Transcript p(y) - Economics of Regulation ECON-d-421

Economie Publique II
February-May 2010
Prof. A. Estache
Lecture 1
Overview
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Some organizational issues
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Course organization
Course content and coverage
What I assume you know already…
Required readings and what they mean to
you
• Exam…a first sense of what you will get
• What this course could do for you
2
Course organization
• Lectures are on Wednesdays 10-12 at H5.164
• You will have 12 lectures
• I will post the lectures and any related material on
my web site (bottom of the entry page for a list of
courses)
http://164.15.69.62/index.php?option=com_compro
filer&task=userProfile&user=107&Itemid=263
• You will have to follow the reading list
• Trying to read ahead of time will help you
understand the lectures
• I will also post any readings not easily available in
pdf format on the course web site.
• Always happy to meet with you or hear from you if
something is not working out the way you
3
want…my email is [email protected]
Course content (1)
• This course will focus on how best to
regulate firms with significant market
power.
– A crucial role of governments and hence
central to public economics knowledge
• It will get both into the theory and the
practice of regulation.
• Network industries will offer the main
illustration of the concepts
4
Course content (2)
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Week 1: Introduction and Overview (…today!)
Week 2: Regulation with complete information
Week 3: Regulation with asymmetric information
Week 4: Extensions to the basic model
Week 5: The regulation of prices
Week 6: The regulation of quality
Week 7: Equity-efficiency trade-offs in regulation
Week 8: Incentives issues built-in the design of regulatory
institutions
Week 9: Financial Modeling of Regulated Industries
Week 10: Asset Valuation of Regulated Industries
Week 11: Cost of Capital of Regulated Industries
Week 12: Efficiency Measurement in Regulated Industries
5
What I assume you know already
• You NEED to be familiar with everything you
have been taught on the theory of monopolies!!!!
– If you don’t, review it before next class
• IT IS CRITICAL since that is at the core of everything you will
see in this class
– To make it easier for you to review this theory, I have
attached in the annex the slides from Varian on this
topic…you really need to know this!
• You need to be able to set up an optimization
problem under constraint
• You need to be able to have a sense of synthesis
since you will have to read a fair amount of
material
6
You need to remember everything
that goes around this graph!
Euros per
Kwh
Profits from standard
monopoly profit maximization
$120
E
MC
ATC
80
MR
30
D
Number of Kwh consumed
7
Price Regulation: Government can
make solution more efficient as long
as PC < PR < PM
Monopolistic
equilibrium
PM
MC
PR
PC
Competitive Equilibrium
Demand
MR
8
Required readings (1)
• 4 basic texts
– Armstrong and Sappington, 2007, “Recent developments in the
theory of regulation”, in Handbook of Industrial Organization (vol
3), edited by Armstrong and Porter, North Holland
– Armstrong, M. and D. Sappington, (2006), “Regulation,
competition and liberalisation”, Journal of Economic Literature
– Estache, A. and L. Wren-Lewis (2009), “Towards a Theory of
Regulation for Developing Countries: Following Jean-Jacques
Laffont’s Lead”, (Forthcoming), Journal of Economic Literature
(forthcoming), available at
http://ideas.repec.org/p/eca/wpaper/2008_018.html
– Estache, A., M. Rodriguez-Pardina, J.M. Rodriguez and G. Sember
(2002), “An introduction to Financial and Economic Modeling for
Utilities Regulators”, Policy Research Working Paper 3001, World
Bank, Washington, D.C., available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=636363
• Some additional required reading for some of the lectures
9
Required Reading (2)
• For every required reading, I will
give you a few questions you need
to be able to answer
• You will have to provide me with a 1
page summary of your replies.
– These replies will be due 1 week
before the end of the course.
– They should force you to make sure
you understand the material you are
supposed to be familiar with.
10
Exam
• You will have to know the required readings for
the exam
• You will also have to know well the lecture slides
• You will find some of the suggested reading
useful if you have not understood the lectures in
class.
– But these are not required and I will not ask any
questions on those readings.
– They may simply be useful of you decide to specialize
in regulation.
• Your understanding of the course material will be
assessed by means of a three hour examination
• More details on the exam will be provided at the 11
end of the course.
What this course could do for you
• Most courses on regulation of network industries
are highly technical…(e.g. Toulouse, Oxford,
Florida, MIT, …)
• This course is a combination of theory and
practice
• It will provide you with enough theory to give you
a sense of what to deal with in a PhD thesis or
research in the field of regulation
• It will provide you also with a set of tools you
would need to have if you were to work as a
consultant or in a regulatory agency or…in a
regulated company!
12
Overview of the course
•
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A working definition
The policy problem
The view of the world of regulation today
The evolution of research
A zoom on the lessons from theory on
institutional design
• The measurement of the effects of
regulation of network industries
• Concluding comments
13
What exactly is regulation?
• Government regulation of industry is
– local, federal or state government control
– of individual or firm behavior
– via the mechanisms of setting or controlling
• the prices
• the quantity (of service, environmental, safety,…)
• the quality of goods and services produced.
– E.g. setting rates for electricity service.
– E.g. setting quality standards for auto seat belts.
14
The dimensions of the problem
• The actors
• Their objectives
• Their constraints
• The trade-offs
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The actors
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the government (local, national)
a firm (monopolist)
the users (final or intermediate)
a regulation and a competition agency
the tax payers
other firms (as users or competitors)
other agencies
...
16
The objectives of the actors
• the monopolist maximizes its private profits
• the gvt wants to foster efficiency and fairly distribute
the rents:
– accepts monopoly structure (size economies) and maximizes
social welfare…but private agenda (re-election,…)
• the users maximize their net utility
• the agency is a surrogate for the government…but
private agenda (maximizes its net resources  risks of
capture). Governance problems.
• the tax payers react to the fiscal burden that distorts
relative prices
• the other firms maximize their profits

horizontal dimension of the strategy
• other agencies: idem
17
The constraints on policymakers
• technological and economic
– costs, preferences
• legal
– privatization law, concession law, sector laws, antitrust
law,…
– contract design (including duration)
– accounts rules and reporting obligation
• institutional
– who is involved and who decides and how (price control,
wage control, barriers to entry)
– enforcement power
– financing opportunities
• informational
– imperfect but symmetric information
– asymmetric information: adverse selection, moral hazard
18
The trade-offs as the main dimension of
the policy problems
• Efficiency:
– concern of sector people/economists
•
•
•
cost reflecting prices
cost minimizing production choices
getting the investments going as needed
• Fiscal and financial viewpoints:
– concern of the finance team
•
«fiscal pay-off to gvt » (annually/1 time shot)
–
Whether it goes to the treasury or to finance political campaigns and other
expenses by the politician is also relevant
• Social Concerns:
– concerns of politicians
•
•
•
lowest possible price and related considerations
best possible quality
largest cheap expensive looking investments
• Votes!!!
– Concerns of the politicians
• Only real instrument consumers and taxpayers have to voice their
happiness or discontent
19
The big picture on the problem
• Economists and Politicians are against
monopolists and agree they need
regulation…but for different reasons:
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economists: monopolists do not produce
enough
politicians: monopolists charge too much
…and the solution to their concerns could
converge: lower price means more volume
..but often don ’t:
•
•
economist wants price discrimination; politician prefers price
cap which yields rationing but a politically manageable price
economist wants to push competition (entry), politician not
necessarily (strong emotions attached to ownership of assets
supporting public services)
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What has theory had to tell us
about this policy problem?
• Traditional theory (with benevolent gvt and
focus on market failures--monopolies,
externalities, …)
• The recognition of the non-benevolence of
government
• The information asymmetry issue as a
revolutionary shock
• A zoom on the empirical research
21
Traditional theory
• Assumes benevolent gvt
• Focus on market failures
– Solved by regulation or otherwise
• Pigouvian taxes & subsidies (1920s)
• Marginal cost pricing debate (Boiteux (1949, 1956))
• Ramsey, peak load & other fancy pricing
(Baumol/Bradford (1970))
• Coase theorem and bargaining (1960)
• Demsetz auction and competition for the mkt (1968)
• Contestable markets (Baumol, Panzar, Willig (197080s))
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The problems with traditional theory
–Problems are that regulation is:
• Bounded by transaction costs
– Williamson (1960s), Dixit, Martimort (1990s)
• Bounded by information and related incentive
problems
– Baron and Meyerson (1981) Laffont, Tirole,
Armstrong, Milgrom, Newbery, Sappington,
Vickers, Willig (1980-90s), …
• Often responsive (endogeneity issue)
• Driven by complex gvt motivation and
structures and multiple gvt objectives
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New theories: NON BENEVOLENT GVT (1)
• Capture theories
• Role of auction design in achieving
competitive outcomes in regulated markets
• Scope for renegotiation
• Heterogeneity of goals from heterogeneous
gvts (multiprincipals)
• Concerns for coordination
• Political entrepreneurs vs. public service
concern
• Governance aspects and voting
mechanisms
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New theories: NON BENEVOLENT GVT (2)
The various focuses of research
– Regulatory design
• P cap, RoR, Hybrid regime
– Incentive mechanism design
• Accounting explicitly for effort level and degree of information
asymmetry and related strategic concerns
– Institutional design
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Degree of financial and political autonomy
Degree of corruption
Degree of competence
Governance structures
– Timing and sequencing of regulatory reforms
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New theories: NON BENEVOLENT GVT (3)
• Instruments
– Agency models, game theory, advanced simulation
techniques
• Literature
– Theory: Posner (1971), Stigler (1971), Peltzman (1976), Becker
(1983, 1985), more recently, Laffont-Tirole, Noll, Spiller, …
– Empirics: a lot on some aspects but little on many
others!
• Problems:
– Disagreements on degree of common knowledge of
information needed for regulation and related strategic
interactions
– Bridge from theory to practice cuts lots of theory
corners
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New theories: NON BENEVOLENT GVT (4)
Main practical messages are:
• regulation and competition policy generate rents
worth fighting for …but they distort outcomes
and users usually lose if decision makers are
unaccountable
• there are trade-offs between rents and efforts
level by the operators and short term losses by
users may become long term losses if weak
“regulators”
• Various types of risks matter to effort and
investment incentives and should drive choices
• Distributional consequences can be dramatic
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A zoom on what theory tells us
about institutional design
• not much advise from traditional theory
• many more possibilities offered by information
economics and agency theory on organizations
• a lot more coming from recent developments on
collusion theory
• need to build a positive theory of government
around these recent developments
• need to recognize transaction costs and political
constraints
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What are the problems leading to
transaction costs?
• information asymmetries:
demand elasticity?
exact technologies? costs?
• limits to the markets as an implementation
tool for policies private police? private regulators?
• incompleteness of contracts:
non-contingent
contracts + contracts viewed as non-binding by future gvts
which renders renegotiation of some type unavoidable
• multiple principals:
multiple government agencies share
responsibility but fail to coordinate because discretionary politics
drives decision-making by bureaucrats; all this reduces
accountability of regulators
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Why should we care? Because it
tells is that
• structures matter:
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distribution of regulatory rights
definition of regulatory goals
voting procedures driving decisions
• processes matter
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timing of government intervention
length and span of control
design of communication channels
• Both affect regulatory outcomes: work on
the efficiency-rent trade-off
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The specific government failure
to address
• lack of commitment of government
and need for renegotiation
• multiprincipal nature of
government
• discretion of political principal
• discretion of regulator
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Lack of Commitment and
Unavoidable Renegotiation (1)
• new information can change the goals of the
game
• under full commitment: optimal regulation is well
understood
• without full commitment: strategic behavior by
both the gvt and the firm is likely and time
inconsistency problem in the firm’s behavior,
reducing incentive to be efficient in 1st period
• MAIN MESSAGE: Incentive compatibility
constraints are hardened by simple existence of
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renegotiation
How to improve commitment?
• maintain flexibility to renegotiate but spell
out renegotiation rules early on
• there is an optimal degree of separation of
powers but this acts on incentives
• consider a sequential move of regulatory
decisions and overincentivate in period 1
• address explicitly the speed of reform
• spell out checks and balances
• independence and accountability of agency
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The Multiprincipal Nature of
Government (1)
• multiple agencies dealing with regulation
(environ, health, economic)
• it means multiple not necessarily
cooperative objectives
• this means allocative distortions because
coordination problems
• suboptimal decentralization cuts
incentives; too many players decreased
efficiency of regulatory decisions; risk of
free riding
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The Multiprincipal Nature of
Government (2)
• if regulation of complementary activities,
risk of overregulation and cuts incentives
built in contracts due to lack of
coordination
• if regulation of substitute activities, risk of
underregulation (too much incentives) due
to regulatory competition
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Excessive discretion of the
political and regulatory principal
• distinction between formal and real
authority is crucial
• real authority in the hands of
implementing agents
(regulators/bureaucrats)
• formal authority in the hands of political
decision makers
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Need to reduce discretion of the
Political Principal
• structures drive the distribution of power
among interest groups
• politicians end to favor median voter (his
constituency) over majority of voters
(society as a whole)
• apparently suboptimal contracts (average
cost pricing) now could have a rational:
they tie the hands of politicians by cutting
discretion
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Need to reduce discretion of the
Regulators
• increase accountability to deal with the imperfect
monitoring of the regulators
• collusion proof constraint can reduce conflicts
between legislative and regulators: low powered
incentive contracts are usually better since cuts
discretion (influences efficiency-rent trade-offs)
• need to avoid side contracts between regulators and
interest groups: this requires more established, clear
and transparent structures
38
How much empirical evidence do we get
from academic research?
• It measures the effects of regulation and competition on
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Average price levels
Price structures
Access pricing
Static efficiency
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Input distortions (Averch-Johnson effect (1962), Unions,…)
“X-inefficiency” (are we on the production frontier?)
Rent size
Cost of capital
Regulatory costs
– Dynamic efficiency
• Rate of innovations and productivity growth
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Product quality and variety
Contract sustainability
Macroeconomic variables
Distributional implications
• Redistribution of existing rent between players
• Allocation of rents from changes
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The methodology of measurement (1)
• (1) Comparing regulated and unregulated
firms and markets
• ( 2) Tracking variations in regulation
intensity
• (3) Controlled environment experiments
• (4) Structural models and simulation
• [(5) Detailed case studies with statistically
weak evidence]
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The methodology of measurement (2)
• (1) Comparing regulated and unregulated
firms and markets
– Approaches
• Across countries, states (cross-section)
• Historical data (time-series)
– Product/service markets
– Financial markets (track the stock market)
– Additional use
• Generates data for yardstick competition
• Generates data for tariff revisions/price caps,…
– Problems:
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Heterogeneity of regulatory regimes and enforcement
Endogeneity of regulation (responds to local conditions)
Specific legal environment and instruments
Timing, sequencing
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The methodology of measurement (3)
• (2) Tracking variations in regulation
intensity
– Quantitative differences in regulatory
constraints
• e.g. Different levels of rate of return allowed
– Differences in regulatory resources
• e.g. budgets, skills, autonomy
– Specificity of instruments and procedures
• e.g. anglo-saxon vs. napoleonian traditions
– Need for independent rating of quality of
regulator
– Interactions with economic environment
(inflation, growth, corruption, risks…)
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The methodology of measurement (4)
• (3) Controlled Environment Experiments
– Field experiments
• Peak load pricing vs uniform
• Bulk markets vs retail markets
– Problems: expensive to implement and hard to control
correctly
– Laboratory experiments
• Experimental economics
– Problems: risky extrapolations
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The methodology of measurement (5)
• (4) Structural models and simulations
– (i) Demand and cost systems
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Need to estimate cost and production functions
Need to estimate demand
Useful to simulate alternative regimes
A lot of good results available and used
Drawbacks:
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Endogeneity of input prices
Short term vs long term
Regulatory distortion
Changing environment
Interaction with environment
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The methodology of measurement (6)
• (ii) Computable General Equilibrium
Models
– Solve models as if full price control by
monopoly or full competition and the
comparison yields the size of the rent and
hence the value of regulation:
• 0.3% of GDP for Argentina
• (iii) Counterfactuals
– Reconstruct operators accounts and impose
new restrictions
• Galal, et alt. : huge gains from privatization
• Gasmi, Laffont, Sharkey: measures impact of
incentive based regimes vs cost + on telecom
prices
45
Summing up the academic view
of regulation theory:
• Difficult to come up with a single clean story due to
heterogeneity of:
–
–
–
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Initial conditions
Variables monitored
Dimension of regulation
Sectoral diversity
• Regulators and competition agencies have not generated
the data that will help research make them better
regulators, collectively at least
• But plenty of actions in the real world and useful to know
how regulation sometimes work in practice
• So how do you go from theory to practice?
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Back to basics: How to come up with
fair regulation of a Natural Monopoly
Dollars
Unregulated monopoly
$60
A
C
$29
$15
"Fair rate of return"
production
F
MR
50,000
B
LRATC
MC
D
100,000
85,000
Number of
Households
Served
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This faire regulation builds on basic
economics!
SUPPLY
Cost
Recovery =
Allowed
Revenue
Operational
expenses or
OPEX
Capital expenses
or
CAPEX
Average
TARIFF
Economic Signal
Tariff Structure
DEMAND
48
©World Bank Institute
A checklist of tools to do the job!
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Asset valuation
Estimates of the cost of capital
Regulatory Accounting Guidelines
Tariff Rules
Penalties
Efficiency measures
The contract with the government
The economic and financial regulatory model
Indicators of financial viability
A clear view of the analytical decision criteria
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The Tools of the Regulators
Asset Valuation
• At the core of everything
• With the cost of capital, allows the
determination of the allowed revenue for
required efficiency levels
• With the specified deprecition rules, defines
the amortization expenses allowed in OPEX
forecast
• Be clear on which method you pick
• Update regularly
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The Tools of the Regulators
Estimate of the cost of capital
• Minimum rate of return allowed to the
operator of a monopoly
• Imposes going through a fair
assessments of risks
• Require a methodological discussion
• To be reviewed periodically
51
The Tools of the Regulators
Regulatory Accounting Guidelines
• Core instrument to generate the information
required to regulate
• Includes ALL guidelines
– Depreciation rules
– Cost allocation rules
– Expenditures forecast processes
• Unavoidable as few countries tend to generate
good economic information for regulators
• Should be included in contract with operators
52
The Tools of the Regulators
Tariff rules
•
•
•
•
•
Sector law and/or related decrees
Legal specification of tariff structure
Indexation rules
« pass-through » rules
Ordinary and extraordinary tariff revision
rules
• Clarify behavior subject to penalties and
relevance for tariffs
• Specify penalties in legal documents
53
The Tools of the Regulators
Efficiency Measures
• Efficiency gain is economic rent to be
redistributed => MUST be measured
• Announce how it will be measured
• Ensure accounting guidelines will generate
the data needed
• Explain how results will be used in
regulatory decisions
• Specify a related consultation process
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The Tools of the Regulators
The contract with the government!
• Specifies rights and obligations of the
various actors
– Investments
– Quality
– Timing of obligations
– Payment to gvt
– Subsidies
• Includes information obligations
• Core reference document of regulator
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The Tools of the Regulators
The financial and economic model
• Analytical framework which
– Ensures internal consistency of:
• All obligation to all parties and any change to these
• The combination of regulatory instruments,
• Assumptions on the behavior of actors
– Quantifies impact of options to all actors in case
of conflict based on transparent rules
• Calculates the business’ s Internal Rate of
Return
– Which means nothing unless compared to the
cost of capital !!!
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The Tools of the Regulators
A clear decision criteria
• IF IRR = CoC => ideal
– NPV of activity is 0
– No « excess » profit for the operator
– Comparable to a competitive markets returns
• If IRR > CoC => « Excessive » Profit
=>Regulatory action needed t revision time (e.g. cut tariff, subsidies,…)
• If CoC > IRR => Risk of bankruptcy
=>Regulatory action may be needed to ensiure service continuity (e.g.e:
subsidy, change in service obligations level or timing, …)
57
The Tools of the Regulators
Financial viability criteria
• Control of standard financial indicators:
• What credit rating agencies would look at to check credit
worthiness
• Cash flows in term of equity, assets and free cash flows
• Debt ratios, liquidity, debt composition
• …also need to check the consequences of
limited access to capital markets
58
ANNEX:
What Varian taught
you about
Monopolies….
Pure Monopoly
• A monopolized market has a single
seller.
• The monopolist’s demand curve is the
(downward sloping) market demand
curve.
• So the monopolist can alter the market
price by adjusting its output level.
Pure Monopoly
$/output unit
p(y)
Higher output y causes a
lower market price, p(y).
Output Level, y
Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll
highway
Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll
highway
– formation of a cartel; e.g. OPEC
Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll
highway
– formation of a cartel; e.g. OPEC
– large economies of scale; e.g. local utility
companies.
Pure Monopoly
• Suppose that the monopolist seeks to
maximize its economic profit,
( y)  p( y)y  c( y).
• What output level y* maximizes profit?
Profit-Maximization
( y)  p( y)y  c( y).
At the profit-maximizing output level y*
d( y) d
dc( y)

0
p( y)y 
dy
dy
dy
so, for y = y*,
d
dc( y)
.
p( y)y 
dy
dy
Profit-Maximization
$
R(y) = p(y)y
y
Profit-Maximization
$
R(y) = p(y)y
c(y)
y
Profit-Maximization
$
R(y) = p(y)y
c(y)
y
(y)
Profit-Maximization
$
R(y) = p(y)y
c(y)
y*
y
(y)
Profit-Maximization
$
R(y) = p(y)y
c(y)
y*
y
(y)
Profit-Maximization
$
R(y) = p(y)y
c(y)
y*
y
(y)
Profit-Maximization
$
R(y) = p(y)y
c(y)
y*
y
At the profit-maximizing
output level the slopes of
(y)
the revenue and total cost
curves are equal; MR(y*) = MC(y*).
Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d
dp( y)
MR( y) 
.
p( y)y  p( y)  y
dy
dy
Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d
dp( y)
MR( y) 
.
p( y)y  p( y)  y
dy
dy
dp(y)/dy is the slope of the market inverse
demand function so dp(y)/dy < 0. Therefore
dp( y)
MR( y)  p( y)  y
 p( y)
dy
for y > 0.
Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.
Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.
a
p(y) = a - by
a/2b
a/b y
MR(y) = a - 2by
Marginal Cost
Marginal cost is the rate-of-change of total
cost as the output level y increases;
dc( y)
MC( y) 
.
dy
E.g. if c(y) = F + ay + by2 then
MC( y)  a  2by.
$
Marginal Cost
c(y) = F + ay + by2
F
$/output unit
y
MC(y) = a + 2by
a
y
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
and the profit-maximizing output level is
aa
y* 
2(b  b )
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
and the profit-maximizing output level is
aa
y* 
2(b  b )
causing the market price to be
aa
p( y*)  a  by*  a  b
.
2(b  b )
Profit-Maximization; An Example
$/output unit
a
p(y) = a - by
MC(y) = a + 2by
a
y
MR(y) = a - 2by
Profit-Maximization; An Example
$/output unit
a
p(y) = a - by
MC(y) = a + 2by
a
y* 
aa
2(b  b )
y
MR(y) = a - 2by
Profit-Maximization; An Example
$/output unit
a
p(y) = a - by
p( y*) 
aa
ab
2(b  b )
MC(y) = a + 2by
a
y* 
aa
2(b  b )
y
MR(y) = a - 2by
Monopolistic Pricing & OwnPrice Elasticity of Demand
• Suppose that market demand becomes
less sensitive to changes in price (i.e. the
own-price elasticity of demand becomes
less negative). Does the monopolist
exploit this by causing the market price to
rise?
Monopolistic Pricing & OwnPrice Elasticity of Demand
d
dp( y)
MR( y) 
p( y)y  p( y)  y
dy
dy
y dp( y) 

 p( y) 1 
.
 p( y) dy 
Monopolistic Pricing & OwnPrice Elasticity of Demand
d
dp( y)
MR( y) 
p( y)y  p( y)  y
dy
dy
y dp( y) 

 p( y) 1 
.
 p( y) dy 
Own-price elasticity of demand is
p( y) dy

y dp( y)
Monopolistic Pricing & OwnPrice Elasticity of Demand
d
dp( y)
MR( y) 
p( y)y  p( y)  y
dy
dy
y dp( y) 

 p( y) 1 
.

 p( y) dy 
Own-price elasticity of demand is
p( y) dy

y dp( y) so MR( y)  p( y) 1  1  .
  
Monopolistic Pricing & OwnPrice Elasticity of Demand
1

MR( y)  p( y) 1   .
 
Suppose the monopolist’s marginal cost of
production is constant, at $k/output unit.
For a profit-maximum
1

MR( y*)  p( y*) 1    k which is
k


p( y*) 
.
1
1

Monopolistic Pricing & OwnPrice Elasticity of Demand
p( y*) 
k
1
1

.
E.g. if  = -3 then p(y*) = 3k/2,
and if  = -2 then p(y*) = 2k.
So as  rises towards -1 the monopolist
alters its output level to make the market
price of its product to rise.
Monopolistic Pricing & OwnPrice Elasticity of Demand
1

Notice that, since MR( y*)  p( y*) 1    k,


1

p( y*) 1    0


Monopolistic Pricing & OwnPrice Elasticity of Demand
1

Notice that, since MR( y*)  p( y*) 1    k,


1
1

p( y*) 1    0  1   0



Monopolistic Pricing & OwnPrice Elasticity of Demand
1

Notice that, since MR( y*)  p( y*) 1    k,


1
1

p( y*) 1    0  1   0



1
 1
That is,

Monopolistic Pricing & OwnPrice Elasticity of Demand
1

Notice that, since MR( y*)  p( y*) 1    k,


1
1

p( y*) 1    0  1   0



1
 1    1.
That is,

Monopolistic Pricing & OwnPrice Elasticity of Demand
1

Notice that, since MR( y*)  p( y*) 1    k,


1
1

p( y*) 1    0  1   0



1
 1    1.
That is,

So a profit-maximizing monopolist always
selects an output level for which market
demand is own-price elastic.
Markup Pricing
• Markup pricing: Output price is the
marginal cost of production plus a
“markup.”
• How big is a monopolist’s markup and how
does it change with the own-price elasticity
of demand?
Markup Pricing
1

p( y*) 1    k



k
p( y*) 

1 1 
1

is the monopolist’s price.
k
Markup Pricing
1

p( y*) 1    k



k
p( y*) 

1 1 
1

k
is the monopolist’s price. The markup is
k
k
p( y*)  k 
k  
.
1 
1 
Markup Pricing
1

p( y*) 1    k



k
p( y*) 

1 1 
1

k
is the monopolist’s price. The markup is
k
k
p( y*)  k 
k  
.
1 
1 
E.g. if  = -3 then the markup is k/2,
and if  = -2 then the markup is k.
The markup rises as the own-price
elasticity of demand rises towards -1.
A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit
from (y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit
from (y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
• A: By maximizing before-tax profit, (y*).
A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit
from (y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
• A: By maximizing before-tax profit, (y*).
• So a profits tax has no effect on the
monopolist’s choices of output level, output
price, or demands for inputs.
• I.e. the profits tax is a neutral tax.
Quantity Tax Levied on a Monopolist
• A quantity tax of $t/output unit raises the
marginal cost of production by $t.
• So the tax reduces the profit-maximizing
output level, causes the market price to
rise, and input demands to fall.
• The quantity tax is distortionary.
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(y*)
MC(y)
y
y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
MC(y) + t
p(y*)
t
MC(y)
y
y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(yt)
p(y*)
MC(y) + t
t
MC(y)
y
yt y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(yt)
p(y*)
The quantity tax causes a drop in
the output level, a rise in the
output’s price and a decline in
demand for inputs.
MC(y) + t
t
MC(y)
y
yt y*
MR(y)
Quantity Tax Levied on a Monopolist
• Can a monopolist “pass” all of a $t quantity
tax to the consumers?
• Suppose the marginal cost of production is
constant at $k/output unit.
• With no tax, the monopolist’s price is
k
p( y*) 
.
1 
Quantity Tax Levied on a Monopolist
• The tax increases marginal cost to
$(k+t)/output unit, changing the profitmaximizing price to
(k  t ) 
p( y ) 
.
1 
t
• The amount of the tax paid by buyers is
p( yt )  p( y*).
Quantity Tax Levied on a Monopolist
(k  t ) 
k
t
p( y )  p( y*) 


1 
1  1 
t
is the amount of the tax passed on to
buyers. E.g. if  = -2, the amount of
the tax passed on is 2t.
Because  < -1,  /1) > 1 and so the
monopolist passes on to consumers more
than the tax!
The Inefficiency of Monopoly
• A market is Pareto efficient if it achieves
the maximum possible total gains-to-trade.
• Otherwise a market is Pareto inefficient.
The Inefficiency of Monopoly
$/output unit
The efficient output level
ye satisfies p(y) = MC(y).
p(y)
MC(y)
p(ye)
ye
y
The Inefficiency of Monopoly
$/output unit
The efficient output level
ye satisfies p(y) = MC(y).
p(y)
CS
MC(y)
p(ye)
ye
y
The Inefficiency of Monopoly
$/output unit
The efficient output level
ye satisfies p(y) = MC(y).
p(y)
CS
p(ye)
MC(y)
PS
ye
y
The Inefficiency of Monopoly
$/output unit
p(y)
CS
p(ye)
The efficient output level
ye satisfies p(y) = MC(y).
Total gains-to-trade is
maximized.
MC(y)
PS
ye
y
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
MC(y)
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
CS
MC(y)
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
CS
MC(y)
PS
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
CS
MC(y)
PS
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
CS
MC(y)
PS
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)
CS
PS
MC(y*+1) < p(y*+1) so both
seller and buyer could gain
if the (y*+1)th unit of output
was produced. Hence the
MC(y) market
is Pareto inefficient.
y
y*
MR(y)
The Inefficiency of Monopoly
$/output unit
Deadweight loss measures
the gains-to-trade not
achieved by the market.
p(y)
p(y*)
MC(y)
DWL
y
y*
MR(y)
The Inefficiency of Monopoly
The monopolist produces
$/output unit
less than the efficient
quantity, making the
p(y)
market price exceed the
efficient market
p(y*)
MC(y)
price.
e
DWL
p(y )
y*
y
ye
MR(y)
Natural Monopoly
• A natural monopoly arises when the firm’s
technology has economies-of-scale large
enough for it to supply the whole market at
a lower average total production cost than
is possible with more than one firm in the
market.
Natural Monopoly
$/output unit
ATC(y)
p(y)
MC(y)
y
Natural Monopoly
$/output unit
ATC(y)
p(y)
p(y*)
MC(y)
y*
MR(y)
y
Entry Deterrence by a Natural
Monopoly
• A natural monopoly deters entry by
threatening predatory pricing against an
entrant.
• A predatory price is a low price set by the
incumbent firm when an entrant appears,
causing the entrant’s economic profits to
be negative and inducing its exit.
Entry Deterrence by a Natural
Monopoly
• E.g. suppose an entrant initially captures
one-quarter of the market, leaving the
incumbent firm the other three-quarters.
Entry Deterrence by a Natural Monopoly
$/output unit
ATC(y)
p(y), total demand = DI + DE
DE
DI
MC(y)
y
Entry Deterrence by a Natural Monopoly
$/output unit
ATC(y)
An entrant can undercut the
incumbent’s price p(y*) but ...
p(y), total demand = DI + DE
DE
p(y*)
pE
DI
MC(y)
y
Entry Deterrence by a Natural Monopoly
$/output unit
ATC(y)
An entrant can undercut the
incumbent’s price p(y*) but
p(y), total demand = DI + DE
DE
p(y*)
pE
pI
the incumbent can then
lower its price as far
as
p
,
forcing
I
DI
the entrant
to exit.
MC(y)
y
Inefficiency of a Natural
Monopolist
• Like any profit-maximizing monopolist, the
natural monopolist causes a deadweight
loss.
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)
p(y*)
MC(y)
y*
MR(y)
y
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)
Profit-max: MR(y) = MC(y)
Efficiency: p = MC(y)
p(y*)
p(ye)
MC(y)
y*
MR(y)
ye y
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)
Profit-max: MR(y) = MC(y)
Efficiency: p = MC(y)
p(y*)
DWL
p(ye)
MC(y)
y*
MR(y)
ye y
Regulating a Natural Monopoly
• Why not command that a natural
monopoly produce the efficient amount of
output?
• Then the deadweight loss will be zero,
won’t it?
Regulating a Natural Monopoly
$/output unit
At the efficient output
level ye, ATC(ye) > p(ye)
ATC(y)
p(y)
ATC(ye)
p(ye)
MC(y)
MR(y)
ye y
Regulating a Natural Monopoly
$/output unit
ATC(y)
p(y)
ATC(ye)
p(ye)
At the efficient output
level ye, ATC(ye) > p(ye)
so the firm makes an
economic loss.
MC(y)
Economic loss
MR(y)
ye y
Regulating a Natural Monopoly
• So a natural monopoly cannot be forced to
use marginal cost pricing. Doing so makes
the firm exit, destroying both the market
and any gains-to-trade.
• Regulatory schemes can induce the
natural monopolist to produce the efficient
output level without exiting.