full natural monopoly answer.

definition of natural monopoly.

• a market where a single firm can supply the entire output at lower cost than multiple firms due to subadditive costs.

what are the characteristics of a natural monopoly?

• decreasing AC up until a relevant market size.

• high sunk original investment but low marginal costs to serve one extra user. the cost structure is very top heavy.

• one firm cheaper than many.

• economies of scale.

what do technology characteristics do in stimulating natural monopolies?

more likely when they push fixed costs up or marginal costs down.

when advanced water treatment centre needed then one firm is more efficient to built it alone that multiple.

when wireless broadband replaces copper cables, there is less need for one large network.

what do economies of scale do for the formation of natural monopoly?

• allow for two related products to be produced more cheaply by one firm.

• one single utility company running the water supply and water treatment centre. no need for more than one company.

what does the market size do to the possibility of natural monopoly being present?

• low market size, then AC is still falling and therefore more efficient for one firm to supply.

• if the market size expands past the minimum AC point, then one firm can no longer operate with the lowest average cost. more efficient to have multiple firms supplying.

what are the welfare implications of natural monopoly?

• cost efficiency.

• lower ac than multi firm industry.

• deadweight loss.

• P>MC, under consumption.

• hold up problem may exist due potential under investment.

• lack of competition leads to low incentive to minimise costs.

• weak innovation incentives.

why is regulation needed for a natural monopoly?

• p>mc because it faces no competition.

• restricted output and DWL.

• eliminates the ability for consumers whose WTP>MC<MON to consume.

• monopolist may cut quality to save money without the fear that consumers will switch.

what is first best pricing?

• P=MC.

• ALLOCATIVE EFFICIENCY.

• firms make losses and so isn’t feasible.

• requires subsidies which are funded by taxation elsewhere.

what is second best pricing? what happens in the multiproduct case?

minimising the DWL subject to the firm breaking even.

AC=P and therefore only small DWL.

in a multiproduct case, then firms produce multiple products using the same shared fixed assset. fixed cost cannot be assigned to one product.

• distortions are placed where they hurt least.

• high markups are placed on low elasticity product.

• low markups are placed on high elasticity product.

• minimised welfare loss.

• firms break even.

what are the limitations of ramsey pricing?

• regulators must know the elasticity of demand for each product.

• essential services often have inelastic demand. higher prices.

• incentives to reduce costs if costs are reimbursed.

what is the loeb magat benchmark model under asymmetric information?

regulator wants p=mc, but regulator cannot observe the firm’s cost or effort.

assumes no distortive transfers.

there are no distribution concerns, the regulator only cares about total surplus and not consumer surplus.

regulator delegates price choice to the firm.

regulator promises a transfer equal to consumer surplus.

firm becomes the residual claimant of total surplus.

firm chooses p=mc.

firm reveals type through price choice.

why is the loeb magat unrealistic?

transfers are distortive in reality.

require taxation or access to fees.

giving all the CS to the firm is politically impossible.

regulator must know the CS at every price, they must have full knowledge of demand.sse

what is cost of service regulation?

• prices are set to cover the costs, including an allowed rate of return on capital.

• P=AC.

• ensures firms remain solvent and can finance investment.

• low powered incentives, if firms don’t cut costs then the price will rise. if they do then price will drop. RATCHET EFFECT.

• no reward for efficiency.

what is the averch johnson effect?

• firms profit by expanding capital base.

• Incentive to over invest in capital.

• leads to inefficiently high capital/labour ratio.

what are the main limitations to the cost of service regulation?

information asymmetry of true costs.

capture may allow for inflated allowed returns.

monitoring costs associated with measuring costs.

No incentive to improve quality as they are costly and not rewarded.

how can effects of cost of service be mitigated?

• there is regulatory lag, prices are not updated immediately, can keep profits temporarily.

• regulators enforces prudence reviews, discourages unnecessary capital projects.

what is price cap regulation?

sets a max price which firm can set for 4-5 years.

calculated using the expected inflation - expected efficiency gains.

if firms cut costs below the cap then they keep all the savings as profit.

strong motivation to innovate and reduce waste.

what are the problems with the price cap regulation?

• regulator may not be committed and tighten the cap afer firm invests. regulatory risk.

• cutting costs may result in cutting quality, need for quality standards aswell.

• if X is set too high, then firms cannot recover costs.

• if firms argue for low X; regulators argue for high x this is costly and time consuming.