Sustainable Energy Systems
Theory of Regulation
PhD, DFA
M. Victor M. Martins
Semester 2
2008/2009
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly
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2.2 Natural monopoly and competition
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Sustainability of natural monopolies and
contestability
Evolution of natural monopolies regulation
Regulation of unregulated markets
Bibliography
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( VVH) Chap 11, 15
Baumol, W. and R. Willig 1981 “ Fixed Costs, Sunk Costs, Entry
Barriers and Sustainability of Monopoly “Quartely Journal of
Economics, 95, August, 405-431
Slide 2
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: sustainable natural monopoly
Sustainable Monopoly
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The definition of a natural monopoly is that a single firm can produce
the total market demand at lower cost than any combination of two or
more firms.
However, a natural monopoly is only sustainable if there exists a price
and output combination such that entry by rival firms is unattractive,
while all demand is satisfied and revenues cover total costs of
production.
In a natural monopoly market with a single product, a sufficient
condition for sustainability is that average costs of production fall as
output expands. Consequently, this means that average costs will be
higher than marginal (or incremental) costs.
Unfortunately, it is quite possible for marginal costs to be above
average costs, yet for the firm’s cost structure to remain consistent with
a natural monopoly.
If this occurs, a competitor can potentially undercut the monopolist’s
price, whilst making a profit, resulting in an unsustainable natural
monopoly.
Hence, for an unsustainable natural monopoly, natural monopoly and
competition are not mutually exclusive.
Slide 3
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: sustainable natural monopoly
Natural monopoly is sustainable up to q1; In q* the natural
monopoly is unsustainable
Price
Cost
€
AC1
AC2
P*
q1
q*
q2
Q
Slide 4
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: sustainable natural monopoly
A sustainable monopoly can prevent market entry:
There exist q,p such that
(1)
q=D(p),
(2)
pq=C(q),
(3)
p’q’<C(q’) for all p’<p and all q’≤D(p’)
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The monopolist satisfies the whole demand, can recover
its costs and no other firm can charge a lower price and
recover its costs, hence a natural monopoly is sustainable
if ATC are falling up to quantity q where ATC = demand
If condition (1) is not fulfilled, i.e. monopolist is not
satisfying whole demand, entrant might try to satisfy
residual demand at high price
The monopolist just covers her costs. This is enough to
start production, because costs include opportunity costs.
Slide 5
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Contestable markets
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Theory of contestable markets developed by William J.
Baumol, John Panzar and Robert Willig (1982) helped to fill
important gaps in market structure theory.
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Perfectly contestable market – the pure form – not common
in reality but a benchmark to explain firms’ behaviours
Key characteristics:
Firms’ behaviour influenced by the threat of new entrants to
the industry
No barriers to entry or exit
No sunk costs
Firms may deliberately limit profits made
to discourage new entrants – entry limit pricing
Firms may attempt to erect artificial barriers to entry – e.g…
Slide 6
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Contestable markets
{
Over capacity – provides the opportunity to flood
the market and drive down price in the event
of a threat of entry
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Aggressive marketing and branding strategies
to ‘tighten’ up the market
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Potential for predatory or destroyer pricing
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Find ways of reducing costs and increasing
efficiency to gain competitive advantage
Slide 7
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Contestable markets
{
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‘Hit and Run’ tactics – enter the industry, take the
profit and get out quickly (possible because of the
freedom of entry and exit)
Cream-skimming – identifying parts of the market
that are high in value added and exploiting those
markets
Examples of markets exhibiting contestability
characteristics:
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Financial services
Airlines – especially flights on domestic routes
Computer industry – ISPs, software, web development
Energy supplies
The postal service?
Slide 8
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Contestable markets
{
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Contestable markets and regulation
The theory of contestable markets would have strong
implications: if entry is free, we should not care about
monopolists, as efficient outcome is reached.
Critique: the theory depends on two strong assumptions:
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Unrealistic timing of the game (I cannot change price as E enters
the market)
No fixed sunk costs of entry (hit-and-run strategy not profitable
for entry if some costs are non-recoverable)
But the theory has the merit to stress the role of free entry in
limiting market power: crucial in merger analysis.
Slide 9
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Contestable markets
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Results:
With increasing returns to scale the following conclusions are
predicted
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There is a unique operating firm in the industry
This firm makes zero profits
Average-cost pricing prevails
In the absence of competition, potential entry is very
effective in disciplining incumbent firms : this theory
( contestable markets) presents a strong argument against
regulation or nationalization of utilities
Criticism: Generally believed that prices adjust more rapidly
than decisions about quantity or entry
Slide 10
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
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Deregulation of regulated markets
Question
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Dynamic changes in the market can result in a
industry no longer being a natural monopoly?
Yes,
In certain conditions the regulatory agency should
be open to this possibility and then adapt the
regulatory model – entry and price controls - to
the new market and firm conditions.
Slide 11
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Evolution of a regulated industry
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General rule: Monopoly regulation is appropriate
when the minimum efficient size of the firm is
approximately equal to market demand
Technological innovation and changes in input
prices affect the cost and demand underlying the
rationale for monopoly regulation
The question is to determine when such changes
are so decisive that the industry is no longer a
natural monopoly.
Slide 12
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
{
Demand side
Factors underlying demand shifts:
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Exogenous changes in consumer preferences
Changes in income
Price
D
Changes in productivity
1
D0
If income raises the
demand function shifts
to the right
Quantity
Slide 13
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Natural monopoly and Minimum Efficient Scale (MES)
After a demand shift the optimal output is 3 times Q0 enough
to support 3 firms
Price
D0
D*
P*
0
AC(Q)
Q*
Q0
Quantity
3Q0
Slide 14
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Ex. With a more realistic cost function
Price
Cost
P=D1(Q)
P=D0(Q)
AC
P
0
Q*
Q0MES
Q0 /
2
Q0MES
Q**
Slide 15
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monoply: Evolution of natural monopolies regulation
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Cost side
The cost function ( marginal and average) will
change when there is technological innovation or
when there is a change in input prices
The change in cost structure can affect the
natural monopoly in two ways:
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The efficient firm size can change
The social optimal output can be affected
These two effects may be illustrated by changes
in fixed costs and by changes in variable costs
Slide 16
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Reduction in fixed costs
e
Price
Cost
D
AC0
P*
AC1
C(Q)=FC+VC(Q)
P0
AC(Q)=FC/Q+AVC(Q)
0
Q0
Q**
2Q0
Q
Slide 17
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Consequences:
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A fall in fixed costs as a result of innovation
makes it less likely that an industry is a natural
monopoly
In figure of slide 17 the fixed cost fall moves the
industry from being a natural monopoly in one in
which two firms can profitably exist: MES from
Q** to Q0
At the same time the socially optimal price is
lower P0<P*
Slide 18
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Rise in the price of inputs Î average variable cost
to rise
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Price
Cost
DINELASTIC
DELASTIC
AC1
P
AC0
0
Q0
Q*
2Q*
Q^
Q
Slide 19
Theory of Regulation
Sustainable
Energy
Systems
Regulation of natural monopoly: Evolution of natural monopolies regulation
{
Consequences:
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If AC0Î AC1
MES falls from Q^to Q*
Higher AC reduces the socially optimal output, but
the net effect depends in the elasticity of demand:
{ If DELASTIC , output moves from Q^ to 2Q0 and
two firms can profitably existe in this market
{ If DINELASTIC , output moves from Q^ to Q0 and the
natural monoploy still exists
Slide 20
Theory of Regulation
Sustainable
Energy
Systems
Contestable markets: discussion
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Conclusions:
When faced with this type of changes just described,
which policies should the regulatory agency pursue?
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Pursue full deregulation
Continue regulation process and practice
Pursue partial deregulation
Competition is desirable where it is possible
Regulation does tend to limit competition
Regulation extremely slow to adapt to change in
technology and demand once put in place
Slide 21