Regulation: Lecture 1 Lecture 2 Natural Monopoly Optimal pricing Excess entry

Natural Monopoly Monopoly and perfect competition When does a single producer has a cost advantage relative to any other number of producers? The cost fnct. is sub-additive: Take output levels y’+y”= y* then there is sub- additivity iff: C(y*)< C(y’)+C(y”)  y’, y” Scale economies: C( y’) 1 implies decreasing average costs

Natural Monopoly: sub additivity Economies of scale are an imprecise definition for capturing situations of natural monopoly: Cost subadditivity is best (between ym and ysa); A Natural monopoly situation depends from technology, but also from the position of the demand function;

Scope economies Two goods x and y, define cost function as C(x, y). C(.,.) is sub-additive if, given some output levels x’, x” ed y’, y”, then: C (x’+x”, y’+y”)<C(x’, y’)+C(x”, y”) Scale economies are not necessary, as there are scope economies; C (x, y)<C(x)+C(y) Scope economies may derive from – A non rival prod. factor; – One of the goods results from production of the other.

Temporary/Permanent Natural Monopoly A permanent natural monopoly arises usually if there are scale economies for every possible level of production; Natural Monopoly can be temporary for at least two reasons: 1) Demand may shift and the market becomes large enough for two producers; 2) New tecnologies may diminish the extent of sub-additivity;

Deadweight costs

DW Costs Generic (inverse) linear demand fnct. p=a-by Total revenue: RT= py = (a-by)y Differentiating, marginal revenue: RM= a – 2by

Elasticity and DW loss.

Costs: efficiency Less incentives to efficiency (no stick). John Hicks ‘the best of mon. profit is a quiet life’’. Cost Inefficiency worsens allocative inefficiency Less incentive to innovation

Monopoly ed efficiency

A different view According to Posner, the costs of mon. are not so large and we can’t do anything about it: Redistribution is not so bad; Deadweight losses estimates are very low and they may be actually lower as mon. discriminate; Direct and indirect costs of reg. May be very large. Regulation is ineffective, may increase rents; If reg is effective in reducing profits it destroys incentives to efficiency.

Contestable Markets Contestable when hit and run competition is possible. Conditions: 1) No sunk costs; 2) Easy and quick entry is possible; 3) Consumer react instantan. to price differenc.; 4) Incumbent cannot react immed. Equilibrium price is average cost, profit are nul and entry never occurs Difficult to trace elements of realism in the theory although it is a matter of degree.

Marginal Cost pricing The problem with marginal cost pricing is that a loss for the firm must arise if mc is lower than ac;

How to cover the loss By govn. revenue: –They cause deadweight losses from taxes; these are proportional to the squared marginal tax rate; –Adverse Incentive Effects. Govn. subsidies always deliver inefficient behaviour, cost inflation; –Service is subsidized by non-users;

How to cover the loss Non linear pricing –Two-part tariff: may exclude low quantity users if surplus is low; This decreases surplus directly and impede the realization of some economies of scale; see graph. –Multipart tariffs. Diminishing marginal utility –Self-selecting menus of two-part tariff. Low users may select in low fixed tariff/high variable tariff, and still participate;

Pricing and alternatives Ramsey pricing: optimal distortion of prices in multiproduct monopoly (p i -c i )/p i =λ/η i for all i’s Note: monopoly maximization similarity Loeb and Magat proposal: transfer the whole consumer surplus to the monopolist and auction the right to produce as monopolist- He will maximize welfare. However regulator need to know the demand fnct.

Sustainable Natural Monopoly: entry regulation Why does entry regulation exists? Maybe for intrinsic instability of natural monopoly configurations with possible cream skimming. Suppose in fig you order the monopolist to price at (where demand meets) average cost. An entrant can produce ym and sell it atprice larger than c min and get a nice profit.

Entry restrictions: Why? Two stage game. 1) entry and bear sunk cost k; 2) competition in the market, mg cost is constant at c; In second stage either monopoly or extreme competition-price may be c; In first stage one or more may enter. If one enters then there is monopoly pricing and inefficiency from DL; If more than one enters, then no allocative inefficiency (mg.cost pricing), but duplication of fixed cost→ productive inefficiency and instability.

Entry restrictions The example above was driven by extreme competition in the market and therefore instability; But excess entry and welfare loss may come forth when there’s cournot competition provided there’s a fixed cost (although no barriers to entry); Remember the exc. we solved in Motta.