Transcript Resource Misallocation - Illinois State University

Regulating a Monopolist

Monopolist choose output qm ,whereas the efficient output is qw .
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
Figure 2.2 The monopoly and the welfare-maximizing outcomes
$
p(q)
x
c
p(qm)
MC
MR
R
d
a
AC
f
b
p(qw)
y
g
e
qm
qw
q
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 AC0, 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 AC1, 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. qs 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
q0 and rising thereafter.

Over the range 0 ≤ q ≤ qs, costs will be subadditive. Given demand curve
and marginal cost curve, efficient pricing yields output qw , where costs
are subadditive; however, average cost is increasing.
Weak Natural
Monopoly
p
(q)
p(q)
c'(q)
e
g
c(q)/q
p(qw)
h
a
2c(q/2)/q
q0
qw
qα
qs
2q0
q
Barriers to Entry
Monopoly type
Barriers to entry
Enforce p =MC, and subsidize
Strong natural monopoly( MC firm or Deviate from MC
pricing creates a deficits)
pricing to eliminate deficit
Table 2.1 Appropriate regulatory policies
Weak natural monopoly (MC Enforce p= MC, and address
pricing allows nonnegative
possible "problem" of excess
profits)
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 qw, but greater
than monopoly output qm.
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 qw.

There is no single price that will keep out entrants.

Even at qa , 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
Monopoly type
No barriers to entry
Enforce p= MC, and
subsidize firm or Do not
Strong natural monopoly(
regulate, letting threat of
MC pricing creates a deficits) entry force break-even prices
Enforce p= MC, prevent
Weak natural monopoly (MC further entry into the market,
pricing allows nonnegative and address possible
profits)
"problem" of excess profit.
Table 2.1 Appropriate regulatory policies
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
