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17/02/2006Master of Engineering and Management of Technology – 9th Edition - Microeconomics1 Monopoly and Regulation Filipe Janela Miguel Martins Sónia.

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Presentation on theme: "17/02/2006Master of Engineering and Management of Technology – 9th Edition - Microeconomics1 Monopoly and Regulation Filipe Janela Miguel Martins Sónia."— Presentation transcript:

1 17/02/2006Master of Engineering and Management of Technology – 9th Edition - Microeconomics1 Monopoly and Regulation Filipe Janela Miguel Martins Sónia Romão Tiago Martinho

2 17/02/20062 Definition of Monopoly Definition of Monopoly Monopoly Behaviour Monopoly Behaviour Natural Monopolies Natural Monopolies Characteristics Characteristics The Problem of Natural Monopoly The Problem of Natural Monopoly Regulation Regulation Economic Theory of Regulation Economic Theory of Regulation Basic Problems and Effects Basic Problems and Effects State ownership vs Privatisation and Regulation State ownership vs Privatisation and Regulation Privatization, De-regulation and Barriers to Entry Privatization, De-regulation and Barriers to Entry Examples of Monopolies Examples of Monopolies

3 17/02/20063 Definition of Monopoly

4 17/02/20064 Monopoly Definition A single firm selling all the output in a market A single firm selling all the output in a market It´s a model – it rarely exists in pure form It´s a model – it rarely exists in pure form But many firms have some degree of monopoly power But many firms have some degree of monopoly power Example: Can a cinema, in a local village, be considered as a monopoly according to these definition? Example: Can a cinema, in a local village, be considered as a monopoly according to these definition? Depends on the alternatives. If the product (film) can be substituted for another one or not. If the local cinema has on exibition a good film and it´s the only one nearby, then a person, as long as interested, has only one place to go (Monopoly). Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

5 17/02/20065 Causes of monopoly power Control of resources (de Beers over diamonds) Control of resources (de Beers over diamonds) Economies of scale (software) Economies of scale (software) Patent Protection (AZT, anti-AIDS Drug) Patent Protection (AZT, anti-AIDS Drug) Government Protection Government Protection What causes a single firm selling all the output in a market? Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

6 17/02/20066 Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

7 17/02/20067 Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

8 17/02/20068 Monopoly Behaviour Marginal revenue = B - C Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

9 17/02/20069 Optimum where MR = MC MR = MC = 12 Q* = 6, P* = 18 AC = 8 Profit = (18-8)  6 = 60 Maximizing Profit Example Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

10 17/02/ Optimum where MR = MC MR = MC = 12 Q* = 6, P* = 18 AC = 8 Profit = (18-8)  6 = 60 Maximizing Profit Example Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

11 17/02/ For the consumers… The monopolist operates with prices greater than Marginal Costs  prices higher and output lower than in a competitive environment consumers typically be worse For the firms… In contrast, firms will be better under monopoly, as they can manipulate the price in order to increased profits An economic arrangement is Pareto efficient if there is no way to make anyone better without making anyone worse, so Consumers typically be worse Is the monopoly Pareto Efficient? Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Monopoly Behaviour

12 17/02/ Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Monopoly Behaviour

13 17/02/ Since p > Marginal Costs  extra output could be sold at a price lower than the market price, but still higher than MC  each side gets betterSince p > Marginal Costs  extra output could be sold at a price lower than the market price, but still higher than MC  each side gets better The monopoly is not Pareto efficient because the monopolist cannot lower the price of the extra units without lowering the prices of all units The monopoly is not Pareto efficient because the monopolist cannot lower the price of the extra units without lowering the prices of all units Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Monopoly Behaviour

14 17/02/ Measure how inefficient is a monopoly Variations of producers’ and consumers’ surpluses by imposing a perfect competition to a monopoly situation Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Monopoly Behaviour Deadweight Loss of the Economy

15 17/02/ Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Monopoly Behaviour

16 17/02/ Natural Monopolies

17 17/02/ Natural Monopolies DEFINITION DEFINITION A "natural monopoly" is defined in economics as an industry where the fixed cost of the capital goods is so high that it is not profitable for a second firm to enter and compete. There is a "natural" reason for this industry being a monopoly, namely that the economies of scale require one, rather than several, firms. Small-scale ownership would be less efficient. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

18 17/02/ Natural Monopolies The existence of natural monopolies is determined by the interaction of two factors: 1. Technology 2. Dimension of the market. SUNK COSTS SUNK COSTS Any good whose provision demands a very high level of initial investment which cannot be recovered will face what is called sunk costs. Any good whose provision demands a very high level of initial investment which cannot be recovered will face what is called sunk costs. Natural monopolies are typically utilities such as the distribution of electricity, gas or water supplies, telecommunications services, rail and air transports. These activities demand a large initial investment in the establishment of a network serving all the potential customers. Natural monopolies are typically utilities such as the distribution of electricity, gas or water supplies, telecommunications services, rail and air transports. These activities demand a large initial investment in the establishment of a network serving all the potential customers. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

19 17/02/ Natural Monopolies SUNK COSTS SUNK COSTS Sunk Costs characteristics: They cannot be recovered and demand regular maintenance activities that, to a certain point, are independent of the output (fixed costs); They cannot be recovered and demand regular maintenance activities that, to a certain point, are independent of the output (fixed costs); (when the network is working below full capacity) Once the network is set up, the additional cost of serving a new customer is very small when compared to the investment (sunk) cost. Once the network is set up, the additional cost of serving a new customer is very small when compared to the investment (sunk) cost. The larger the number of consumers, the lower will be the average cost of production, since the amount of costs independent of the quantity produced (both sunk and fixed) is much larger than the marginal cost. The larger the number of consumers, the lower will be the average cost of production, since the amount of costs independent of the quantity produced (both sunk and fixed) is much larger than the marginal cost. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

20 17/02/ Natural Monopolies The most advantageous way to organise a market such as this (given the dimension of the demand) is the establishment of a monopoly, since the existence of two or more competing firms would mean the building of many different networks, and would multiply sunk costs The most advantageous way to organise a market such as this (given the dimension of the demand) is the establishment of a monopoly, since the existence of two or more competing firms would mean the building of many different networks, and would multiply sunk costs It would be very costly to build a second set of water and sewerage pipes in a city. Water and gas delivery service has a high fixed cost and a low variable cost. It would be very costly to build a second set of water and sewerage pipes in a city. Water and gas delivery service has a high fixed cost and a low variable cost. Electricity is now being deregulated, so the generators of electric power can now compete. But the infrastructure, the wires that carry the electricity, usually remain a natural monopoly, and the various companies send their electricity through the same grid. Electricity is now being deregulated, so the generators of electric power can now compete. But the infrastructure, the wires that carry the electricity, usually remain a natural monopoly, and the various companies send their electricity through the same grid. In these cases, we have a situation where the joint supply of several different products/services can be done at a lower cost than would be the case if these products were supplied separately. The concept of scale economies is then joined by that of economies of scope. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

21 17/02/ Natural Monopolies Even though monopoly is inefficient, forcing the monopolist to equate price to MC will sometimes determine negative profits. That happens whenever the demand curve intersects the MC curve beneath the AC curve. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

22 17/02/ Regulation

23 17/02/ Economic Regulation Theories of Regulation Public Interest: responds to market failures; insure competitive conditions; Public Interest: responds to market failures; insure competitive conditions; Capture Theory of Regulation: regulation in activities which do not seem to present any need for regulation and yet are subjective to extensive intervention; tend to substitute public interest for the private; Capture Theory of Regulation: regulation in activities which do not seem to present any need for regulation and yet are subjective to extensive intervention; tend to substitute public interest for the private; Economic Theory of Regulation: regulation is subject to economic laws of demand and supply. Economic Theory of Regulation: regulation is subject to economic laws of demand and supply. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

24 17/02/ Keep in mind: Regulatory activities are costly, since they call for the supervision and monitoring of the firms’ internal activities (cost structures) and of the performance of the market; Regulatory activities are costly, since they call for the supervision and monitoring of the firms’ internal activities (cost structures) and of the performance of the market; Agency discretion should be limited, since the agency might act according to interests different then the society’s; Agency discretion should be limited, since the agency might act according to interests different then the society’s; Positive economic theory, and not political convenience or ideology, should be the main basis of regulatory activity. Positive economic theory, and not political convenience or ideology, should be the main basis of regulatory activity. Economic Regulation Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

25 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: Concept: Rate Of Return (ROR) - regulation, a firm is allowed to earn no more than a “fair” rate of return on its capital investment, defined as the level of profits per unit of capital used. Analysis: i) ROR above the current cost of capital (the interest rate r) ii) ROR below the present cost of capital iii) ROR equal to the interest rate Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

26 17/02/ Regulation through the Rate of Return Capital: The firm is allowed to earn no more than a “fair” rate of return on its capital investment The firm is allowed to earn no more than a “fair” rate of return on its capital investment The regulated firm will choose a higher capital- labour ratio than it would without regulation, thus being internally inefficient The regulated firm will choose a higher capital- labour ratio than it would without regulation, thus being internally inefficient It is not certain that output will increase It is not certain that output will increase If the regulator sets the maximum rate of return below the cost of capital, the firm will shut down If the regulator sets the maximum rate of return below the cost of capital, the firm will shut down Under any type of rate of return regulation, the regulated firm will always over-utilise the rate base Under any type of rate of return regulation, the regulated firm will always over-utilise the rate base Regulation of Natural Monopoly: Basic Problems and Effects Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

27 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

28 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: There is a logical explanation for this outcome: by imposing a constraint on the rate of return to capital, defined as the ratio between revenues minus non-capital costs and the level of capital used, the regulatory agency is providing an incentive for the firm to increase that level thereby keeping within the constraint with a minimum loss in terms of profits: K - the rate base – increases | profits before capital costs (P.Q - w.L) allowed within the constraint will be larger. Any reduction in the ROR will lead to further over- utilisation of capital. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

29 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Other Regulatory Mechanisms Based on Returns: i) Regulation of the return on output: here the firm is constrained on the level of profit per unit of output sold. ii) Regulation through the rate of return on sales: the regulatory agency imposes a limit on the amount of profit per unit of revenue. iii) Return on cost regulation: the firm is allowed a certain amount of profit per each unit of cost. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

30 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Price Cap Regulation: Characteristics: i) the regulator sets a maximum price for the market, called the price cap; the firm can set a price equal or below this one, and is able to retain all profits; ii) the regulator might specify that the price cap will be adjusted over time by a preannounced adjustment factor that is exogenous to the firm - for instance some form of general price index RPI –X ; iii) at long intervals, the price cap is reviewed by the regulator and possibly changed, considering the profits, cost and demand conditions. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

31 17/02/ Regulation of Natural Monopoly: Basic Problems and Effects Price Cap vs. Rate of Return Regulation Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

32 17/02/ State ownership vs Privatisation and Regulation  Social ownership of strategic means of production should be ensured  It facilitates the planning of key sectors of economy This only make sense in politically unstable societies All companies plan and planning is nor alternative, but complementary to the market system  It facilities income redistribution, making fundamental utilities and services available to all Leave the provision to the market and make the appropriate transfers through taxes and price controls REASONS FOR STATE OWNERSHIP Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

33 17/02/ State ownership vs Privatisation and Regulation REASONS FOR STATE OWNERSHIP  Redistribution Issues – it may be easier to enforce the reduce of the prices charged to smaller users of electricity or gas directly through public provision than by finding appropriate specific forms of assistance Public ownership allows for the practice of specific pricing policies - Cross-subsidies that, although not maximizing profit in the sense that they allow for profitable areas of clients to subsidise others. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

34 17/02/ State ownership vs Privatisation and Regulation REASONS FOR PRIVATISATION  It increases the cost efficiency of firms, that is, the internal process of cost minimisation is better achieved  Private firms are more efficient in terms of cost structure than public firms producing the same goods, even if they are under regulatory constrains and have similar technology The main cause of these differences is a change in management behaviour, resulting from the profit-maximizing pressure and from the management concern with the market value of the firm’s shares in the stock market.  Demands from the government an acceptance of the firm’s objective of profit maximization and a mind to pursue other objectives through regulation and in the case of public utilities, possibly also taxation and subsidisation Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

35 17/02/ State ownership vs Privatisation and Regulation The second best equilibrium – resulting from price regulation, for the private firm (P=AC) in point P is actually a better solution in terms of total welfare for the market than the first best equilibrium achieved by the state-owned firm in point S, with lower price and a higher output Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

36 17/02/ Privatization, De-regulation and Barriers to Entry Public Utility providing one product or service telecommunications, gas or electricity distribution  Privatise but independently of any regulation, a new firm should be allowed to enter the market, in case it wants Promote competition and lower prices in the market, benefiting the consumers Game - theory Scale Economies Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

37 17/02/ Efficient Pricing in Multi- product Natural Monopolies Single- Product Multi- Product  The cost structure of the firm will lead to a constrained social welfare optimum in which the price the consumers were willing to pay for the last unit consumed is still above the marginal cost of producing that unit (P=AC)  The design of prices involves balancing the welfare losses across product markets as prices deviate from marginal costs  Price structure will be dependent both on the cost structure of the firm and on the different demand functions faced in each market Assume the firm is a natural monopoly Marginal Cost pricing is unsustainable Ramsey Prices Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

38 17/02/ Efficient Pricing in Multi- product Natural Monopolies Welfare loss in market i – more rigid demand Welfare loss in market j – more elastic demand Cross- subsidisation ↓ Policies in which profits in some markets will subsidise eventual losses made in others Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

39 17/02/ Structural Efficiency, Competition and Vertical Economies Economies of Scope Providing a variety of products or services using the same network (Telecommunications)   Joint production is done at a lower average cost than when done separately On the other hand… Growth in demand for several services  Range across which average costs are decreasing for an industry does not anymore cover all the dimension of the market These two circumstances have led to situations in which the regulatory agencies have chosen to break-up natural monopolies in terms of market dimension HORIZONTAL BREAK-UP Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

40 17/02/ Structural Efficiency, Competition and Vertical Economies VERTICAL BREAK-UPVERTICAL BREAK-UP  Economies of scale in generation are more limited than in distribution  Unlike distributors, it is possible for generation to store energy and inputs  Distribution has been broken up into regional networks, thus creating a market for generators On the other hand…  Uncertainty associated with equipment failures in input process and demand  exhaustion of scale economies in generation might not be enough to guarantee a truly competitive  Incentives for large investments hindered by opportunities behaviour  A firm joining different stages in the vertical chain will have a wider technological knowledge Example of generation and distribution of electricity… Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

41 17/02/ Examples of Monopolies

42 17/02/ Examples of Monopolies Salt Until common salt (sodium chloride) was mined in quantity in comparatively recent times, its availability was subject to the vagaries of climate and environment. A combination of strong sunshine and low humidity or an extension of peat marshes was necessary for winning salt from the sea - the most plentiful source - by solar evaporation or boiling. Mines and inland salt springs being scarce and often located in hostile areas like the Dead Sea or the salt mines in the Sahara desert, they required well-organised security for transport, storage and highly monopolised distribution. Changing sea levels flooded many of these sources during certain periods and caused salt “famines” and communities were left to the mercy of those who monopolised these few inland sources. The “Gabelle", a notoriously high tax levied upon salt, played a role in the start of the French Revolution and is possibly the most cruel example in recent history. Anyone was allowed to purchase salt; however, strict legal controls were in place over who was allowed to sell and distribute salt. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

43 17/02/ Examples of Monopolies AT&T For many years, AT&T had been permitted to retain its monopoly status under the assumption that it was a natural monopoly. The rise of cheap microwave communications equipment in the 1970s opened a window of opportunity for competitors--no longer was the acquisition of expensive rights-of-way necessary for the construction of a long-distance telephone network. In light of this, the FCC permitted MCI (Microwave Communications, Inc) to sell communication services to large-businesses. This technical-economic argument against the necessity of AT&T's monopoly position would hold for a mere fifteen years until the beginning of the fiber- optics revolution sounded the end of microwave-based long distance. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

44 17/02/ Examples of Monopolies Standard Oil By 1890, Standard Oil controlled 88% of the refined oil flows in the United States. Gradually, its market share fell to 64% by Standard's oil production as a percentage of total market supply fell to 11 percent by 1911, down from 34 percent in By 1911, it was in competition with Associated Oil and Gas, Texaco, Gulf Oil, and 147 independent refineries. (DiLorenzo, Thomas The ghost of John D. Rockefeller) Nevertheless, it was claimed by many to be a monopoly. As the public became more aware of the Standard Oil trust in allowing its oil companies in different states to be headed by the same board of directors, there was more public support in calling for its dissolution. Eventually, the company was broken up after the United States Supreme Court declared the trust to be an "unreasonable" monopoly under the Sherman Antitrust Act. Thus, on May 15, 1911, though Standard Oil's share of the market had been steadily declining from 1900 to 1910 (Standard's share of oil refining was 64% at the time of the trial and in competition with over 100 other refiners), the Supreme Court of the United States ordered the dissolution of Standard Oil Company into 34 smaller companies, each with their own board of directors. John D. Rockefeller in 1897 had completely retired from the Standard Oil Company of New Jersey, though he continued to own a large fraction of its shares. The notion that Standard was a monopoly is rejected by some economists. And, no one claims that they harmed consumers but rather the reverse --that their aggressively competitive practices drastically lowered prices. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

45 17/02/ Bibliography José Mata, Economia da Empresa, Fundação Calouste Gulbenkian, Lisboa, 2000


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