Regulation of Monopoly

M1 QEA
 Outline
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Definition of Natural Monopoly

Public intervention: pricing rules

Implementation and incentive regulation tools

 What is a natural monopoly?
3

A When a single firm can produce a product or a group of

products more cheaply than two or more firms.

B 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(q1+q2)<c(q1) + c(q2)
 What is a natural monopoly?
4

C Subadditivity is not the same as economies of scale.

Costs can be subadditive even if diseconomies exist (near
the total output q1+q2).

C In the single product case, scale economies is a sufficient condition

for subadditivitity.

D 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.
 What is a natural monopoly?
5

E 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.

F Sustainable natural monopoly is one where entry can be

prevented. (Price where Long Run Average Total Costs
meets demand curve - no incentive to enter).
 Other Reasons for Regulation.
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 Destructive competition results from pricing at MC.

Happens in industries where fixed costs are large and
demand is highly cyclical or variable.
 Equity concerns. Errors with price discrimination. Cross-
subsidies . Geographic rate averaging.
 Rationing. Radio or TV spectrum.
 Regulators' problems
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A. Pricing

- In many regulated industries, there are significant

economies of large-scale production
- In an industry with economies of scale, the Long Run
Average Cost-LRAC curve is downward sloping
- If average cost is declining, then the MC is below AC
 Monopoly Regulation

 Two theories about how regulation works are

 Social interest theory: the political and regulatory

process relentlessly seeks out inefficiency and regulates to
eliminate deadweight loss.
 Capture theory: regulation serves the self-interest of the
producer, who captures the regulator.

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 Monopoly Regulation
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Efficient Regulation of a Natural Monopoly

 When demand and cost conditions create natural monopoly,
the quantity produced is less than the efficient quantity.
 How can government regulate natural monopoly so that it
produces the efficient quantity.
 Marginal cost pricing rule is a regulation that sets the
price equal to the monopoly’s marginal cost.
 The quantity demanded at a price equal to marginal cost is
the efficient quantity.
 Monopoly Regulation
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 This figure illustrates the

marginal cost pricing rule.

 Unregulated the natural

monopoly maximizes
economic profit by
producing the quantity at
which marginal revenue
equals marginal cost …

 and charging the highest

price at which that quantity
will be bought.
 Monopoly Regulation
11
 The demand curve is the
MSB curve.
 The marginal cost curve is
the MSC curve.
 Regulating a natural
monopoly in the social
interest sets the quantity
where MSB = MSC.
 Efficient regulation sets the
price equal to marginal cost.
 Monopoly Regulation
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 With marginal cost pricing

rule, the quantity produced
is efficient,
 but the average cost exceeds
price, so the firm incurs an
economic loss.
 How can the firm cover its
costs and at the same time
obey the marginal cost
pricing rule?
 Monopoly Regulation
13

 Where possible, a regulated

natural monopoly
might be permitted to
price discriminate to
cover the loss from
marginal cost pricing.
 Or the natural monopoly
might charge a one-time
fee to cover its fixed
costs and then charge a
price equal to marginal cost
 Monopoly Regulation
14

 Second-Best
Regulation of a
Natural Monopoly
 Another alternative is to
permit the firm to produce
the quantity at which price
equals average cost and to
set the price equal to
average cost—the
average cost pricing
rule.
 Or the government might
pay a subsidy equal to the
monopoly’s loss.
 Implementation
15

How regulation can preserve some « efforts » by the

monopolist?
 Depends from the strenght of the incentives/time horizon/costs
 Transfer t= a+b*Costs

Costs Incentives Time horizon Impact of the

incentives
1. b=0 Regulation of the profit ex post weak
rate
(rate of return
regulation)
2. 0<b<1 Incentive contract Periodically average

3. b=1 Price fixing ex ante strong

(price cap)
 Monopoly Regulation in practice
16

 Implementing average cost pricing can be a problem

because it is not possible for the regulator to be sure what
the firm’s costs are.
 Regulators use one of two practical rules:

 Rate of return regulation

 Price cap regulation
 Monopoly Regulation
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 Rate of Return Regulation

 Under rate of return regulation, a firm must justify
its price by showing that its return on capital doesn’t
exceed a specified target rate.

 This type of regulation can end up serving the self-

interest of the firm rather than the social interest because
…
 the firm’s managers have an incentive to inflate costs and
use more capital than the efficient amount.
 Monopoly Regulation
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 Price Cap Regulation

 A price cap regulation is a price ceiling.
 The rule specifies the highest price that the firm is
permitted to charge.
 This type of regulation gives the firm an incentive to
operate efficiently and keep costs under control.
 The following figure shows how a price works.
 Monopoly Regulation
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 Unregulated, a natural
monopoly profit-
maximizes.
 A price cap sets the
maximum price.
 The firm has an incentive to
minimize cost and produce
the quantity on the demand
curve at the price cap.
 The price cap regulation
lowers the price and
increases the quantity.
 Price-cap regulation in the UK
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 1984: CPI-3%. Line rentals, local & long distance calls;

individual cap of CPI + 2% on line rentals until 1997.
 1989: CPI - 4.5%. Line rentals, local & long-distance.
 1991: CPI - 6.25%. Basket extended to include international
calls.
 1997-2001: CPI - 0%. Line rentals for small business. Low
usage small business service packages must be as good as
for residential segment.
 Price-cap regulation in France
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1995: CPI - 4.5%. Basic voice telephony services

without discount schemes, comprising access, line
rentals, calls (local, national, international and
payphones).
1996: CPI - 5.5%. Basic voice telephony services, as
defined above.
1997: CPI - 9%. Basic voice telephony services, as
defined above.
 Outline

 Regulation of monopoly in practice

Rate of Return regulation

 The Averch Jonhson effect

Other Forms of regulation

 Price Cap
Regulation of monopoly in
practice
 Fair and reasonable rate

Allowed Revenue ( R )=
Expenses (E)+ Fair rate of return.

Fair rate of return = s*RB=

allowed cost of capital (s)*regulatory asset base (or
rate base, RB).

Two problems:
 Rate level (i.e.the allowed revenue)
 Rate structure (i.e. permissible price discrimination which achieves
rate level)
 Rate Level

R=E+s*RB
 E: company submits detailed cost breakdown of regulated
company business.
 Occasionally excessive expenses can be disallowed e.g. for a
nuclear plant, only 20% of cost allowed (the company could
have put in cheaper alternative technology)
 RB: usually original cost of capital.

 s: established in rate hearings and precedent

( in general 10.5%).
 Rate Base

Different ways of calculating the rate base are

possible:
 Original cost, problematic if there is inflation, as current costs
do not reflect LRMC, this gives incentives to over-consume.
 Replacement cost: modern equivalent asset values.
 Fair value cost: weighted value of the above.
 Market value: however this reflects past regulatory decisions
and you are wanting to set rates going forward.
 Rate of return

 WACC = weighted average cost of capital (equity+bond

costs,averaged).

 The WACC is the cost of financing new projects based on

how a company is structured.
 If a company is 100% debt then it would be easy: just find the
interest on the issued debt and adjust for taxes (because interest is
tax deductible).
 In reality, a corporation is much more complex. Finding the true cost
of capital requires a calculation based on a combination of sources.
Some would even argue that, under certain assumptions, the capital
structure is irrelevant, as outlined in the Modigliani-Miller theorem.
 In practice

Indicating with Q the total quantities of the

goods/services (minutes, kWh …)

Price = R / Q

 Hearing process: when the ex post rate of return is

higher than s , regulator reduces prices; if it is lower
than s, regulator increases prices.
 Advantages and Limits

Pros of ROR:
 Financial integrity of regulated firm is always guaranteed;
 Monitoring of profits
 No incentive to reduce service quality
Cons of ROR:
 No incentive to reduce costs (no productive efficiency)
cost plus mechanism
 Incentive to overinvest (inefficiently) if s> r (Averch –
Johnson effect)
 Risk of accounting manipulation
 Information demanded method and so high
administrative costs
The Averch-Jonhson Effect
 Averch-Jonshon Effect (A-J)

1962 A-J showed that RoR regulated firms have an

incentive over-capitalise.
 Firm chooses, amount of capital, K, Q=f(K)
R(q)=R(f(K))
Costs are rk, Other expenditures = 0
Profits = R(f(K))-rK
Under rate of return regulation: Π=(s-r)K
Empirical Evidence?
 Alternative to RoR

Sliding scale plan, shares risk and rewards between

shareholders and consumers (profit sharing).
 Alternatives to RoR

 Yardstick regulation (Shleifer, 1985)

 Set price equal to average cost of comparable
utilities.
 Problem hard to find comparable utilities e.g. local
 electricity distribution companies.

 Price Cap regulation

 CPI-X formula, rise prices by inflation minus some productivity
adjustment formula.
 Usually formula fixed for a period (the regulatory lag)
 Setting X usually involves some form of benchmarking of costs
to assess scope for future productivity gains.
Price cap
 Price cap Regulaiton

 The price cap mechanism is characterized by four characteristics:

 in the single product case, the regulator set a cap and the regulated
firm may choose a price below or equal to this cap, and it is allowed
to retain whatever profits it earns at that price;

 in the multi-product case, the regulator defines an aggregate cap

for a basket of related products. This aggregate cap takes the form of
a price index or a weighted average of prices. While the firm has to
obey the aggregate cap, it is allowed to choose relative prices;

 the regulator specifies that the price cap will be adjusted over time
by a preannounced adjustment factor;

 at longer intervals, the price cap is updated by the regulator.

 Price Cap Formula

Regulator defines, for a certain period of time, a

limit to the growth of price(s) of a (single or a weight
average) set of goods or services:

RPI= retail price index

X = (estimated) growth in productivity & reduction
that regulator wants to pass to consumers
 Advantages and limits of the Price Cap (I)

Pros

It induces firms to reduce their operative costs & increase

in productive efficiency & fixed price method

 Regulated firms freely set their prices. Thus, regulator

delegates to regulated firms the definition of every single
services’ price

Less administrative burdens on regulator … almost at

first sight
 Advantages and limits of the Price Cap (II)

Cons

 Incentive to reduce costs … especially quality expenditure!

 If X is set too high, regulated firm risk to go out of business

 Risk on cost fluctuations is completely in charge of the firm

 Incentive is related to how long is the regulatory lag: if it istoo short … no

incentive at all

 Rachet effect: since regulation is a dynamic control activity, if the regulated

firm anticipate that the information they reveal could be used in future to reduce
retail prices … no incentive to increase efficiency so much!
 Evidence

 Price caps seem to encourage faster rates of cost reduction

than conventional RoR schemes.
 European, South American and Australasian regulators have
selected price cap regulation over RoR and seen sharp
reductions in costs.
 Many US regulators accept the superiority of price cap
regulation and encourage companies to adopt performance
based rate making regimes or simple price caps at times of
rate review.
 However as inflation is low there have effectively been few rate cases
over the last few years at which companies have requested rate
changes.