Regulating a Monopolist Monopolist choose output q m,whereas the efficient output is q w. Regulation will be needed to avoid the former result. However, if the regulator attempts to achieve the latter result, the firm is not financially solvent since price is below average cost and a deficit occurs equal to area bfgy. Average cost is decreasing, society may be better off if the firm is allowed to maintain monopoly status, because this market structure minimizes production costs for any output. A deficit results if society forces the firm to price all units at marginal cost; the firm must be subsidized or else shut down. One regulation option is to force marginal-cost pricing and subsidize the firm.

Regulating a Monopolist

Resource Misallocation Regulation is not costless, and the benefits from correcting minimal misallocations may be less than the cost of running the regulatory agency. (DWL> Regulation Costs) With average cost AC 0, the excess profit given by are abcf is relatively small, but the deadweight loss (or misallocation) given by area bem is relatively large. If bem exceeds the cost of running regulatory agency, intervention may be justified. If there is technology change, causing fixed costs to fall dramatically, average cost drops to AC 1, profit will be greater, but deadweight loss will be unchanged. (because MC is assumed unchanged in the relevant quantity range.) Thus, the excess profit alone is not an adequate indicator of the need for regulation. The basic efficiency issue is whether or not there is much social welfare to be gained if a regulator restricts the monopolist’s pricing policy.

Barriers to Entry The most common barrier is an incumbent firm with large sunk costs (Baumol, Panzar and Willig, 1982). Entrants will have to make prohibitively large investments in order to compete at able the same scale of output as the incumbent. Marginal cost pricing vs. monopoly pricing Barriers to entry have significant implications for regulation in the context of strong and weak natural monopolies.

Weak Monopoly If we consider a weak natural monopoly in conjunction with barriers to entry. q s is the output level at which it becomes efficient for a second plant to be built and operated. Average cost for a single firm is falling up to q 0 and rising thereafter. Over the range 0 ≤ q ≤ q s, costs will be subadditive. Given demand curve and marginal cost curve, efficient pricing yields output q w, where costs are subadditive; however, average cost is increasing.

Weak Natural Monopoly

Barriers to Entry Table 2.1 Appropriate regulatory policies Monopoly typeBarriers to entry Strong natural monopoly( MC pricing creates a deficits) Enforce p =MC, and subsidize firm or Deviate from MC pricing to eliminate deficit Weak natural monopoly (MC pricing allows nonnegative profits) Enforce p= MC, and address possible "problem" of excess profit

NO Barriers to Entry – Strong Monopoly Under no regulation ◦ If a single, linear price structure is used, then the solution is to set price equal to average cost. ◦ If price is set higher than average cost, the firm will generate positive profit and increasing the incentive for other firms to enter. Therefore, output will be less than the efficient output q w, but greater than monopoly output q m. Average cost pricing or a more elaborate nonlinear that will yield zero profit are equally desirable from the firm’s perspective.

NO Barriers to Entry – Weak Monopoly Regulatory intervention is still required to protect consumers, because the firm’s incentive still will be to set a price at which there are still positive profits q w. There is no single price that will keep out entrants. Even at q a, the incumbent firm could implement average cost pricing, but an entrant could charge a slightly lower price and still make positive profit. Regulator’s role is to keep out entrants. What is the relevant range of output? For p hat the firm is a natural duopoly.

Ultra-free Entry Table 2.1 Appropriate regulatory policies Monopoly typeNo barriers to entry Strong natural monopoly( MC pricing creates a deficits) Enforce p= MC, and subsidize firm or Do not regulate, letting threat of entry force break-even prices Weak natural monopoly (MC pricing allows nonnegative profits) Enforce p= MC, prevent further entry into the market, and address possible "problem" of excess profit.

Other Complicating Factors Measuring actual costs Viewed as convenient wealth redistribution to give lower rates to low income citizens, but this complicates the rate structure and who shares what burden of the cost RPS – changes the structure of cost curves Firms produce multiple goods/services, which makes pricing complex Multiple goods in multiple markets (regulated and unregulated)

Additional Issues High Upfront Capital Costs => who should pay the costs intergenerationally? To obtain investors, firms must be able to capture some return of their capital investments. Otherwise, there would be no incentive to invest Some argue that demand is on the increasing side of the AC curve