ECN 3103
INDUSTRIAL ORGANISATION
8. Regulation
Mr. Sydney Armstrong
Lecturer 1
The University of Guyana
Semester 1, 2015
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Our Plan
1 Natural Monopoly
2 Sunk Costs and Competition
3 The Why and How of Regulation
4 Optimal Price Regulation
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1. WHAT IS A NATURAL MONOPOLY?
-first mentioned by John Stuart Mill (1848)
-Alfred Marshall (1890) discusses role of increasing return in
fostering monopoly
-Posner (1969) writes that natural monopoly \does not refer to
the actual number of sellers in a market but to the relationship
between demand and the technology of supply"
-Carlton and Perloff (2004): \When total production costs would
rise if two or more firms produced instead of one, the single
firm in a market is called a natural monopoly.“
-technological definition of natural monopoly
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Definition (Natural Monopoly Single Product)
A firm producing a single homogenous good is a natural
monopoly when it is less costly to produce any level of output Q
= D(p) within a single firm than with two or more rms. It has
to hold that
where C(q) is the identical cost function for all firms and
That is, the cost function is subadditive for all Q = D(p).
-what makes cost functions subadditive?
- how does this concept relate to increasing returns?
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Example 1: C1(q) = F + cq and AC1(q) = F/q + c
- AC1(q) decreases as output expands: economies of scale
- in single product context: economies scale is sufficient for
subadditivity
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-it follows that in the single product context increasing
returns to scale (IRS) are sufficient but not necessary for
subadditive cost
-subadditive cost function encompass more functions than
those that exhibit IRS over entire range
-IRS over a range of outputs are necessary but cost function
can still be subadditive beyond level where IRS are exhausted
whether industry is natural monopoly also depends on
demand
-if demand grows over time, industry might cease to be a
natural monopoly in the long run
definition of natural monopoly can be generalized to multiproduct firms
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Natural Monopoly with multiple products
-two products A and B produced at quantities QA and QB
-subadditivity: when is it less costly to produce both products
in one firm?
-two dimensions: economies of scope and economies of scale
-economies of scope make it more economical to produce the
two products in one firm rather than two (given that all
output of a product is produced by a single firm):
-economies of scale in one product neither suffcient nor
necessary for multi-product subadditivity
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Is the Electricity Industry as a whole a Natural Monopoly?
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2. SUNK COSTS AND COMPETITION
technological definition of natural monopoly does not include
sunk cost
- sunk cost is a retrospective (past) cost that has already been
incurred and cannot be recovered
- for example, capital and technology worthless in alternative
uses or locations
- sunk cost important to explaining why some industries
naturally evolve to a point with only one or few firms
-most regulated natural monopoly industries, e.g. railroads,
electric power, water networks, cable TV networks, have large
share of sunk costs
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3. TYPES OF REGULATION
Rationale for Regulation
1 regulation as a response to market failure (natural monopoly,
sunk cost)
1 allocative efficiency: value of marginal buyer equals
cost of producing good or service
2 productive efficiency: goods and services are produced
at
minimum possible cost
3 dynamic efficiency: investment and innovation
undertaken at efficient levels
2 political economy rationale (level of regulation driven by
demand from firms/consumers and supply from politicians):
capture theory
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3 universal physical and affordable access to essential products
or services (e.g. electricity, telephone, clean water)
Political Economy of Regulation
1 supply of regulation
politicians supply regulation in exchange for votes and money
 process works because the benefits are large and concentrated and
the costs are small and widely distributed

2 demand for regulation from firms to raise their profits
imposing taxes on others and using the proceeds to provide
subsidies to the firms
 raising the cost of entry to other firms
 regulating producers of substitute products
 regulating prices to eliminate price competition within an industry

3 outcome is inefficient because the benefits to the few are less
than the costs to the many
Literature: capture theory of regulation (Stigler 1971, Posner
1971, Peltzman 1989)
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Specific Investment and Regulation
-investment in industry-specific assets is large part of sunk costs
-specific investment creates commitment problems
-can government commit not to regulate the price of activities
associated with the public interest?
-once investment is sunk, regulator has incentive to regulate
price to average variable cost
-ex post, firm accepts this rather than shut down
-ex ante, firm will not invest
-a corollary, but principal reason for regulation is the protection
of sunk, specific investment
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Market Failure Test for Regulation
-when should natural monopoly regulation occur?
-existence of a monopolist or large sunk costs is not sufficient to
justify regulation
-test that justifies regulation has three components:
1 existence and magnitude of the inefficiencies
2 feasibility of intervention
3 cost-benefit analysis of regulatory intervention
 direct costs include administrative and also compliance and
monitoring costs
 indirect costs include all the regulation-induced inefficiencies
 benefits: three types of efficiency
-decide on extent of regulation or intervention
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Extent of Regulatory Intervention
1 spot markets (no intervention, competition viable)
2 private long-term contracts (no intervention, competition
viable but sunk cost, firms are able to write long-term
contracts with customers to protect sunk investment)
3 concession contracts (natural monopoly and low sunk cost,
private company is given exclusive right to operate, maintain
and carry out investment in a public utility)
4 discretionary regulation (natural monopoly and sunk cost,
price and other forms of regulation)
5 public enterprise (public provision or production, typically
when risks of regulatory failure too high, e.g. national
defence, law enforcement, judiciary services
distinctions in practice not always clear-cut, e.g.14
schools/universities, road maintenance, transport, prisons
Public versus Private Ownership of Enterprise
-public enterprises have long history and are still used in many
countries (less in US, more in Europe/Australia)
-some industries more likely to be in public ownership, e.g. postal
services, defence
-long-standing debate on optimal ownership in regulated
enterprises public ownership allows to support low prices by tax
dollars (e.g. public transport)
-high prices may be enforced as revenue collection (e.g. liquor
stores, gambling)
-public ownership also means that government forces taxpayers
to become shareholders in public enterprise; what is the
opportunity cost of raising/using tax money elsewhere?
public ownership creates bureaucracy which is bad at running15
business
4. OPTIMAL PRICE REGULATION
- traditional theoretical regulation literature: regulator sets
price for natural monopolist maximising social welfare subject
to ensuring firm viability
-regulator has full information on demand, cost parameter and
managerial effort levels
- regulated prices that are unable to recover the monopolist's
cost require costly subsidies
if regulated firm supplies multiple products, optimal price
regulation requires common cost allocation across these
products
-if price discrimination is possible, it can increase efficiency of
regulatory schemes
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-franchise bidding is an alternative to post-entry regulation for
natural monopolies with low sunk costs
Implementing First-Best Pricing with Subsidies
- regulating price to efficient level requires subsidies to
compensate the firm for the loss incurred
- subsidies are costly as they need to be funded through
distortionary taxation
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Second-Best Pricing without Subsidies
- regulating price to lowest possible level that allows firm
to cover its fixed cost: pq- cq = F
- solving for p yields as zero iso-prot curve: p = c + F=q =
AC1(q)
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the regulator's maximisation problem is as follows
this yields lowest price on the demand schedule that
guarantees cost coverage for firm
-average-cost pricing avoids subsidies but introduces
deadweight loss relative to first-best allocation
regulated price: c < pR < pm: the closer the best regulated
price is to monopoly, the less gains from regulation
-algebraic solution: cross inverse demand and zero-iso-prot
curve and solve for the lowest price or highest quantity root of19
the resulting quadratic equation