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Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-1 Natural Monopolies And Regulation.

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Presentation on theme: "Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-1 Natural Monopolies And Regulation."— Presentation transcript:

1 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-1 Natural Monopolies And Regulation

2 Natural Monopolies Economies of Scale continue to occur at so large a scale that is it is “productively efficient” (least cost) to have only 1 provider Natural state and optimal state is a monopoly typically high fixed costs and low variable costs electric, natural gas, water, telecommunications (land) and tv cable Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-2

3 Regulation If a natural monopoly arises due to scale economies, the government may prefer to regulate the monopoly. Breaking the firm up may reduce efficiency Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-3

4 Figure 13.2 Natural Monopoly in the Telecommunications Industry Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-4

5 Government Regulation of Price and Output The government cannot require that a natural monopolist set price equal to marginal cost. Because marginal cost is less than average cost, two options: 1. Government subsidizes the loss (Euro approach) No deadweight loss, but requires taxes on other goods 2. Average Cost Pricing (or Rate of Return (ROR)): government sets price equal to average total cost. (US solution) Leads to some deadweight loss, but less than a monopoly Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-5

6 Figure 13.3 Choosing a Price for a Natural Monopolist Copyright © 2006 Pearson Addison-Wesley. All rights reserved.13-6 US French Economic Loss or Subsidy

7 Government Regulation of Price and Output Two methods of regulating price and output: Rate of Return Regulation—the firm is allowed to earn a pre- specified amount of profit in a given time period. Set prices to recover average cost + normal rate of return How do you determine normal ROR? Incentive for regulated firm to “pad” its costs (Averech-Johnson effect) Price Cap—government sets the maximum price or the maximum rate of price increase. After rate setting process: future rates can be raised by rate of inflation – industry’s average productivity (incentive for tech. iinnov.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-7

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