Game Theory & Natural Monopolies Econ 201 Spring 2009 Game Theory & Natural Monopolies

Game Theory Game theory is a methodology that can be used to analyze both cooperative and non-cooperative oligopolies. Recognizes the interdependence of the firms’ actions

Determining the Dominate Strategy A dominant strategy occurs when one strategy is best for a player regardless of the rival’s actions. Dominate strategy equilibrium—neither player has reason to change their actions because they are pursuing the strategy that is optimal under all circumstances.

Multiple Equilibria There are come cases where there are multiple Nash equilibria. In this case, the outcome is uncertain. Firms will have an incentive to collude.

Prisoner's Dilemma A prisoner’s dilemma occurs when the dominate strategy leads all players to an undesired outcome.

Figure 12.9 Prisoners’ Dilemma

Firm Collusion In some situations, firms can improve on the outcome if they collude rather than compete.

Natural Monopolies natural monopoly one firm can produce a desired output at a lower social cost than two or more firms— that is, there are economies of scale in social costs. It is the assertion about an industry, that multiple firms providing a good or service is less efficient than if a single firm provided a good or service. A normative claim which is used to justify the creation of statutory monopolies, where government prohibits competition by law. Examples of claimed natural monopolies include railways, telecommunications, water services, electricity, and mail delivery. Some claim that the theory is a flawed rationale for state prohibition of competition.[3], [4] An industry is said to be a natural monopoly (also called technical monopoly) if only one firm is able to survive in the long run, even in the absence of legal regulations or "predatory" measures by the monopolist. "[1] It is said that this is the result of high fixed costs of entering an industry which causes long run average costs to decline as output expands (i.e. economies of scale in private costs).

Market Conditions for a Natural Monopoly Scale is such that it is cost-efficient for only 1 firm to supply the market, i.e., economies of scale

The Regulator’s Dilemma A couple of alternatives: No regulation Firm will price like a monopolist Set price at ATC Rate-of-return regulation: sets utility’s prices based on cost-of-service

What are the Consequences? Do nothing Firm chooses Q at the point where MR = MC Less than perfect competition Sets Price > MC Higher than perfect competition Higher price and lower Q => deadweight loss

What are the Consequences Set price at ATC Since ATC is falling => MC < ATC And P = ATC > MC Still producing too little – would like P= MC at Q*

The European Approach Assuming LRAC is still falling Set P = MC Subsidize the difference between ATC and P

Regulatory responses doing nothing setting legal limits on the firm's behaviour, either directly or through a regulatory agency setting up competition for the market (franchising) setting up common carrier type competition setting up surrogate competition ("yardstick" competition or benchmarking) requiring companies to be (or remain) quoted on the stock market public ownership Since the 1980s there is a global trend towards utility deregulation, in which systems of competition are intended to replace regulation by specifying or limiting firms' behaviour; the telecommunications industry is a leading example globally.

Telecommunications – an Example Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable costs. fixed costs of establishing a national distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small. average total cost will continue to decline as the scale of production increase, because fixed (or overhead) costs are being spread over higher and higher levels of output The telecommunications industry has in the past been considered to be a natural monopoly. Like railways and water provision, existence of several companies supplying the same area would result in an inefficient multiplication of cables, transformers, pipelines etc. perception of what constitutes a natural monopoly is now changing – new technology reduces traditional barriers to entry within markets. telecommunications industry in the UK, British Telecom has faced increasing levels of competition from new telecommunications service providers during the 1990s - not least the rapid expansion of mobile and cable services. T this has led to a change in the role of the industry regulator (OFTEL). Its main role now is not necessarily the introduction of even more competition into the telecommunications industry - but a policing role to ensure fair competition between service providers.