Economics of Regulation

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Economics of Regulation

• Natural Monopoly

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What is a natural monopoly?

• When a single firm can produce a product or a
  group of products more cheaply than two or more
  firms.
• Technically, a natural monopoly exists in an
  industry where the costs are subadditive. That
  is, where two firms produce q1 and q2
  respectively and the costs are as follows
• C(Q)c(q1q2)

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What is a natural monopoly?

• Subadditivity is not the same as economies of
  scale. Costs can be subadditive even if
  diseconomies exist (near the total output q1q2).
  In the single product case, scale economies is a
  sufficient condition for subadditivitity.
• In the multiproduct case, product-specific scale
  economies is not a sufficient condition.
  Economies of scope is a necessary but not
  sufficient condition for subadditivity. Even
  Economies of scale and scope is no guarantee of
  cost subadditivity.

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What is a natural monopoly?

• Contestable Market is one where there is free
  entry and even a single firm will face pressure
  to keep costs low and to price efficiently.
  Developed by Baumol, Panzer, Willig.
• Sustainable natural monopoly is one where entry
  can be prevented. (Price where LATC meets demand
  curve - no incentive to enter).

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Other Reasons for Regulation.

• Destructive competition results from pricing at
  MC. Happens in industries where fixed costs are
  large and demand is highly cyclical or variable.
  (I.e. electrical conspiracy)
• Equity concerns. Errs with price discrimination.
  Cross-subsidies as in LD to local. Geographic
  rate averaging.
• Rationing. Radio or TV spectrum. Traditional FCC
  versus PCS auctions.

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Other Reasons for Regulation.

• Market Stabilization. Social welfare will
  improve if gov't tames wild price flunctations
  and stabilizes market. Agriculture markets with
  lags.
• Capture and Rent Seeking. This is not in the
  public interest as the other ones are. This is
  only a reason for the firms who want regulation.
  

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Regulators' problems

• A. Pricing
• - In many regulated industries, there are
  significant economies of large-scale production
• - In an industry with economies of scale, the
  LRAC curve is downward sloping
• - If average cost is declining, then the MC is
  below AC

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Regulators' problems
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Regulators' problems

• - Pricing at MC, the firm suffers a loss.
• - loss could be covered by a subsidy for gov't.
  Raising taxes through sales or income tax causes
  other distortions. If it is subsidized, it is
  usually publicly owned.
• - price discrimination where high rates for some
  customers are used to cover the loss. Local
  telephone service subsidized by LD.
• - Pricing at LATC, social welfare is not
  maximize. Deadweight loss triangle.

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Regulators' problems

• B. Incentive Incentive Problem ---- assume
  regulator prices at PATC and firm earns no
  economic profit. No incentive to cut costs -
  increasing costs lead to increasing prices. Leads
  to feather-bedding.

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Demsetz Article

• A. Argues aganist Natural Monopoly Theory which
  he defines as scale economies - less costly for
  one firm than 2 or more firms - left
  unregulated, firm sets price and quantity at
  monopoly levels. B. Deficient because it fails
  to reveal the logical steps that this takes in
  the marketplace

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Demsetz Article

• C. Uses bidding process / why does scale
  economies limit bidders unlimited bidders
  produces pricing at cost
• D. Requires two assumptions
• 1. No control of inputs
• 2. Cost of colluding is high

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Demsetz Article

• E. Objections
• 1. Excessive duplication of utility distribution
  systems
• 2. Prohibit capture of windfall profits from
  technology change due to uncertainty
• F. Demsetz Answers to objections
• 1. Problem is setting proper price of scarce
  resource of rights-of-way
• 2. Best way to capture uncertainty is long-term
  contracts

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Berg Tschirhart Article

• A. Conclusion LECs are either non-sustainable
  natural monopolies or non-natural monopolies.
• B. Regulation is not necessary for a sustainable
  natural monopoly in a contestable market (w/ no
  entry barriers)

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Berg Tschirhart Article

• C. Chart assumes that regulation is costless and
  deadweight loss is large enough to warrant
  intervention.

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Berg Tschirhart Article

• Under partial regulation, four outcomes
• 1. Sustainable or non-sustainable natural
  monopoly losing one or more of its markets to
  entrants (creamskimming).
• 2. Sustainable or non-sustainable natural
  monopoly retaining all of its markets (because
  its a natural monopoly and has cost advantages).
• 3. A non-natural monopoly being sustainable under
  partial regulation and retaining all its markets
  (and no entry in regulated markets because of
  regulators)
• 4. A non-natural monopoly losing one or more of
  its markets.

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Berg Tschirhart Article

• E. Observe LEC experience and find out what
  category it fits into. (But how about if cost
  allocation rules make the competitive product
  higher than it ought to be? I.e. switched and
  special access)
• F. LEC produces three products in their model.
• 1. POTS - residence - regulated.
• 2. BUSINESS - Higher volumes than POTS and data
  transmission - regulated.
• 3. MESSAGE - non-regulated service sold in
  competitive market.

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Berg Tschirhart Article

• G. Three Assumptions
• 1. All firms have access to the same technology.
• 2. LEC is price taker in competitive market. LEC
  produces at least as much MESSAGE as competitor
  and competitor earns zero profit. (But if they
  can influence cost and price of incumbent, they
  may earn positive profit. Regulators afraid of
  predatory pricing.) (And if there aren't
  competitors - then MESSAGE wouldn't be
  deregulated!)
• 3. LEC earns zero profit under partial
  regulation.

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Berg Tschirhart Article

• H. Three Observations
• 1. LECs are losing market share (being bypassed)
  in some of their markets. Eliminates outcomes 2
  3.
• 2. Some users of BUSINESS are bypassing LECs and
  obtaining service from CAPs.
• 3. CATV poised to begin offering POTS to
  residence.

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Berg Tschirhart Article

• I. Conclusion Either outcome 1 or outcome 4.