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Price Regulation of Natural Monopolies

Price Regulation of Natural Monopolies. Average total cost. “ Natural” Monopoly. Price/unit. Industry characterized by declining ATC. 0. Output/hr 产出 / 小时. Recall relationship between MC and ATC. MC. ATC. Price/unit. $3.50. $3.00. $2.50. $2.00. $1.50. $1.00.

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Price Regulation of Natural Monopolies

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  1. Price Regulation of Natural Monopolies

  2. Average total cost “Natural” Monopoly Price/unit Industry characterized by declining ATC 0 Output/hr 产出/小时

  3. Recall relationship between MC and ATC MC ATC Price/unit $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 MC and AC intersectat ATC minimum $0.50 $0.00 0 2 4 6 8 10 12 Output/hr

  4. The Problem of Setting Regulated Prices for a Natural Monopoly Price/unit Problem: Competitive-based pricing (P=MC) does not allow adequate cost recovery (< AC). Demand AC Pc MC Output/hr 0 Qc

  5. Setting Regulated Prices for a Natural Monopoly Price/unit Solution 1: PR = AC(Q) Quantity sold = QR Demand PR AC Pc MC Output/hr 0 QR Qc

  6. Problem with setting P = AC • Loss of price signal to consumers • Increases need for (expensive) peak capacity • Increases costs and prices

  7. Setting Regulated Prices for a Natural Monopoly Solution 2: Two-part tariff: Usage charge PR = MC Fixed charge = [AC (Qc)-MC (Qc)] * Qc Price/unit Demand AC AC (QR) FIXED CHARGE 固定支付 PR MC Output/hr QR = Qc 0

  8. Cost-Based Regulated Price for Natural Monopoly Regulated price = Fixed costs (amortization in current year) + Operating costs + return on equity and debt capital

  9. Problems with Cost-Based Regulated Pricing Setting regulated price = fixed costs + operating costs + return on capital invested • Inadequate incentives for efficiency • Need for significant regulatory supervision • Tendency for “gold-plating”

  10. Price Cap: Alternative to Cost-Based Regulated Prices Revenues in base year Rb = costs in base year Revenues in following year = Rb (1 + Ab) Revenues in year t Rt = Rt-1 (1 + At) t = 2,….n At = adjustment in firm’s prices based on inflation and technological change OR average cost increase for sample of comparable firms. If firm’s increase in costs in year t < At →the firm gets to keep thedifference →incentive to be cost efficient However, firm must be subject to quality standards. Otherwise it can cut costs and reduce quality.

  11. Strategic Positioning Prefer cost-based or price cap regulation? Risk Reward Corporate Mentality Strategic Outlook

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