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Public Policy
Lecture 12


Government Regulation of the Firm

1. Government can "ideally" regulate natural monopolies

    (i) Average Cost Pricing - the government sets the price where the demand curve intersects the long-run ATC

  • The price is lower ( P~< P*)

  • The quantity produced is higher (Q~ > Q*)

  • The firm earns zero economic profit in long run

  • Social welfare improves

  • Allocative inefficient because Price > MC

A Monopolist - Average Cost Pricing

Price, Per-Unit Costs
Average Cost Pricing for a monopolist
  • Unregulated monopolist produces  at MC = MR, so the market price is P* and output is Q*

    (ii) Marginal Cost Pricing - the government sets the price where the demand curve intersects the MC.

  • The price is the lowest (P~ < P*)

  • The quantity produced is the highest (Q~ > Q*)

  • The same social welfare as a competitive market

  • Allocative efficient

    • P = MC

  • The firm earns a loss in long run

    • May need to be subsidized

    • Red area shows the loss

    (iii) Ramsey Pricing - regulated monopolist charges two prices

  • Two prices

    • Rate charge is the price, P~, where price equals marginal costs

    • Fixed charge - monopolist take loss and charges the loss to consumers as fixed fees

  • Allocative efficient and does not need to be subsidized by government

A Monopolist - Marginal Cost Pricing

Price, Per-Unit Costs
Marginal Cost Pricing for a monopolist

2. Natural Monopoly

  • Government can regulate the firm

  • Government can set the rate base, which is rate of return of a firm's invested capital

r = (TR - TC) / K

  • Total Revenue (TR)

  • Total Cost (TC)

  • Value of Capital (K)

  • Rate of return (r)

  • Government can use three methods to set the base rate

    • Cost of Raising Capital - interest rate if company issues bonds

    • Company's Attraction Requirement - return must be set high enough to attract investors

    • Comparable returns of other companies in the same industry

      • This method is the most popular

3. Capture Theory - industry captures control over the regulatory agency

  • Government first regulated natural monopolies, such as railroads, electricity, natural gas, and communications

  • Capture Theory explains why government regulates industries with no economies of scale

    • Trucking and airline industries

  • Regulatory agency protects its industry and prevent competition

  • Government allows the transfer of wealth (consumers' surplus) to industry

  • Alternative explanation

    • Legislators protect industry and elections are expensive

    • The industry pays campaign contributions

  • Professional organizations encourage government to establish professional licenses

    • Licenses restrict market entry

    • Some occupations require licenses

      • Doctors, lawyers, electricians, engineers, plumbers, hair stylists

      • They charge high prices

4. Government can take over monopoly

  • Worse than a private firm monopoly

    • No profit motive

    • No incentives to minimize costs and satisfy consumers

    • Taxpayers could end up subsidizing it

Effects of Regulation

1. Efficiency

  • Regulatory lag - government agency takes time to adjust returns or adjust prices

  • X-inefficiency - the firm's cost immediately increase, but the firm cannot raise prices until government decides

  • Research - the firm's cost fall immediately, but the firm cannot lower prices until government decides

2. Averch-Johnson Effect

  • Firm has an incentive to over invest in capital if r > s

    • r: firm pays r for capital

    • s: firm's cost for capital

  • Example

    • The market cost of capital is 5%

    • A firm is permitted to pay 8% for capital

    • Firm earns gains an extra 3% in profit because it can raise its prices to match the capital

    • Firm's cost of capital = cost - profit = s - (r - s) = 2s - r

    • So firm's cost of capital = 5% - 3% = 2%

The Averch-Johnson Effect

  • Isoquant - combination of capital and labor to produce q1 units

  • The cost line, C1 = kK + wL

    • k is capital cost

    • w is wage rate

    • L is labor

    • K is capital

  • Averch-Johnson Effect

    • C2 = (2s - r) K + wL

    • K = (C2 - wL) / (2s - r)

    • The slope is steeper

    • Firm uses more capital and less labor to produce same output

  • Evidence

    1. Utilities invested in capacity that exceeds peak demand

      • Peak demand - a period when many consumers are using the service at the same time

      • Electricity - peak demand happens on hot, summer days when people use air conditioning

    2. Utilities delayed development of less capital-intensive technology

      • AT&T used under water cables for phone lines instead of satellites

    3. Utilities do not rent out facilities to reduce cost

    4. Utilities set a high service reliability

      • Increases capital

    5. Utilities encouraged its suppliers to charge high prices

      • Boosts costs and rate bases

3. Peak-load Pricing

  • Peak-load prices work for electricity market or water market when suppliers have a production capacity

  • Consumers demand electricity to use in their homes

  • Electric companies supply electricity

    • Grid - wires that connects the generators to the businesses and houses

    • System has a maximum capacity

    • If consumers use more than Qmax, the system shuts down

      • Black out

      • Otherwise, the wires could melt, etc.

Peak-load pricing

  • California and other states make it difficult for suppliers to expand the grid and add generators

    • Government sets the regulated price to P*

  • It's very hot in summer in the U.S. and people switch on air conditioning

    • Greater demand for electricity

    • Consumers exceed the system capacity, which is Q'

Peak-load pricing

  • Utility has two choices

    • Use electronic switches to cut off power to some neighborhoods to reduce quantity of electricity

    • People have special meters

      • People are charged the price P' when demand is high (peak demand)

      • The greater price forces people to reduce their demand from exceeding the system capacity

      • People are charged the normal price, P*, when demand is not near system capacity


1. Government can deregulate the industries

  • Deregulation

    • Allow the market to set the price

    • Reduces market barrier and increase competition

    • Reduce licensing requirements

    • Reduce trade barriers that exposes monopoly to international competition

  • New technology - could make the natural monopoly obsolete

    • A monopoly controls the telephone system

      • People can use Skype to circumvent the telephone industry

    • Gov. controls the post offices

      • People use e-mail and electronic payments to avoid mail

  • U.S. government began deregulation during the 1980s

    • Railroad industry

    • Trucking industry

    • Banking

    • Airline industry

2. U.S. government deregulated the airline industry during late 1970s

  • Before deregulation

  • Government agency set the air fare, rate of return on investment

    • Airlines earned revenues beyond cost of air travel

    • Inefficient airlines stayed in market

  • Airlines had high cost which reduced profits

    • Airlines used nonprice competition

      • Reduced waiting times

      • Gourmet meals

      • Movies

    • Airlines served unprofitable routes

      • Planes had empty seats

    • Airline employees were members of labor unions

      • Paid high wages and benefits

  • Government discouraged competition

    • Government allowed only a new airline to enter the market if it did not harm an existing firm

  • After deregulation

    • Positive effects

      • New competition as new firms entered market

      • Airlines opened new routes

      • Number of flights increased

      • Rise of the hub-and-spoke system - passengers transfer to other planes on long routes in one section of the airport

        • Passengers stay with the same airline

      • Air fare prices fell for popular routes

    • Negative effects

      • Airlines reduced costs

        • Airlines broke up the unions, and workers's wages and benefits fell

        • Airlines abandoned unpopular routes, and airfares rose for these routes

      • Squeezed more seats on a plane

      • Reduced amenities

        • Charge for food, snacks, and drinks

      • Airlines began to merge

        • Number of bankruptcies increased

3. Antitrust policies - increase the number of firms in a market

  • Government can break up monopolies

  • Prevent companies from merging that may reduce competition

  • Prosecute firms engaging in collusive behavior

  • Do not breakup natural monopolies!

    • Per-unit costs will be higher with more firms

    • In 1984, the U.S. gov. broke AT&T into five baby bells

    • A large monopoly broken down into 5 smaller regional monopolies

    • AT&T charged high rates for long-distance calls and used this revenue to subsidize local phone service

    • Local phone rates increased


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