality Pay source to increaseCollect fee from beneficiaries
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Resolving externalities: HurdlesResolving externalities: Hurdles
Information Source and recipient of externality may Source and recipient of externality may
disagree over relative benefit/cost and how to pay for resolution
Free-rider Party contributes less than its marginal y g
benefit to the resolution of the externality
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Resolving externalities: Disneyland
Anaheim: Bought hotels around theme park.
Hong Kong: Disney Co. has option over real estate adjoining theme park.
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OutlineOutlineOutlineOutline
externality resolving externalitiesg network effects & externalities public goods public goods technology
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Network effect/externalityNetwork effect/externality
Network effect: Benefit/cost depends on total number of other users
Examples Telephone service Internet telephony, eg, Skype Instant messenger serviceOpen source software, eg, LinuxOffice productivity software
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Network Effects & ExternalitiesNetwork Effects & Externalities
benefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service providery p p network externalities are a special case of network effects
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Net ork Effects & E ternalitiesNetwork Effects & Externalities
knetwork network externality
networkeffect
monopolyseller
fragmentedmarket
no market
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Network Effects & Externalities:Critical MassCritical Mass
definition: number of users at which demand becomes positivedemand becomes positive
demand takes longer to take off, then ti llgrows exponentially
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Network Effects & Externalities:Installed BaseInstalled Base
quantity of complementary item in service
access devices/Internet service CD players/music CDs computers/software DVD players/DVD titles
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Network Effects & externalities: Demand ElasticityDemand Elasticity
highly elastic around tipping pointhighly inelastic at low demand levels (awayhighly inelastic at low demand levels (away
from tipping point)
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Network effect/externality:Expectations
Users concerned about inherent usefulness of item what others will buy
Influence them through commitments commitments hype
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Network effect/externality: Negative
Congestion Transport facilities – roads, bridges, tunnelsp g Computer networks
VirusesMS Internet Explorer has 95% share – so
malicious programmers target viruses at IEMozilla Firefox relatively safer
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OutlineOutlineOutlineOutline
externality resolving externalitiesg network effects & externalities public goods public goods technology
20(c) 1999-2007, I.P.L. Png & D.E. Lehman
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Public goodPublic good
Definition: Provides non-rival consumptionNon-rival consumption – one person’s increase p p
does not reduce quantity to other Benefit from one unit is the sum of benefits to
llall users Extreme economy of scale – cost of serving
one user = cost of serving many usersone user = cost of serving many users
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Public Goods:RivalnessRivalness
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Public Goods:Content visContent vis--àà--vis Deliveryvis Delivery
Distinguish Content – non-rival Delivery - rival
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Public good: ExcludabilityPublic good: Excludability
Provider can exclude particular consumer Excludability depends ony p
law technology technologynature of product, eg,
process for distillationprocess for distillationrecipe, eg, fusion cuisine
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Public good: LawPublic good: Law
Intellectual property patent – product or p p
process copyright – artistic
iexpression
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Public good: LawPublic good: Law
Intellectual property (IP) – trade-off Stronger IP more incentive for creative
work and research and developmentWeaker IP benefit from more usage
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Public Goods:Market ProvisionMarket Provision
Market provision typically depends on excludabilityCounter-examples: portals, network television
- advertising open-source software
- customization music
- concerts, novelties
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OutlineOutlineOutlineOutline
externality resolving externalitiesg network effects & externalities public goods public goods technology
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Technology:Delivery mode
Can apply technology to delivery mode, so that possible to exclude and enforce, eg, Scramble broadcast television signal Encrypt digital music and videos
Digital rights management
Delay stock prices
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Technology: StandardsTechnology: Standards
Social trade-off Too late opportunity loss Too early discourage innovation
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A t i I f tiAsymmetric Information
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Life Insurance for Some or for All?
The Hartford offers $5000 of life insurance for all state of Massachusetts employees and optional additional insurance up to 8 times their annual salaryinsurance up to 8 times their annual salaryPremiums vary by age and smoking statusHartford insurance for the general public for premiums g p pwhich vary by age and smoking status (and which require a physical exam)Insurance premiums for the general public areInsurance premiums for the general public are considerably higher than for group insurance for State employees
Wh ?
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Why?
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Adverse Selection:The Hartford; Term life insurance premiumsTerm life insurance premiums
Massachusetts Group Insurance Commission plan
General public (for coverage of less than $500,000)
Age Smoker Non-smoker Smoker Non-smokergUnder 35 $0.09 $0.05 $0.10 $0.06
35 – 44 $0.13 $0.06 $0.15 $0.08
45 – 49 $0.24 $0.09 $0.26 $0.1345 49 $0.24 $0.09 $0.26 $0.13
50 – 54 $0.38 $0.15 $0.35 $0.18
55 – 59 $0.58 $0.23 $0.43 $0.25
60 – 64 $0 88 $0 34 $0 58 $0 3660 64 $0.88 $0.34 $0.58 $0.36
65 – 69 $1.57 $0.83 $0.89 $0.57
70 and over $2.81 $1.30 $1.16 $0.75
(age 70 only) (age 70 only)
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(age 70 only) (age 70 only)
(monthly, per $1,000 of coverage)
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling
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Imperfect vis-à-vis Asymmetric Information
imperfect information – absence of certain knowledge (uncertainty)
asymmetric information -- one party has better information than the other party with worse information also suffers from
imperfect information
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Imperfect Information:RiskRisk
uncertainty about benefit or cost arises from imperfect informationp risk-averse person prefers certain payment to
uncertain payments with same expected p y pvalue
risk-averse person will buy insurance
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling
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Adverse SelectionAdverse Selection
economic inefficiency possible market failurep
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Adverse selectionAdverse selection
Definition: Party with less information draws a selection of bad attributes.
Consequences economic inefficiency possible market failure
“There is almost no correlation between price pand quality”
Allan Sichel, Bordeaux wine expert
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Adverse selection:Market equilibrium
Actual demand = combined supply of good and bad
At equilibrium price actual marginal benefit (adjusted for
probability of getting bad vintage) = price actual marginal cost (of good vintage) = price
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Adverse Selection:Market FailureMarket Failure
conventional market: when supply exceeds demand, lower price restores equilibrium
wine market with adverse selection: lower price drives out better vintages, leaving even worse adverse selection
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Adverse selection:Market failure
Conventional market When supply exceeds demand, lower price pp y p
restores equilibrium.
Wine market with adverse selection Lower price drives out better vintages, leaving
even worse adverse selection.
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Adverse selection: Group vis-à-vis individual term life insurance
Group policy avoids adverse selection covers specific class of peoplep p p limits coverage
Individual policy attracts adverse selectionp y open to everyone, regardless of occupation no maximum policy coveragep y g
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling
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AppraisalAppraisal
Directly resolving information asymmetry Unknown attribute must be objectively j y
verifiable search attribute experience attribute
Potential gain must cover appraisal costg pp
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Appraisal: Moody’sAppraisal: Moody s
Charges Rating 10-year cumulative default Charges issuers for rating
Rating 10 year cumulative default rate
Aaa 0.40%gAa 0.25%-0.33%
A 0.84%-1.69%
Baa 2.31%-7.20%
Ba 12.38%-36.24%
B 47.43%-62.32%
Caa-C 78.81%
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Caa C 78.81%
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Appraisal: Who procures?Appraisal: Who procures?
Does seller or buyer procure the appraisal? Factors:
number of buyers nature of unknown attributes –
common/specific to various less informed parties
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Appraisal: Who procures?Appraisal: Who procures?
Usually, the informed party will procure the appraisal Appraisal is public good – can be supplied to
all uninformed parties at no additional cost. Larger the number of uninformed parties,
greater the saving if informed party procures appraisalappraisal.
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SamplingSampling
Directly resolving information asymmetry Unknown attribute need not be objectively j y
verifiable Sampling can resolve asymmetry about
subjective attributes
Potential gain must cover sampling cost low-cost items, eg, wine tasting some high-cost items, eg, car test drive
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling
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ScreeningScreening
Less informed party indirectly elicits other party’s characteristic through structured choice
Better informed party must be differentially sensitive to the choice
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Screening:Indirect Segment DiscriminationIndirect Segment Discrimination
restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundlep cents-off coupons
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Screening:Criminal Justice SystemCriminal Justice System
Defendant might expose his guilt on witness stand Common Law - right to remain silent Civil Law - court can draw inference from defendant’s silence
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Screening: AuctionScreening: Auction
Purpose can be to buy, or sell
Applies competitive pressure to induce bidders to reveal informationbidders to reveal information.
Bidders act strategically Bid conservatively greater profit from Bid conservatively – greater profit from
winning Bid aggressively – higher chance of winning.
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gg y g g
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Screening: AuctionScreening: Auction
Methods Sealed / open biddingp g Reserve price
Seller will not sell at price below this.
Discriminatory / non-discriminatory pricingDo winning bidders pay their bid or last winning
bid?bid?
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Screening:Winner’s CurseWinner’s Curse
In auction to buy: winning bidder over-estimates the true value
In auction to sell: winning bidder under-estimates the true cost
More severe where More severe wheremore bidders true value/cost more uncertain true value/cost more uncertain sealed-bid auction
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling
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Dividend policyDividend policy
U.S. publicly-listed companiesDividends are costly – subject to double y j
taxation (corporate and shareholder levels).Why pay dividends?
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SignalingSignaling
Better informed party communicates attribute through signal
Cost of signal differs according to attribute: self-selection signal is credible
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Signaling: ExamplesExamples
auto manufacturers – extended warranty Intuit – money-back guarantee on Quickeny g Q U.S. publicly-listed companies -- dividends
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OutlineOutlineOutlineOutline
imperfect information adverse selection appraisal screening screening signaling contingent contract contingent contract
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Contingent ContractContingent Contract
Payment is contingent on realized characteristic:
international trade -- buyback (supplier of technology must buy future product)
mergers and acquisitions – payment in shares
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Contingent Contract:Contingent FeeContingent Fee
Lawyer has better information about likelihood of success at trial contingent fee time-based fee
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Resolving Information AsymmetryResolving Information Asymmetry
direct methods appraisalpp sampling
indirect methods screening signalingg g contingent payment
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Incentives and OrganizationIncentives and Organization
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OutlineOutline
moral hazard incentives holdup and contract ownership and vertical
incentschem
monit
syste
integration organizational
h
tive m
es
toring em
s
architecture ownership
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Moral hazard: DoctorsMoral hazard: Doctors
• Brazil: among pregnant women, rate of cesarian section– 30% (81 of 269) in public
hospitalsp– 66% (117 of 177) in private
hospitalshospitals• Happy coincidence?
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Moral HazardMoral Hazard
asymmetric information about action conflict of interest
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OutlineOutlineOutlineOutline
moral hazard incentives holdup and contracts ownership and vertical integration ownership and vertical integration organizational architecture
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IncentivesIncentives
incentive scheme conditional paymentp y quota
monitoring systemg y incentives must be based on observables
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Incentives:RiskRisk
Efficient scheme balances benefits of more effort benefits of more effort costs of risk bearing
degree of risk degree of risk risk aversion
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Incentives:Relative PerformanceRelative Performance
Employment - promote the best worker
Sports - gold, silver, bronze
Examination – grade on a curve Examination grade on a curve
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OutlineOutlineOutlineOutline
moral hazard incentives holdup and contracts ownership and vertical integration ownership and vertical integration organizational architecture
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Holdup: Resolution Holdup: Resolution
Avoid specific investmentsSpecificity = percentage of the investment that p y p g
will be lost if the asset is switched to another use
d l d Write more detailed contracts Vertical integration (redistribute ownership)
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ContractContract
Complete Contract - specifies actions and payments in every contingency
Degree to which a contract should be lcomplete
potential benefits and costs at stakef bl extent of possible contingencies
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OutlineOutlineOutlineOutline
moral hazard incentives holdup and contracts ownership and vertical integration ownership and vertical integration organizational architecture
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OwnershipOwnership
Owner has residual rights Residual rightsg Control – rights that have not been
contracted awayy Income – remaining after payment of all
other claims
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Vertical IntegrationVertical Integration
Definition: Combination of assets for two successive stages of production under a common ownershipcommon ownership upstream: away from final consumer
Dominion Resources acquired ConsolidatedDominion Resources acquired Consolidated Natural Gas, 1999
downstream: closer to final consumer Phillips Petroleum acquired Tosco, 2001
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Vertical integration: ImpactVertical integration: Impact
Owner gets rights to residual control and residual
iincome reduces potential for holdup
Example: Example: Auto manufacturer acquires parts supplier
can prevent holdup by parts supplier can prevent holdup by parts supplier now faces moral hazard by workers at parts
supplier
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Vertical Integration:Make or buy?Make or buy?
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OutlineOutlineOutlineOutline
moral hazard incentives holdup and contracts ownership and vertical integration ownership and vertical integration organizational architecture
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Organizational architectureOrganizational architecture
Base – distribution of ownership Two pillarsp incentive schemes monitoring systems monitoring systems
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Organizational architecture:Corporate governance
• Incentives– shares and options Monitoring
B d f Di t – bonuses– profit-sharing
Board of Directors major shareholders
• Ownership– proxy fight– takeover
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Organizational architecture:Corporate governance
Daimler Chrysler, July 2005: CEO Jurgen Schremp g p
resigned Share price jumped 9.8%
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R l tiRegulation
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OutlineOutlineOutlineOutline
natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods
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Natural MonopolyNatural Monopoly
Average cost minimized with single supplier large scale/scope economies g / p relative to market demand
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Natural Monopoly:ManagementManagement
government ownership beholden to employeesp y cannot borrow or raise capital independently
private franchise subject to regulationp j g
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Natural Monopoly:Marginal Cost PricingMarginal Cost Pricing
Require provider set price equal to marginal cost set price equal to marginal cost supply quantity demanded
i t ill i b id price < average cost will require a subsidy
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Natural Monopoly:RegulationRegulation
price regulation – incentive to exaggerate reported costs
rate of return regulation – incentive to over-invest in rate baseNew York PSC switched Con Ed from
rate of return regulation to price cap
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Natural Monopoly:Rate of Return RegulationRate of Return Regulation
maximum rate of return on rate base costs plus the allowed return comprise the costs plus the allowed return comprise the
“revenue requirement” prices are set to recover the revenue prices are set to recover the revenue
requirement
di ll d fit t d t disallowed profit returned to users
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OutlineOutlineOutlineOutline
natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods
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Potentially Competitive MarketPotentially Competitive Market
Economies of scale/scope are small relative to market demand. Natural monopoly markets may be transformed into potentially competitive markets (or vice versa), due to changes in technology market demand
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Potentially Competitive Market:TelecommunicationsTelecommunications
Increase in market demand for long-distance service: AT&T break up, 1984 long-distance market opened to competition local providers retained monopoly
Convergence between cable TV and local telephone service: local service opened to
99competition, 1996
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Potentially Competitive MarketCompetition LawsCompetition Laws
prohibit collusion limit mergersg deter anti-competitive business practices
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Potentially Competitive MarketStructural RegulationStructural Regulation
Natural monopoly may exist at one stage in the production chain, but need not apply upstream or downstreamBar franchise holder from vertically related markets
prevent monopoly from extending market powerpower
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OutlineOutlineOutlineOutline
natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods
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Asymmetric Information: ResolutionResolution
mandatory disclosure – requires objectively verifiable information (difficult in medicine)
f regulation of conduct (e.g., prohibit medical advertising, require second opinions, etc.)
structural regulation (e g require doctors to structural regulation (e.g., require doctors to specialize in diagnosis or treatment, but not both))
self-regulation – professional licensing associations
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Asymmetric Information:Who to regulate?Who to regulate?
external agency self-regulation: common with professions g p
(lawyers, financial advisors, doctors, architects, engineers)
self-regulation potentially can be anti-competitive
external agency will generally be inefficient
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OutlineOutlineOutlineOutline
natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods
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Negative ExternalitiesNegative Externalities
Production will be excessive since it ignores the external costs
Efficiency requires the marginal social benefit to be set equal to the marginal social costs
Many external costs are public bads: the marginal social cost is the sum of the
i l t t th i timarginal costs to the victims
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Externalities:Emissions StandardEmissions Standard
allocate licenses through auction allow trading of licensesg also achieves economic efficiency
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Externalities:LocationLocation
marginal benefit and cost vary with location economically efficient quantity depends on locationwindy vs still area populated vs unpopulated area
cross-border externalities
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Externalities:TimeTime
Marginal benefit and cost vary with time economically efficient quantity depends on time
day vs. night summer vs. winter
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Externalities:Tort LawTort Law
Governs interactions between parties with no contractual relationship liability – conditions under which one party must pay damages to another damages = price for harm
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OutlineOutlineOutlineOutline
natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods
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Public GoodsPublic Goods
legal framework enables excludability copyright py g patent
trade-off incentive for knowledge creation economically efficient usage of informationy g
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Public Goods:U.S. ConstitutionU.S. Constitution
“The Congress shall have power … To promote the progress of science and useful arts, bythe progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries”
Article I, Section 8, Clause 8
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Public Goods:Public ProvisionPublic Provision
For some public goods, practically difficult to enforce exclusion national defense clean air fireworks
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