Week 6 Dynamic Issues

Regulatory Policy Changing environment Demand and Cost Conditions Regulatory policy should take this into consideration Usually, small changes change the socially optimal price and quantity However, large changes may question monopoly regulation

Natural Monopoly: revision Demand Matters for determining the existence of a natural monopoly. If demand intersects AC before Qhat, then surely a natural monopoly. If above, look at intersection with the minimum efficient scale. If intersection larger than 2Qhat, then no regulation.

Natural monopoly Scale economies up to Q hat. If demand D(P), it is a natural monopoly, since it intersects AC when AC is falling That is, cost is certainly sub-additive Under linear pricing, one firm operates at price equal to P* (average cost pricing) P* maximises welfare under restriction that firm profit is non-negative Total cost is minimized at Q*

Information about market demand important Information about market demand is required to determine the optimal regulatory policy Let AC be the same and consider larger demand D bar. The socially optimal linear price is then P hat. This equals the minimum average cost AC(Q) Market demand is 3 Q hat, that is three firms No reason to regulate

Ct'd Minimum efficient scale (lowest quantity at which average cost is minimised) cost is equal to or larger than market demand, then regulation is appropriate If D is demand, regulation appropriate If D bar is demand, market demand is three times minimum efficient scale, therefore regulation is inappropriate Here, market demand at p=min AC is exactly equal to three times minimum efficient scale.

Flat average cost

Flat AC ctn'd Minimum efficient scale is Q lower bar Average cost is minimized over Q lower bar to Q upper bar If D(p), then natural monopoly No natural monopoly under D bar If Q lower bar < Q 0 /2 < Q upper bar, then industry cost is minimised by having two firms

Sources of natural monopoly transformation Demand side: events that make efficient size smaller relative to market demand at the socially optimal price (income elast., preferences, prices of alternatives and complements) Cost side: cost changes can affect the socially optimal output See next example C(Q) = FC + VC(Q), that is, cost is equal to fixed cost (that does not depend on output Q) and variable cost that depends on Q AC(Q)=FC/Q + AVC(Q), that is, average cost is average fixed cost plus average variable cost.

Reduction in fixed cost What happens to the minimum efficient scale? What to the optimal output?

Reduction in fixed cost Reduction of fixed cost causes falling average costs Since average cost falls, the socially optimal output under average cost pricing is higher Since fixed cost are a smaller part of cost, minimum efficient scale falls. AC falls to AC bar Minimum efficient scale falls from Q hat to Q bar Price P* falls to P bar Now demand is 2Q bar, efficient market structure is two firms. When fixed cost decrease, efficient output increases and minimum efficient scale decreases, industry may become potentially competitive

Change in variable cost This is a case of increase of variable cost. Minimum Efficient scale decreases, efficient quantity also. Which effect dominates? Can you do it for a variable cost decrease?

Variable cost Change in variable cost has an ambiguous effect Example: rise in input prices shifts AC to AC bar Average cost is higher Fixed cost make up a smaller proportion of total cost, minimum efficient scale falls from Q hat to Q bar. A smaller minimum efficient scale makes the industry less likely to remain a natural monopoly.

Changes in variable cost Higher average cost reduces the socially optimum output (opposite effect) Net effect depends on the elasticity of demand If demand is highly inelastic like D, the socially optimal output does not fall very much Example: from Q hat to 2 Q bar, monopoly regulation not necessary any more If demand is elastic like D bar, the socially optimal output falls a lot, natural monopoly Example: from Q hat to Q zero

Policy Alternatives Continuation of price and entry regulation Full deregulation (remove price and entry regulations entirely) Partial deregulation (loosening entry restrictions; keeping substantive price regulations, for example maximum and minimum prices; asymmetric price regulation (entrants are treated differently to incumbents) Structural separation

Asymmetric regulation and cream skimming Established firms are treated differently from entrants For example, pricing of established firm restricted, pricing of entrant unrestricted Problem: avoid cross-subsidisation, that is, one product generates additional revenues to subsidise the sale of a second product But also want to avoid setting the prices with cross subsidization that might assist entry but may induce cream skimming

Creamskimming Two products:X and Y Economies of scope, producing two products by one firm is cheaper than producing separately by two firms C(X,Y)<C(X,0)+C(0,X) Product-specific economies of scale: for single-product firm this means AC is declining For multi-product firm: Average incremental cost are declining AIC(X)=[C(X,Y)-C(0,Y)]/X is declining

Ct'nd Note that product-specific economies of scale and economies of scope imply we have a multi-product natural monopoly However we may like to test some competition in both market, so free entry. Example: Suppose we have regulation of the two prices as in the following figure

Creamskimming Average incremental and average stand alone cost are decreasing in both markets. But AIC are always lower than AC. There’s cross subsidization for market Y.

Creamskimming Product Y is priced below its average incremental cost, and product X is priced relatively high Firm makes zero economic profit (normal profit) Firm is a natural monopoly (see cost function) Asymmetric regulatory policy leads to wasteful entry Entrant enters in profitable market X by slightly undercutting the price (but not in Y since this is unprofitable) CREAMSKIMMING

Creamskimming Entry is wasteful because for each output pair, one firm in the market is cost- minimising (average incremental cost is below average cost for single-product firm) Cross-subsidisation not socially optimal, since the high price in market X gives the wrong signal to entrant Entry by less efficient firm would not be profitable under Ramsey-Boiteux pricing

Example: intercity telecommunications market in US Technological developments in the (long distance) telephone industry (in part microwave technology developed late ’40) implied much lower fixed costs, allowed competitors to AT&T to theor. enter the market. Demand for tel services proved to be very elastic to income (up to 2.76), so demand was shifting outward considerably. Still balance uncertain. Did we still have a natural monopoly? Most studies early 70’s demonstrated that economies of scale were exausted at really small scale.

Deregulation Late 60’s entry was allowed in high density connections But asymmetric regulation of AT&T was kept in place. In part. AT&T was compelled to heavily cross subs. the low density routes (less attractive to entrants). Evidence of discriminatory behaviour: in 1982 as a result of a 7-year Antitrust case of the FCC, AT&T severed its operations in regional markets,’Local Exchange and Transport Areas’ (LATA), assigned to new companies, which couldn’t operate in inter-LATA services market;

Deregulation This notwithst. regulation of AT&T was kept in place with cross subsidisation in pratice to assist entry and avoid dominance Market Share of AT&T steadily declining

Structural separation Benefits: Avoid cross subsidization of competitive services to deter entry; It may be easier in case of common costs; difficult to attribute to different services Monopolist will try to attribute them to regulated business (cost padding) Avoid strategic use of essential facilities to deter entry. An independent operator will be impartial among competitors

Structural separation Costs Less competition; Incumbent may be more efficient and preventing his participation may be welfare decreasing. But separation does not mean death of the incumbent firm; Economies of scope. But then may be an overall natural monopoly Double margins- need to regulate the infrastrucure anyway