Economics of Regulation
Natural Monopoly
What is a natural monopoly?
A When a single firm can produce a product or a group of
products more cheaply than two or more firms.
B Technically, a natural monopoly exists in an industry
where the costs are subadditive. That is, where two firms
produce q1 and q2 respectively and the costs are as
follows
C(Q)=c(q1+q2)<c(q1) + c(q2)
What is a natural monopoly?
C Subadditivity is not the same as economies of scale.
Costs can be subadditive even if diseconomies exist (near
the total output q1+q2). In the single product case, scale
economies is a sufficient condition for subadditivitity.
D In the multiproduct case, product-specific scale
economies is not a sufficient condition. Economies of
scope is a necessary but not sufficient condition for
subadditivity. Even Economies of scale and scope is no
guarantee of cost subadditivity.
What is a natural monopoly?
E Contestable Market is one where there is free entry and
even a single firm will face pressure to keep costs low
and to price efficiently. Developed by Baumol, Panzer,
Willig.
F Sustainable natural monopoly is one where entry can be
prevented. (Price where LATC meets demand curve - no
incentive to enter).
Other Reasons for Regulation.
Destructive competition results from pricing at MC.
Happens in industries where fixed costs are large and
demand is highly cyclical or variable. (I.e. electrical
conspiracy)
Equity concerns. Errs with price discrimination. Crosssubsidies as in LD to local. Geographic rate averaging.
Rationing. Radio or TV spectrum. Traditional FCC versus
PCS auctions.
Other Reasons for Regulation.
Market Stabilization. Social welfare will improve if gov't
tames wild price flunctations and stabilizes market.
Agriculture markets with lags.
Capture and Rent Seeking. This is not in the public
interest as the other ones are. This is only a reason for the
firms who want regulation.
Regulators' problems
A. Pricing
- In many regulated industries, there are significant
economies of large-scale production
- In an industry with economies of scale, the LRAC curve
is downward sloping
- If average cost is declining, then the MC is below AC
Regulators' problems
Regulators' problems
- Pricing at MC, the firm suffers a loss.
- loss could be covered by a subsidy for gov't. Raising
taxes through sales or income tax causes other
distortions. If it is subsidized, it is usually publicly
owned.
- price discrimination where high rates for some
customers are used to cover the loss. Local telephone
service subsidized by LD.
- Pricing at LATC, social welfare is not maximize.
Deadweight loss triangle.
Regulators' problems
•
B. Incentive
Incentive Problem ---- assume regulator
prices at P=ATC and firm earns no
economic profit. No incentive to cut costs increasing costs lead to increasing prices.
Leads to feather-bedding.
Demsetz Article
A. Argues aganist Natural Monopoly Theory which
he defines as scale economies -> less costly for
one firm than 2 or more firms -> left unregulated,
firm sets price and quantity at monopoly levels.
B. Deficient because it fails to reveal the logical
steps that this takes in the marketplace
Demsetz Article
C. Uses bidding process / why does scale
economies limit bidders; unlimited bidders
produces pricing at cost
D. Requires two assumptions
• 1. No control of inputs
• 2. Cost of colluding is high
Demsetz Article
E. Objections
• 1. Excessive duplication of utility distribution systems
• 2. Prohibit capture of windfall profits from technology
change due to uncertainty
F. Demsetz Answers to objections
• 1. Problem is setting proper price of scarce resource of
rights-of-way
• 2. Best way to capture uncertainty is long-term
contracts
Berg & Tschirhart Article
A. Conclusion: LECs are either non-sustainable
natural monopolies or non-natural monopolies.
B. Regulation is not necessary for a sustainable
natural monopoly in a contestable market (w/ no
entry barriers)
Berg & Tschirhart Article
Barriers to
entry
No Barriers
sustainable Non sustainable
Natural
Monopoly
Regulate
Non-Natural Antitrust Monopoly
Breakup
Do not
Regulate
Regulate
Impossible
Do not Regulate
C. Chart assumes that regulation is costless and deadweight loss is
large enough to warrant intervention.
Berg & Tschirhart Article
Under partial regulation, four outcomes:
• 1. Sustainable or non-sustainable natural monopoly losing one or
more of its markets to entrants (creamskimming).
• 2. Sustainable or non-sustainable natural monopoly retaining all
of its markets (because its a natural monopoly and has cost
advantages).
• 3. A non-natural monopoly being sustainable under partial
regulation and retaining all its markets (and no entry in regulated
markets because of regulators)
• 4. A non-natural monopoly losing one or more of its markets.
Berg & Tschirhart Article
E. Observe LEC experience and find out what category it
fits into. (But how about if cost allocation rules make the
competitive product higher than it ought to be? I.e.
switched and special access)
F. LEC produces three products in their model.
• 1. POTS - residence - regulated.
• 2. BUSINESS - Higher volumes than POTS and data transmission regulated.
• 3. MESSAGE - non-regulated service sold in competitive market.
Berg & Tschirhart Article
G. Three Assumptions
– 1. All firms have access to the same technology.
– 2. LEC is price taker in competitive market. LEC
produces at least as much MESSAGE as competitor
and competitor earns zero profit. (But if they can
influence cost and price of incumbent, they may
earn positive profit. Regulators afraid of predatory
pricing.) (And if there aren't competitors - then
MESSAGE wouldn't be deregulated!)
– 3. LEC earns zero profit under partial regulation.
Berg & Tschirhart Article
H. Three Observations
• 1. LECs are losing market share (being
bypassed) in some of their markets. Eliminates
outcomes 2 & 3.
• 2. Some users of BUSINESS are bypassing LECs
and obtaining service from CAPs.
• 3. CATV poised to begin offering POTS to
residence.
Berg & Tschirhart Article
I. Conclusion: Either outcome 1 or outcome
4.