Chapter 2 – Economic Concepts of Regulation

1. 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

2. 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

3. 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

4. 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 • 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

5. 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.

6. Rising Average Cost B A

7. Definition of natural monopoly • Strong natural monopoly satisfies decreasing AC (2.1) • Weak natural monopoly satisfies subadditivity (2.2) but not necessarily decreasing AC (2.1) over the relevant range of q

8. The problem with monopolies:Price setter vs. price taker P PM DWL MC P* D QM Q* Q MR

9. One Regulatory Solution: Average Cost Pricing P PM DWL PAC AC MC P* D QM Q* QAC Q MR

10. Welfare Maximization • 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(qw) = C‘(qw)≡ MC(qw) The prime indicates a derivative, and qwis the output produced and sold.

11. Profit Maximization • 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(qm)≡ p(qm) + qmp‘(qm) = C' (qm) ≡ MC (qm) where qmis the profit-maximizing output, and primes indicated derivatives. This process yields similar result that marginal revenue equals marginal cost.

13. 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, the excess profit given by are xcdais relatively small, but the deadweight loss (or misallocation) given by area cegis relatively large. If cegexceeds 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 AC1, profit will be greater, but deadweight loss will be unchanged. (because MC is assumed unchanged in the relevant quantity range.) • Thus, the excess profit alone 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.

14. 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 extent 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.