1. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-1 Natural Monopolies And Regulation

2. Natural Monopolies Economies of Scale continue to occur at so large a scale that is it is “productively efficient” (least cost) to have only 1 provider Natural state and optimal state is a monopoly typically high fixed costs and low variable costs electric, natural gas, water, telecommunications (land) and tv cable Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-2

3. Regulation If a natural monopoly arises due to scale economies, the government may prefer to regulate the monopoly. Breaking the firm up may reduce efficiency Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-3

4. Figure 13.2 Natural Monopoly in the Telecommunications Industry Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-4

5. Government Regulation of Price and Output The government cannot require that a natural monopolist set price equal to marginal cost. Because marginal cost is less than average cost, two options: 1. Government subsidizes the loss (Euro approach) No deadweight loss, but requires taxes on other goods 2. Average Cost Pricing (or Rate of Return (ROR)): government sets price equal to average total cost. (US solution) Leads to some deadweight loss, but less than a monopoly Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-5

6. Figure 13.3 Choosing a Price for a Natural Monopolist Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-6 US French Economic Loss or Subsidy

7. Government Regulation of Price and Output Two methods of regulating price and output: Rate of Return Regulation—the firm is allowed to earn a pre-specified amount of profit in a given time period. Set prices to recover average cost + normal rate of return How do you determine normal ROR? Incentive for regulated firm to “pad” its costs (Averech-Johnson effect) Price Cap—government sets the maximum price or the maximum rate of price increase. After rate setting process: future rates can be raised by rate of inflation – industry’s average productivity (incentive for tech. iinnov.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-7

8. Deregulation The current trend is for the government to remove regulation and allow market forces to determine prices, output, profits, and industry structure. Factors favoring deregulation: Difficulty in determining a regulatory strategy Advances in technology that have lead to increased competition Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-8

9. Reasons For Deregulation In deciding to deregulate an industry, the government must be confident that private market outcomes will be more efficient than regulated outcomes. Will deregulation affect product safety or reliability? Will deregulation eliminate service for some customers? Will the benefits of deregulation accrue to only a few customers? Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-9

10. Application: Deregulation of the Airline Industry In 1978, the U.S. Airline Deregulation Act removed regulations on prices, the number of carriers and route assignments. (some) Passengers have benefited from the resulting price competition among air carriers. FAA set similar rates for flights of similar difference, regardless of destination (and demand in large/small cities) “legacy” losses and gains Smaller cities saw higher prices and fewer flight Larger cities: lower prices, more flights Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-10

11. Application: Deregulation of theTelecommunications In 1980, AT&T and the “Baby Bells” were broken up into 8 different companies AT&T could offer only long distance service and had to compete with MCI and Sprint (no longer a monopoly) Baby Bells’ customer could choose their LD provider Took several years for AT&T market share to drop below 80% Colbert video – “it’s all back together again” FCC missed that there were economies of scale – led to mergers to reduce costs 1996 Congress passed the Telecommunications Act Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-11

12. Application: Deregulation of theTelecommunications 1996 Congress passed the Telecommunications Act Required Baby Bells and GTE to open their local markets to all competitors Established prices that Bells could charge competitors for “renting” their lines and switching equipment Prices were set below incurred (or historical) costs Decreased incentive to maintain and update existing equipment Previously business line rates set higher than costs to subsidize residential phone service New entrants targeted business customers and high long distance usage customers (winners) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-12

13. Strategy and Policy The Department of Justice takes on Cingular–AT&T Wireless merger In 2004, Cingular agree to buy AT&T Wireless, creating a company with an HHI of 8,000 in some markets. In 2005, the firm was required to divest the entire AT&T Wireless network in the 13 markets where concentration was highest. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-13