Transcript MSc EPS price regulation lecture 2011

Regulatory Price-Setting in
Theory and Practice
Seán Lyons ([email protected]), ESRI & TCD
2 December 2011
PS6: Economic & Legal Aspects of
Competition & Regulation
Agenda

Economics of price regulation

Goal 1: Preventing prices being “too high”

Goal 2: Preventing prices being “too low”

Goal 3: Geographical or distributional
equity; other social objectives
2
Part A: Economics of price regulation
3
Economic rationale for price
regulation
Health warning
But...some persistent market failures can
best be addressed using sustained conduct
regulation


o

Usually due to presence of market power or
informational problems.
Normally applied by sectoral regulators or
direct legislation rather than via competition
regulators
4
Optimal price regulation
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Optimal regulation: P=MC, if regulated
firm has no fixed overheads
However, many price-regulated firms have
large fixed overheads (implying increasing
returns to scale)
C(Q)=cQ+K
If we set price = c, firm makes a loss of K
One option is to give a subsidy of K,
allowing price to be set at c; but must be
financed by lump sum tax to be efficient
5
Increasing returns illustration
Green arrow shows loss
to firm if P=MC
6
Second best approaches

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Charging a price based on average cost
C(Q)/Q lets firm break even, but leaves per
unit price above marginal cost
Two part tariffs involve charging an access
price to recover K, which allows a per unit
price of c
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‘First best’ only if customers are homogeneous
Otherwise some customers, e.g. with low
demand, may not buy service at all
Non-linear tariffs can help calibrate the mix
of access and usage prices to customer
types
7
Non-linear tariff illustration
8
Multi-product firms
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What if the regulated firm produces two
goods with joint fixed costs?
Costs must be allocated between them to
set prices
Equi-proportionate markups: allocate
overheads in proportion to c for each good
Ramsey prices: allocate overheads in
proportion to the inverse elasticity of
demand
o
o
i.e. services attracting greatest willingness to
pay are allocated highest share of overhead
Minimises reduction in quantity demanded
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Ramsey pricing illustration
Product A: Elastic demand
Product B: Inelastic demand
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Informational problems in regulation
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Optimal regulatory pricing rules demand a
lot of information
Regulators have imperfect information,
particularly about costs
Firms can exploit informational asymmetry
to extract rents
Firms worry that regulators may expropriate
investments once costs are sunk
Administratively practicable methods are
needed to set regulated prices and underpin
credibility of policy
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Policy/competition concerns
regulators wish to address
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Excessive pricing
Predatory pricing, margin squeeze
High prices or lack of supply in high cost
geographical areas or groups of users
Other reasons for preventing prices being
too low or too high (e.g. political or capture
motives)
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Competing objectives
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Low retail prices
Increased competition
Efficient level of investment
Efficient level of product quality
Maintain incentives for innovation
Allow regulated firm a normal return on
capital; ensure it can finance its operations
(“financeability”)
Universal service (geographical and
distributional)
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Goal 1: Preventing prices being “too high”
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Rate of return / “cost of service”
regulation
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allowed revenue = allowed operating
expenditure +allowed rate of return x (capital
stock + allowed investment)+ depreciation
Avoids excessive profits in any given year; firm’s
financeability is protected
Averch-Johnson effect: firm has an incentive to
over-invest in capital (“gold-plating”)
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Averch-Johnson effect
(PQ – wL – rK )
RoR 
cK
o
o
o
o
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r = user cost of capital
w = average wage
c = average price of capital stock
K = stock of capital
Increasing the size of the capital stock allows
higher profits for a given rate of return
Leads to inefficiently high capital-labour ratio
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RPI-X price cap
1.6
1.4
Starting price + inflation
Cost and price
1.2
Starting price
C
1
Starting price + inflation productivity growth
Actual cost
0.8
A
0.6
A - cost level chosen by firm
B
B - efficiency gain retained
by firm
C - controlled by regulator
0.4
0
1
2
3
Year of price control
4
5
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RPI-X price cap
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Provides an incentive towards greater efficiency,
at least in early years of control
However, can lead to sizeable profits in some
years; issue for public perception
Weaker incentives to invest than RoR control
If too tight, could compromise solvency of the
regulated firm
Can lead to under-provision of quality of service if
no supporting incentives/contraints included
Attractive option where static inefficiency is seen
to be the main problem
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Continuum between price cap and
rate of return regulation
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If price cap is only for a year, it is effectively a rate
of return control
Price cap incentive effect weakens as the end of
the period approaches
Setting either of them requires detailed info on
actual and target level of efficiency, required
investment, cost of capital, etc.
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Menu regulation
Menu regulation: offer regulated firms choice of regulatory
contracts that encourage them to reveal true cost conditions
they face; save on admin cost and informational demands
Example: % reward for different levels of cost performance
Ex ante cost proposal relative to regulator est.
Ex post actual
cost
-10%
-5%
0%
+5%
+10%
-10%
3.25
3.19
3.00
2.69
2.25
-5%
1.50
1.56
1.50
1.31
1.00
0%
-0.25
-0.06
0
-0.06
-0.25
+5%
-2.00
-1.69
-1.50
-1.44
-1.50
+10%
-3.75
-3.31
-3.00
-2.81
-2.75
Adapted from Oxera (2008); for detailed discussion see Laffont & Tirole (1993)
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Efficiency assessment
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Traditional benchmarking
o
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Statistical benchmarking
o
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Risks ignoring differences in local context behind
firms’ results
Requires consistent data on firms from many
jurisdictions
Yardstick competition
o
Can only be done in jurisdictions with a
significant number of regional suppliers; requires
harmonised reporting of results
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Wholesale market price regulation
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Typically in the context of regulated
access to facilities or services
Example: network services (noncompetitive) sold to retail market
(potentially competitive)
“Cost plus” – wholesale price cap based
on costs of wholesale services
“Retail minus” – wholesale price cap
based on discount from retail price of
vertically integrated firm
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Wholesale market price regulation
120
100
80
60
Cost of supply
Cost of network services
40
20
0
Network-only
incumbent
Vertically integrated
incumbent
Service-based
Entrant
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Related regulation of quality, access,
investment and financial decisions
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Quality and price are simultaneously
determined in competitive markets; sometime
quality omitted in regulatory controls
o
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Quality may then be biased downward
If access is regulated, e.g. “must serve”, price
will have to be regulated and vice versa
Step-in rights or special administration powers
needed to ensure continuity of service and
reverse incentive for over-leveraging
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Goal 2: Preventing prices being “too
low”
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Regulatory tools in liberalised
markets

Competition policy approach
o
o
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Price < MC too low per se
Price between MC and AC requires examination
Margin squeeze – charging too much for
wholesale input and/or too little for retail service
such that efficient service-based entrants are
excluded
o
o
Require incumbent to charge own retail unit 3rd
party wholesale price
Margin squeeze tests
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Goal 3: Geographical or distributional
equity; other social objectives
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Universal service / public service
obligations
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Uniform price rules with implicit crosssubsidies
Vulnerable user schemes: targeted crosssubsidies or tariff structure regulation
But also more extensive interventions
o
o
o
o
Anti-inflation measures / incomes policies
Fuel prices
Rent control
Anti-usury laws
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Some references
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Easy intro: Viscusi, Vernon & Harrington, 2005 (4th Ed.), Economics
of Regulation and Antitrust, Ch.11 and first half of 12
Armstrong, Cowen and Vickers, 1994, Regulatory Reform:
Economic Analysis and British Experience.
Averch, H. and and Johnson, L., 1962, “Behaviour of the firm under
regulatory constraint,” AER 52(5), 1053-1069.
Oxera, 2008, Menu regulation: is it here to stay?
http://www.oxera.com/cmsDocuments/Agenda_Jan08/Menu%20regulation.pdf
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Advanced: Laffont and Tirole, 1993, A Theory of Incentives in
Procurement and Regulation.
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