Lecture 4
Monopoly regulation
Nathalie Daley
SciencesPo Paris
Introduction
 You saw with Emmanuel Frot different forms of industrial
organization and pricing strategies
– Perfect competition
– Monopoly
– Oligopoly models
 Today, we focus on monopoly and on its regulation
 The outline of this lecture is
– The different sources of monopoly power
– Why regulate monopolies?
– Price regulation
– 2 students' presentation: gas and telecommunications cases
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The different sources of monopoly power
 In monopoly market, one firm serves the entire demand
 Monopoly setup can result from different reasons and three
broad categories of monopolies exist
– Technological monopolies
– Legal monopolies
– Natural monopolies
 The frontier between these categories is not clear-cut in
practice
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Technological monopolies
 A first source of monopoly (or quasi-monopoly) is technology
– Technological monopolies (or quasi-monopolies) occur when the
good of the company is legally protected by a patent or a copyright
– The monopoly results generally from competition on the merits:
the company is rewarded for its R&D efforts
– The idea is that absent the patent (i.e., the monopoly), it would
discourage companies in investing in costly R&D activities as
competitors would benefit from its efforts
 The monopoly is temporary by nature as patents are granted for
a limited time period
– It usually lasts 20 years or until a new technology is created that is
close substitute
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Technological monopolies
 There are many examples in different industries
– It is quite common in the pharmaceutical industry where producers
are granted patents on the new molecule they discover
– It is also common in high tech industries: operating systems,
standards, etc.
 The case of Polaroid in instant photography market illustrated the
temporary nature of technological monopolies
– In 1947, the founder of the Polaroid Corporation invented the first
instant camera and through a series of patents, he created a
monopoly
– By the time other technologies emerged and if the company
remains the leading seller of instant cameras and film, this
technology has become a minor segment of consumers
photography market
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Legal monopolies
 A second source of monopoly is legacy
– A legal monopoly is protected by law from competition
– Government have imposed legal monopolies on various products
since long
 They are both a source of public revenues and a means of
control
 Legal monopoly is generally motivated in order to
consumer or for public service purposes
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protect
Legal monopolies
 In many countries, states have a monopoly on gambling
– In France for instance, Française des jeux and PMU have a
monopoly on gambling
– They are the only authorized companies for offline gambling
 Legal monopolies on alcohol is also commonplace in all Nordic
countries (except Denmark)
– In Sweden, Systembolaget is a government-own chain of liquor
stores
– It is the only retail store allowed to sell beverages that contain
more than 3.5% of alcohol
 Postal services are also granted a legal monopoly for public
service purposes
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Natural monopolies
 A third kind of monopolies is natural monopoly
– In some markets, it would be inefficient to have more than one
company competing for consumers’ business
 It is the case in industries that face high fixed cost structures
– The cost necessary to produce even a small amount is very high
– In turn, when the initial investment has been made, the average cost
decrease with every unit produced
 A single supplier is most efficient due to economies of scale, a
situation in which the average cost of production falls as the
producer grows larger
– The more customers the company serves, the more efficient its
operation becomes, as its high fixed costs are spread out over a large
number of buyers
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Natural monopolies
Natural monopoly case
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Competition case
Natural monopolies
 Competition is not desirable because a large number of firms
would result in duplication of capital equipment
– For instance, some cities in Sweden experienced the coexistence
of two unconnected telephone networks at the beginning of the
20th century
– The client saw the obligation to take two subscriptions, and the
cost of civil works and wiring were duplicated unnecessarily
 Examples of industries in natural monopoly: telephone,
electricity, railroads and water supply
– For instance, the cost of the French local loop is estimated by the
French regulator of telecommunications and posts (ARCEP) at €28
billions + €10 billions for the general network
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Why regulate natural monopolies?
 Whether legal and/or natural monopoly, several reasons have
been identified that justify the regulation of monopolies
– Allocative efficiency
– X-inefficiency
– Technological change
– Universal service obligations
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Reminder: allocative efficiency
 Monopoly leads to higher prices and lower quantities than
competition does
 Higher prices have two effects on consumers
– Some keep on buying the good but pay more (transfer effect)
– Some stop buying (deadweight loss)
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X-inefficiency
 Monopoly raises the question of whether it seeks cost
minimization
– As it is no longer pressured by strong competitors to keep its costs
at the competitive minimum, it could lack efficiency
– Often cited examples are US Steel, General Motors, IBM or
American airlines which once dominated their industry and felled
victim of their own inefficiencies
 For instance
– GM managed to reduce its costs by 20% to 30% when faced by
competition of Japanese car makers in the 80’s suggesting that its
X-inefficiency was that high
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Technological progress
 Technological progress
– Technological developments have been the drive behind the
transformation of certain natural monopoly markets to more
competitive one
– This is the case for instance in the telecoms industry where new
technologies such as fiber optic has come to provide a strong
substitute of traditional copper network
– The classical argument goes that monopoly firms lack incentive to
promote technical change and invest in R&D
– Because it is protected from competition, a monopoly would not
fear that a rival would promote new production methods
– Criticism of this approach: monopoly could spend time and money
on innovation to safeguard its position
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Universal service obligations
 Universal service obligations
– Because of social considerations, governments have often considered
to offer some services or products at a price lower than cost to some
consumers
– Government may ask for the provision of universal services: the same
services and prices are offered regardless of consumers’ location
– It is often financed by obtaining higher profits on the sale of other
products and services, i.e., cross-subsidization
– If the monopoly burdened with universal obligations it has to be
protected from competition as otherwise it would lead to
inefficiencies
– Entrants would focus on profitable services and the monopoly would
be left with high costs consumers which would lead to losses under
uniform pricing
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French regulators
 Before the introduction of competition in natural monopoly
markets, firms were regulated by ministries
 Since then, independent regulatory bodies have been created
– L'autorité de régulation des télécommunications was created in
1996 (it is also in charge of postal services right now – ARCEP)
– La Commission de régulation de l'énergie (CRE) was created in
2000
– The creation of l'autorité de régulation des activités ferroviaires
(ARAF) dated back to 2009
– L'Autorité de régulation des jeux en ligne (ARJEL) is even more
recent: 2010
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Which regulation?
 Regulators can put in force different mechanisms of regulation
depending on the stage of market liberalization
– Before liberalization, regulation focused on monopoly's price to
final consumers
– In the 1990's, competition started to be introduced in different
sectors and the focus was put on access pricing regulation, i.e., the
price that the natural monopoly should offer to competitors to
access its network
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Price regulation
 One solution is to set the price of the monopoly at its marginal
cost (first best solution)
– In that case, the monopoly is loosing money and will not be able
to stay in business in the long run
– Reminder: marginal cost is lower than average cost
– The only way to keep the monopoly in business is to provide a
public subsidize corresponding to the amount of loss
– The government can levy taxes on other markets to finance the
deficit
– But by doing this it introduces distortions on those markets
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Price regulation

A second solution is to set price at average cost (second best solution)
– The rate of return regulation consists in paying the monopoly its costs
– The regulator looks at the monopoly's base rate, cost of capital, operating
expenses and overall depreciation in order to estimate the total revenue
needed to fully recover its expenses
– The base rate corresponds to the amount of capital and assets used by the
monopoly to provide its services (B)
– The regulator also takes into account the cost incurs by the monopoly to finance
its base rate (r)
– The operating expenses are the cots (including labor and capital) used in one
year to provide services (E)
– Depreciation is the annual amount the firm spends on accounting for
depreciation of capital (d)
– Taxes that are not charged directly to consumers are also taken into account (T)
– The rate of return = (B*r) +E +d+T
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Price regulation

The advantages of the rate of return regulation are that
– They prevent the monopoly from making large profits
– It provides stability to investors: they won't make large dividends but they will
make constant returns
– It also protects the monopoly from negative public opinion: consumers are
ensured to pay a fair price

The disadvantages of this regulation
– It does not provide strong incentives for the monopoly to operate efficiently
– The monopoly can engage in disproportionate capital accumulation as it raises
its price
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
This regulation was in the first place used in the US to regulate utilities
(electricity, gas, phone services, etc.)

It was gradually replace by new and more efficient regulation
Price regulation
 Price cap regulation consists in fixing ex ante the maximum
revenue of the monopoly
– This price is evaluated on the basis of the monopoly's historical costs
(or forecasts) (P0)
– The price cap is then adjusted according to an efficiency gain
coefficient (X) and the rate of inflation (RPI)
– X is not only based on the firm's performances but also on other firms
performances
– So the maximum revenue = P0 * (1+RPI – X)
 This regulation was designed in the 1980's and applied for instance
in the water industry in the UK
 It is also used in telecommunications in Asia and in the US (local
exchange carriers)
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Price regulation
 The advantages of price regulation is that it gives incentives to
the monopoly for efficiency savings
– The firms keeps the productivity gains
 The main problem is that regulators have ex ante to define the
revenues of the monopoly without knowing its costs
– Price might be too low or too high
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Incentive regulation
 The main problem of regulators is information asymmetry
– It cannot know for sure the level of the monopoly's costs
 Menu regulation consists in presenting monopoly with a choice
of contracts
– Monopoly are offered contracts that differ in expected costs and
revenues and chooses among them
– Monopolies that have a more potential for costs reductions are
regulated with a higher-incentive contract while those that do not
have the potential are regulated with a lower-incentive contract
– It is a fairly recent regulation that has been apply for instance in
the UK
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Incentive regulation
 Here is an example of menu regulation
– The monopoly choose the projected expenditure (business plan) which
gives him the level of efficiency incentive and additional income
– If it chooses for instance 95 %, its reward is 1.56% (98.7-95)*32.5%+0.34
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Access pricing
 Some activities are not a natural monopoly in the long run
– Because of technological evolution or products differentiation
 In that case they can be opened to competition
– The regulator will concentrate on natural monopoly regulation
(network)
– The other activities will be under the scrutiny of the competition
authorities
 Access pricing will be the major challenge for regulators
– If prices are too high competitors won't be able to effectively
compete with the incumbent
– If they are too low, the incumbent won't be able to maintain the
network
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