Price Regulation of Natural Monopolies

“Natural” Monopoly Average total cost Output/hr 产出 / 小时 Price/unit 0 Industry characterized by declining ATC

MC ATC Recall relationship between MC and ATC $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $ Output/hr MC and AC intersect at ATC minimum Price/unit

The Problem of Setting Regulated Prices for a Natural Monopoly Output/hr Price/unit 0 MC AC Problem: Competitive-based pricing (P=MC) does not allow adequate cost recovery (< AC). Demand Qc Pc

Setting Regulated Prices for a Natural Monopoly Output/hr Price/unit 0 MC Demand ACPRPR Solution 1: P R = AC(Q) Quantity sold = Q R QRQR Qc Pc

Problem with setting P = AC Loss of price signal to consumers Increases need for (expensive) peak capacity Increases costs and prices

Setting Regulated Prices for a Natural Monopoly Output/hr Price/unit 0 MC Q R = Q c Demand AC FIXED CHARGE 固定支付 Solution 2: Two-part tariff: Usage charge P R = MC Fixed charge = [AC (Qc)-MC (Qc)] * Qc PRPR AC (Q R )

Cost-Based Regulated Price for Natural Monopoly Regulated price = Fixed costs (amortization in current year) + Operating costs + return on equity and debt capital

Problems with Cost-Based Regulated Pricing Setting regulated price = fixed costs + operating costs + return on capital invested Inadequate incentives for efficiency Need for significant regulatory supervision Tendency for “gold-plating”

Price Cap: Alternative to Cost-Based Regulated Prices Revenues in base year R b = costs in base year Revenues in following year = R b (1 + A b ) Revenues in year t R t = R t-1 (1 + A t ) t = 2,….n A t = adjustment in firm’s prices based on inflation and technological change OR average cost increase for sample of comparable firms. If firm’s increase in costs in year t < A t → the firm gets to keep the difference → incentive to be cost efficient However, firm must be subject to quality standards. Otherwise it can cut costs and reduce quality.

Strategic Positioning Prefer cost-based or price cap regulation? RiskReward Corporate Mentality Strategic Outlook