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

Quantity

• 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

Quantity

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%

• Isoquant - combination of capital and labor to produce q ₁ units

• The cost line, C ₁ = kK + wL

  • k is capital cost

  • w is wage rate

  • L is labor

  • K is capital

• Averch-Johnson Effect

  • C ₂ = (2s - r) K + wL

  • K = (C ₂ - 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.

• 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'

• 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

Deregulation

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