Natural
Monopolies
And
Regulation
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Natural Monopolies
 Economies of Scale continue to occur at so large a scale
that is it is “productively efficient” (least cost) to have
only 1 provider
 Natural state and optimal state is a monopoly
 typically high fixed costs and low variable costs
 electric, natural gas, water, telecommunications (land)
and tv cable
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Regulation
 If a natural monopoly arises due to scale economies,
the government may prefer to regulate the monopoly.
 Breaking the firm up may reduce efficiency
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Figure 13.2 Natural Monopoly in the
Telecommunications Industry
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Government Regulation of
Price and Output
 The government cannot require that a natural
monopolist set price equal to marginal cost.
 Because marginal cost is less than average
cost, two options:
1. Government subsidizes the loss (Euro approach)


No deadweight loss, but requires taxes on other goods
2. Average Cost Pricing (or Rate of Return (ROR)):
government sets price equal to average total cost. (US
solution)

Leads to some deadweight loss, but less than a monopoly
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Figure 13.3 Choosing a Price for a Natural
Monopolist
US
French
Economic Loss
or Subsidy
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Government Regulation of Price
and Output
 Two methods of regulating price and output:
 Rate of Return Regulation—the firm is allowed to earn
a pre-specified amount of profit in a given time period.

Set prices to recover average cost + normal rate of return


How do you determine normal ROR?
Incentive for regulated firm to “pad” its costs (Averech-Johnson
effect)
 Price Cap—government sets the maximum price or the
maximum rate of price increase.

After rate setting process: future rates can be raised by rate of
inflation Copyright
– industry’s
average productivity (incentive for tech.
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iinnov.) rights reserved.
Deregulation
 The current trend is for the government to remove
regulation and allow
market forces to determine prices, output, profits, and
industry structure.
 Factors favoring deregulation:
 Difficulty in determining a regulatory strategy
 Advances in technology that have lead
to increased competition
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Reasons For Deregulation
 In deciding to deregulate an industry,
the government must be confident that private
market outcomes will be more efficient than
regulated outcomes.
 Will deregulation affect product safety or reliability?
 Will deregulation eliminate service for
some customers?
 Will the benefits of deregulation accrue to only a few
customers?
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Application:
Deregulation of the Airline Industry
 In 1978, the U.S. Airline Deregulation Act removed
regulations on prices, the number of carriers and
route assignments.
 (some) Passengers have benefited from the resulting
price competition among air carriers.


FAA set similar rates for flights of similar difference, regardless
of destination (and demand in large/small cities)
“legacy” losses and gains

Smaller cities saw higher prices and fewer flight

Larger cities: lower prices, more flights
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Application:
Deregulation of theTelecommunications
 In 1980, AT&T and the “Baby Bells” were broken
up into 8 different companies
 AT&T could offer only long distance service and had to
compete with MCI and Sprint (no longer a monopoly)
 Baby Bells’ customer could choose their LD provider

Took several years for AT&T market share to drop below 80%
 Colbert video – “it’s all back together again”

FCC missed that there were economies of scale – led to
mergers to reduce costs
 1996 Congress passed the Telecommunications Act
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Application:
Deregulation of theTelecommunications
 1996 Congress passed the Telecommunications Act
 Required Baby Bells and GTE to open their local markets
to all competitors



Established prices that Bells could charge competitors for
“renting” their lines and switching equipment
Prices were set below incurred (or historical) costs
 Decreased incentive to maintain and update existing
equipment
Previously business line rates set higher than costs to
subsidize residential phone service
 New entrants targeted business customers and high long
distance usage customers (winners)
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Strategy and Policy
 The Department of Justice takes on Cingular–AT&T
Wireless merger
 In 2004, Cingular agree to buy AT&T Wireless, creating a
company with an HHI of 8,000 in some markets.
 In 2005, the firm was required to divest the entire AT&T
Wireless network in the 13 markets where
concentration was highest.
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