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Regulation of Natural Monopoly 1

Regulation of Natural Monopoly 1. Natural monopoly : declining ATC relative to market demand means that significantly lower costs are possible with only one firm producing than if more than one does

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Regulation of Natural Monopoly 1

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  1. Regulation of Natural Monopoly1 • Natural monopoly : declining ATC relative to market demand means that significantly lower costs are possible with only one firm producing than if more than one does • However, if the right to be a monopolist is granted, an unconstrained monopolist will charge the monopoly price and earn a monopolist’s economic profits. • So, we grant monopoly status but regulate to prevent monopoly abuse, usually by setting price.

  2. Regulation of Natural Monopoly 2 • Marginal cost pricing is economically efficient, but may lead to profits or losses • Setting price so that output is where average total cost is a minimum is not efficient and may lead to profits or losses • Setting price so that output is where price = average total cost results in zero economic profit • This is also called rate of return regulation

  3. Regulation of Natural Monopoly3 $ D MR Pm MC ATC Patc Pmc Q Qm Qatc Qmc

  4. Regulation of Natural Monopoly 4 • Elements of a rate case before a regulatory agency to establish price • + TR = Sum of (P for each group of customers *Q for each group) • Adjust P’s to make profits = 0 allowing for demand relationship Q=f(P,…), I.e., Q’s change with P’s • - TC = Sum of allowable costs (from the regulators’ point of view) • Variable costs (fuels, materials, labor, utilities) change with Q’s • Fixed explicit costs (rents, interest costs, administrative costs) • Fixed implicit accounting costs (depreciation) • = Accounting profits = Rate of return * Value of assets • If rate of return = “normal” rate of return, accounting profits = normal profits and therefore ECONOMIC PROFITS = ZERO • What is “normal” rate of return, i.e., what rate of return should regulators allow? • What assets should be included (partially completed new plants?)

  5. Regulation of Natural Monopoly5 • Other issues in regulation of natural monopoly • What costs should be allowed? (Marketing, costs of boardrooms) • Rate cases pancaking (first one not decided before another is filed) • Fuel adjustment charges as automatic price setting adjustment • Over-investment in capital because of regulation (Averch-Johnson effect) • Efficiency of regulated industries • Dynamic efficiency (technical change) vs. static efficiency • MC pricing with 2-part tariff • Peak load pricing • Franchise bidding as an alternative/complement to price regulation • Public ownership (Many other countries have more) • Utilities(electric,water,cable,telephone, etc.), fuels (oil, gas, coal), transport (subway,rail,bus,air), critical industries (steel, ship-building)

  6. Regulation of Natural Monopoly6 • Agencies • Federal: ICC, FERC (FPC), SEC, FCC, CAB) • State: Public Utility or Public Service Commissions • Participants • Commissioners • Commission staffers • Company personnel • Intervenors

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