Theory of Regulation
PhD, DFA
M. Victor M. Martins
Semester 2
2008/2009

Theory of Regulation
Regulation of natural monopoly
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{ z z z
Sustainability of natural monopolies and contestability
Evolution of natural monopolies regulation
Regulation of unregulated markets z z
( VVH) Chap 11, 15
Baumol, W. and R. Willig 1981 “ Fixed Costs, Sunk Costs, Entry
Barriers and Sustainability of Monopoly “Quartely Journal of
Economics, 95, August, 405-431
Sustainable
Energy
Systems
Slide 2

Theory of Regulation
Regulation of natural monopoly: sustainable natural monopoly
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Sustainable Monopoly
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The definition of a natural monopoly is that a single firm can produce the total market demand at lower cost than any combination of two or more firms.
However, a natural monopoly is only sustainable price, whilst making a profit, resulting in an if there exists a price and output combination such that entry by rival firms is unattractive, while all demand is satisfied and revenues cover total costs of production.
In a natural monopoly market with a single product, a sufficient condition for sustainability is that average costs of production fall as output expands. Consequently, this means that average costs will be higher than marginal (or incremental) costs.
Unfortunately, it is quite possible for marginal costs to be above average costs, yet for the firm’s cost structure to remain consistent with a natural monopoly.
If this occurs, a competitor can potentially undercut the monopolist’s unsustainable natural monopoly.
Hence, for an unsustainable natural monopoly, natural monopoly and competition are not mutually exclusive.
Slide 3

Theory of Regulation
Regulation of natural monopoly: sustainable natural monopoly
Natural monopoly is sustainable up to q1; In q* the natural monopoly is unsustainable
Sustainable
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Price
Cost
€
P*
AC
1
AC
2 q1 q* q2 Q
Slide 4

Theory of Regulation
Regulation of natural monopoly: sustainable natural monopoly
Sustainable
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Systems
A sustainable monopoly can prevent market entry:
There exist q,p such that
(1)
(2) q=D(p) , pq=C(q),
(3)
{
{ p’q’<C(q’) for all p’<p and all q’ ≤ D(p’)
The monopolist satisfies the whole demand, can recover its costs and no other firm can charge a lower price and recover its costs, hence a natural monopoly is sustainable if ATC are falling up to quantity q where ATC = demand
If condition (1) is not fulfilled, i.e. monopolist is not satisfying whole demand, entrant might try to satisfy residual demand at high price
The monopolist just covers her costs. This is enough to start production, because costs include opportunity costs.
Slide 5

Theory of Regulation
Regulation of natural monopoly: Contestable markets
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{
{
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Theory of contestable markets developed by William J.
Baumol, John Panzar and Robert Willig (1982) helped to fill important gaps in market structure theory.
z
Perfectly contestable market – the pure form – not common in reality but a benchmark to explain firms’ behaviours
Key characteristics:
Firms’ behaviour influenced by the threat of new entrants to the industry
No barriers to entry or exit
No sunk costs
Firms may deliberately limit profits made to discourage new entrants – entry limit pricing
Firms may attempt to erect artificial barriers to entry – e.g…
Slide 6

Theory of Regulation
Regulation of natural monopoly: Contestable markets
{
Over capacity – provides the opportunity to flood the market and drive down price in the event of a threat of entry
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{
Aggressive marketing and branding strategies to ‘tighten’ up the market
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Potential for predatory or destroyer pricing
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Find ways of reducing costs and increasing efficiency to gain competitive advantage
Slide 7

Theory of Regulation
Regulation of natural monopoly: Contestable markets
{
{
{
‘ Hit and Run’ tactics – enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit)
Cream-skimming – identifying parts of the market that are high in value added and exploiting those markets
Examples of markets exhibiting contestability characteristics: z z z z z
Financial services
Airlines – especially flights on domestic routes
Computer industry – ISPs, software, web development
Energy supplies
The postal service?
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Slide 8

Theory of Regulation
Regulation of natural monopoly: Contestable markets
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{
Contestable markets and regulation
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The theory of contestable markets would have strong implications: if entry is free, we should not care about monopolists, as efficient outcome is reached.
Critique: the theory depends on two strong assumptions: z z
Unrealistic timing of the game (I cannot change price as E enters the market)
No fixed sunk costs of entry (hit-and-run strategy not profitable for entry if some costs are non-recoverable)
But the theory has the merit to stress the role of free entry in limiting market power: crucial in merger analysis.
Slide 9

Theory of Regulation
Regulation of natural monopoly: Contestable markets
{
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With increasing returns to scale the following conclusions are predicted z
There is a unique operating firm in the industry z z
This firm makes zero profits
Average-cost pricing prevails
In the absence of competition, potential entry is very effective in disciplining incumbent firms : this theory
( contestable markets) presents a strong argument against regulation or nationalization of utilities
Criticism: Generally believed that prices adjust more rapidly than decisions about quantity or entry
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Slide 10

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
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{
{
z z z
Dynamic changes in the market can result in a industry no longer being a natural monopoly?
Yes,
In certain conditions the regulatory agency should be open to this possibility and then adapt the regulatory model – entry and price controls - to the new market and firm conditions.
Slide 11

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
Sustainable
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{
z z z
General rule : Monopoly regulation is appropriate when the minimum efficient size of the firm is approximately equal to market demand
Technological innovation and changes in input prices affect the cost and demand underlying the rationale for monopoly regulation
The question is to determine when such changes are so decisive that the industry is no longer a natural monopoly.
Slide 12

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
{
Demand side
Factors underlying demand shifts: z z z
Exogenous changes in consumer preferences
Changes in income
Changes in productivity Price
D
1
D
0
If income raises the demand function shifts to the right
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Quantity
Slide 13

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Natural monopoly and Minimum Efficient Scale (MES)
After a demand shift the optimal output is 3 times Q 0 enough to support 3 firms
Price
D 0
D*
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P*
AC(Q)
0
Q* Q 0
Quantity
3Q 0
Slide 14

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Ex. With a more realistic cost function
Price
Cost
P=D
1
(Q)
P=D
0
(Q)
AC
P
0 Q* Q 0
MES
Q 0 /
2
Q 0
MES
Q**
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Energy
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Slide 15

Theory of Regulation
Regulation of natural monoply: Evolution of natural monopolies regulation
{
{
{
The cost function ( marginal and average) will change when there is technological innovation or when there is a change in input prices
The change in cost structure can affect the natural monopoly in two ways: z z
The efficient firm size can change
The social optimal output can be affected
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These two effects may be illustrated by changes in fixed costs and by changes in variable costs
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Slide 16

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Reduction in fixed costs
Cost
P*
P 0
0
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D
AC
0
Q 0
AC
1
Q**
C(Q)=FC+VC(Q)
AC(Q)=FC/Q+AVC(Q)
2Q 0 Q
Slide 17

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
Sustainable
Energy
Systems
{
z z z
A fall in fixed costs as a result of innovation makes it less likely that an industry is a natural monopoly
In figure of slide 17 the fixed cost fall moves the industry from being a natural monopoly in one in which two firms can profitably exist: MES from
Q** to Q 0
At the same time the socially optimal price is lower P 0 <P*
Slide 18

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Rise in the price of inputs Î average variable cost to rise
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Cost
P
D
ELASTIC
D
INELASTIC
AC
1
AC
0
0
Q 0 Q* 2Q* Q^
Q
Slide 19

Theory of Regulation
Regulation of natural monopoly: Evolution of natural monopolies regulation
Sustainable
Energy
Systems
{
z z z
If AC 0 Î AC 1
MES falls from Q^to Q*
Higher AC reduces the socially optimal output, but the net effect depends in the elasticity of demand:
{
If D
ELASTIC , output moves from Q^ to 2Q 0 and two firms can profitably existe in this market
{
If D
INELASTIC , output moves from Q^ to Q 0 and the natural monoploy still exists
Slide 20

Theory of Regulation
Contestable markets: discussion
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When faced with this type of changes just described, which policies should the regulatory agency pursue?
z
Pursue full deregulation z z
Continue regulation process and practice
Pursue partial deregulation
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Competition is desirable where it is possible
Regulation does tend to limit competition
Regulation extremely slow to adapt to change in technology and demand once put in place
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Slide 21