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 Competition PP QQ P* Individual FirmCompetitive Market AC 1 MC 1 QFQF QMQM S=∑MC D

Consumer and Producer Surplus P Q P* Competitive Market QMQM 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 Monopoly P Q QMQM AC MC 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(q i )/q i < C(q j )/q j for all q i and q j, where 0 < q j < q i ≤ 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 q 1,………. q m such that ∑ i=0 m q i = q. This condition is necessary and sufficient to ensure that costs will be lowest when there is a single supplier.

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)

A B

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

Price setter vs. price taker P Q QMQM DWL MC D MR Q* P* PMPM

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

One Regulatory Solution: Average Cost Pricing P Q Q* AC MC D QMQM MR DWL PMPM Q AC P AC P*

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

Pricing when AC is increasing P Q P* Q* MC D AC MR Q AC Q MC P AC AC Q* PMPM Welfare Loss

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

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(q w ) = C‘(q w )≡ MC(q w ) The prime indicates a derivative, and q w is the output produced and sold.

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(q m )≡ p(q m ) + q m p‘(q m ) = C' (q m ) ≡ MC (q m ) where q m is the profit-maximizing output, and primes indicated derivatives. This process yields similar result that marginal revenue equals marginal cost.

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.

Resource Misallocation

Regulating a Monopolist Monopolist choose output q m,whereas the efficient output is q w. Regulation will be needed to avoid the former result. However, if the regulator attempts to achieve the latter result, the firm is not financially solvent since price is below average cost and a deficit occurs equal to area bfgy. Average cost is decreasing, society may be better off if the firm is allowed to maintain monopoly status, because this market structure minimizes production costs for any output. A deficit results if society forces the firm to price all units at marginal cost; the firm must be subsidized or else shut down. One regulation option is to force marginal-cost pricing and subsidize the firm.

Resource Misallocation Regulation is not costless, and the benefits from correcting minimal misallocations may be less than the cost of running the regulatory agency. (DWL> Regulation Costs) With average cost AC 0, the excess profit given by are abcf is relatively small, but the deadweight loss (or misallocation) given by area bem is relatively large. If bem exceeds the cost of running regulatory agency, intervention may be justified. If there is technology change, causing fixed costs to fall dramatically, average cost drops to AC 1, profit will be greater, but deadweight loss will be unchanged. (because MC is assumed unchanged in the relevant quantity range.) Thus, the excess profit along is not an adequate indicator of the need for regulation. The basic efficiency issue is whether or not there is much social welfare to be gained if a regulator restricts the monopolist’s pricing policy.

Barriers to Entry The most common barrier is an incumbent firm with large sunk costs (Baumol, Panzar and Willig, 1982). Entrants will have to make prohibitively large investments in order to compete at able the same scale of output as the incumbent. If the entrant is successful, expansion of market output which partly depends on the incumbent’s reaction to entry, may so reduce the price that entry will be unprofitable. Barriers to entry have significant implications for regulation in the context of strong and weak natural monopolies.

If a single, linear price structure is used, then the solution is to set price equal to average cost. Therefore, output will be less than the efficient output q w, but greater than monopoly output q m. NO Barriers to Entry – Strong Monopoly

If we consider a weak natural monopoly in conjunction with barriers to entry. q s is the output level at which it becomes efficient for a second plant to be build and operated. Average cost for a single firm is falling up to q 0 and rising thereafter. Over the range 0 ≤ q ≤ q s, costs will be subadditive. Given demand curve and marginal cost curve, efficient pricing yields output q w, where costs are subadditive; however, average cost is increasing. Regulatory intervention is still required to protect consumers, because the firm’s incentive still will be to set a price at which marginal revenue and marginal cost will be equal. NO Barriers to Entry – Weak Monopoly

Ultra-free Entry Table 2.1 Appropriate regulatory policies Monopoly typeBarriers to entryNo barriers to entry Strong natural monopoly( MC pricing creates a deficits) Enforce p =MC, and subsidize firm or Deviate from MC pricing to eliminate deficit Enforce p= MC, and subsidize firm or Do not regulate, letting threat of entry force break-even prices Weak natural monopoly (MC pricing allows nonnegative profits) Enforce p= MC, and address possible "problem" of excess profit Enforce p= MC, prevent further entry into the market, and address possible "problem" of excess profit.