Regulation of Markets Exam 1

What is regulation?

• Any attempt by a gov to control the behavior of individuals, companies, or other governments. Regulations restrict choice sets.

• Taxes/subsidies try to establish incentives via the pricing mechanism

Why do we regulate?

• To correct market failures, promote efficiency (maximize benefits relative to cost)

  • Regulations ask if we value benefits to consumers more than producers

• Politics

• Change the distribution of welfare (regulations aimed at helping certain groups)

Pros of Federal Regulation

• Economies of scale for firms: cheaper for firms, uniform/consistency so firms don’t have different processes of approval per state

• Prevent race to the bottom

  • ex) 2 states, no safety standards, one keeps reducing regulations so they get more firm business

• Problems may cross state/local lines (externalities)

• Expertise: fed budget is a lot larger than a state/local budget

• Interest group capture: at a local level, interest groups can influence more & capture regulators

Pros of state/local regulation

• Heterogeneity of costs/benefits

• Diversity/preferences (easier to tailor preferences to smaller areas)

• Allows people to vote with their feet (people can move around and vote in accordance with their beliefs around regulations)

Cost-Benefit

• Benefit-cost ratio should be greater than 1 or equal to 1

• Want to maximize the difference total cost and total benefits

Capture Theory & What Regulators Maximize

In theory: National interest subject to legislative mandates

Capture Theory: Regulatory agency is captured by economic interests that it serves

What are 3 key antitrust laws?

Sherman Act, Clayton Act, FTC Act

Sherman Act (1890)

• Motivation: widespread growth in “trusts” in 1800s

• Section 1: Prohibits contracts, combinations, conspiracies in restraint of trade

• Section 2: Prohibits monopolization, attempts/conspiracies to monopolize

• Summary: No acting like a monopoly

Clayton Act (1914)

• Dealing with price discrimination, mergers, vertical restraints (different supply chain contracts), interlocking directorates (same people in board of directors for both firms)

• Creates system for approving mergers

  • All mergers illegal if they substantially lessen competition or create a monopoly

  • If 2 firms want to merge, they need to submit a request

• Summary: A framework for mergers and acquisitions

Federal Trade Commission Act (1914)

• Unfair methods of competition are unlawful

• Created Federal Trade Commission (FTC)

• Summary: unfair methods of competition & creates FTC

What agencies enforce Antitrust?

• Department of Justice (DOJ)

  • Brings criminal and civil enforcement actions

• Federal Trade Commission (FTC)

  • both investigatory & adjudicative functions, brings civil enforcement actions

What are some antitrust enforcement tools?

• Block mergers

• Fines

• Criminal penalties

• Structural remedies (divestiture)

Explain the Principal/Agent Problem

Principal Owner/Shareholders → Agent Manager

• Manager now looks after their own incentives as opposed to yours (the principal owner)

• Principal hires agent, agent makes $ and sends back to manager/company, but now the agent has access to the company (leverage)

Explain Perfect Competition

• Firms make zero profit, free entry/exit, all information is readily available to consumers, there are no externalities, homogenous products, many buyers/sellers, firms have same technology

• Supply = MC, Demand = MB

• Maximizes total surplus

• A competitive equilibrium is pareto optimal

Price Controls & Effects & Calculations to Know

• Price ceilings (binding vs. non-binding)

• Shortages

Welfare Effects of Price Controls

• Consumer Surplus (top triangle)

• Producer Surplus (bottom triangle)

• Deadweight loss

• Efficiency vs. equity

Calculations

• Solve for equilibrium price & quantity (MC=MD), compute welfare

3 theories for why regulation exist

• normative analysis as a positive theory

• capture theory

• economic theory of regulation

Normative Analysis as a Positive Theory

• regulation exists to correct market failures

• policymakers act in the best interest of society

• normative analysis (when should regulation occur) —> positive theory (when does regulation occur)

Critiques:

• what is the mechanism?

• lacks empirical evidence

Capture Theory

• Regulators may be influenced/captured by firms

• Regulation can protect industry profits

• Empirical evidence shows regulation favors firms

Critiques

• regulations impacts many interest groups (consumers, workers, and industry) so why does the industry “capture” regulators/legislators?

• empirical irregularities that do not align with the theory

Economic Theory of Regulation

• explains how regulation improves the welfare of interest groups in different industries

• States why regulations occur: 1) the government has the power to coerce and redistribute wealth 2) politicians and interest groups maximize utility

• The implications of this: 1) politicians pass laws to maximize political support or reelection probability 2) interest groups trade political support for favorable legislation

What is economic regulation?

• government intervention that limits or directs firm behavior in a particular industry

• it aims to influence market outcomes

4 main instruments of regulation

1. price controls

2. quantity controls

3. entry and exit restrictions

4. control of other variables

Natural Monopoly

• A market structure where one firm can supply the entire market at a lower cost than multiple firms

• cost structure makes one firm efficient

  • differs from a standard monopoly, which have market power due to barriers to entry

When do natural monopolies arise?

• large fixed costs

• economies of scale over the entire relevant output range

• duplication of infrastructure would be inefficient

Unregulated Natural Monopoly

• firms set output where MR=MC

• price determined from demand curve

• price exceeds marginal cost

• deadweight loss relative to efficient outcome

What does an unregulated natural monopoly graph look like

Natural Monopoly Pricing: Allocative Efficiency

• Output where P=MC

• The consumers’ willingness to pay equals marginal cost

• No deadweight loss

• Graph: s=mc, d=mb → intersection is allocatively efficient (market)

Natural Monopoly Pricing: Productive Efficiency

• production at the lowest possible average total cost

• occurs at minimum point of ATC

• Graph: ATC curve and intersection of MC → productive efficiency

Typical Natural Monopoly

• High fixed cost

• Low constant MC

Temporary Natural Monopoly

• Economies of scale are eventually exhausted

• on graph: demand curve shifts out

Permanent Natural Monopoly

• Economies of scale over any level of output

• Graph?

Marginal Cost Pricing

• Regulators sets P=MC

• Achieves allocative efficiency

• Problems:

  • firms may incur losses if ATC > MC

  • firms may exit the industry

Average Cost Pricing

• Regulator sets P=ATC

• Firm breaks even

• problems:

  • not allocatively efficient (P>MC)

  • firms may inflate costs

Two-Part Tariff

• per-unit price equal to marginal cost

• fixed fee covers fixed costs

• can be more efficient and cost-effective

1. fixed fee

2. constant price per unit of consumption

Consumers pay: F + PQ

f= fixed fee, p=price, q=quantity

Pricing Trade-Off: Marginal Cost Pricing vs Pricing-Trade Off

Marginal Cost Pricing:

• efficient

• financial losses

Average Cost Pricing:

• financially sustainable

• deadweight loss

Franchise Bidding & Intended Benefits & Potential Drawbacks

• Government auctions the right to serve the market

• Firms bid what price they could deliver the service for

Intended Benefits:

• competitive bidding drives price toward cost

• do not need cost information

• transfers surplus to consumers

Drawbacks:

• need to know consumer preferences (does the consumer value service quality)

• franchise may try to provide low-quality goods

• graph example:

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ENERGY & ELECTRICITY MARKETS

ENERGY & ELECTRICITY MARKETS

4 Phases of Electricity Supply

1. Generation

2. Transmission

3. Distribution

4. Retail

Historical Structure of Energy/Electricity Markets

• Natural monopoly structure

• Each region has one vertically integrated firm that handles all functions

• state-level Rate-of-Return Regulation

Energy/Electricity Markets: Why unbundle?

• limited economies of scope → generation vs. distribution

• The Public Utilities Regulatory Policy Act of 1978: PURPA

  • “qualifying facilities” can sell power to utilities

• 1996 FERC Order 888

  • Transmission = common carrier → interconnection

  • interconnection → vertical unbundling → more competition

• common carriers must provide service to those willing to pay (in return, firms often receive regulated monopoly privileges)

Traditional Rate-of-Return Regulation

• it is the practical implication of average cost pricing

• set prices such that P=AC, so the firm is making zero economic profit (this includes the opportunity cost of capital)

• economic cost = explicit cost + implicit cost

  • implicit costs are the opportunity costs of the firm’s resources

• in practice firms set prices such that: Revenue=operating expenses + s x Rate Base

• Rate base = the value of a firm’s capital

• s is the allowed rate of return on capital

Problems with RORR

• accounting cost reimbursement → no incentive to minimize cost

• if s is too large → firm uses too much capital

Averch-Johnson Effect

• Occurs when the allowed return is greater than the true cost of capital

• Causes incentive to overinvest in capital

• Overcapitalization

Regulatory Lag

• Prices fixed for period

• Cost reductions → temporary profits (welfare goes up w/ increase in PS)

• creates efficiency incentive

• mispricing over time

What are 3 types of incentives regulations?

• Price Cap Regulation (PCR)

• Earnings Sharing

• Yardstick Regulation

Price Cap Regulation

• Prices set based on forecasted costs

• firm keeps cost savings

• stronger efficiency incentives

More Advantages:

• price flexibility → helps minimize industry costs by ensuring customers are served by the least cost supplier

Disadvantages:

• can result in wide variation of earnings

• can reduce a firms incentive to deliver high quality services

Earnings Sharing

• Cost savings are shared between the consumer and monopoly

  • Lower prices for consumers

  • Firms allowed to keep profits

More advantages:

• Allows regulators to avoid especially high and particularly low earnings

Disadvantages:

• reduces incentives for major cost reductions

Yardstick Regulation

• Set as a goal for the performance of other firms → compares the firm’s performance against similar or competing firms operating in separate market or regions

• incentive to lower cost and keep profits

• provides incentive for forms to operate efficiently by avoiding linking a firm’s authorized price to it’s costs

• Disadvantage: doesn’t account for the fact that not all firms operate under the same circumstances

Multiproduct Natural Monopoly

C(X+Y) < C(X) + C(Y)

• economies of scope

• common cost allocation problem

Fully Distributed Cost

• allocate common cost across products

• where Pi = ACi

• often an arbitrary allocation rule

What are ramsey prices?

• Optimally set prices to minimize the aggregate DWL

• Higher prices for the more inelastic good

Cross Market Subsidization

• determining if one market is paying more than its share

• stand alone cost test

• average incremental cost test → what is the additional cost of Good X when good Y has already been produced?

• Good is produced subsidy free if Px is greater than or equal to the average incremental cost of x

Time of Use Pricing

• Different price for the same service based