L2, Regulation

Page 2: Introduction to Regulation

Key Topics

1. Designing optimal regulation under no information asymmetry

   • Setting the right price when costs and demand are known

2. Designing optimal regulation under information asymmetry

   • Challenge: Why imperfect information on costs makes regulation imperfect

Page 3: Stakeholders in Regulation

Objectives of Stakeholders

• Regulated Firm: Focused on maximizing private profits

• Government: Aims to foster efficiency and fair distribution of rents

• Users/Consumers: Seek to maximize their net utility

• Regulator: Acts as a benevolent referee but may have its own agenda

• Taxpayers: Interested in minimizing the fiscal burden that distorts prices

• Other Firms: Aim to maximize their private profits

• Agencies: Each has its own private agenda (e.g., environmental agencies)

Page 4: Constraints on the Regulator

Types of Constraints

• Technological and Economic Constraints: Include costs and preferences. cannot be changed , are constraints

• Legal Constraints: Encompass laws such as privatization law, antitrust laws

• Institutional Constraints: Involving decisions on price and wage controls

• Informational Constraints: Covering asymmetric information including adverse selection and moral hazard

Page 5: Trade-offs between Regulator’s Objectives

Considerations

• Efficiency: Ensure prices reflect costs, minimize production choices

• Fiscal Viewpoints: Provide fiscal payoff to the government

• Social Concerns/Equity: Aim for lowest price and highest quality

• Voting Mechanism: Voters may express support or discontent

• Governance: Ensures accountability among all actors

Page 6: Summary of Regulation Dimensions

Key Points

• Importance of aggregating multiple perspectives to formulate policies

• Quantifying main concerns reflected in policy trade-offs

• Utilizing standard theory to measure profits, costs, and demand for risk assessment

• Objective: Build rules of thumb to document trade-offs in regulation

Page 7: The Problem of Monopoly

Context

• Natural Monopoly: Characterized by large fixed investments with low marginal costs

• Regulator’s Dilemma: Balancing exploitation of scale economies against monopoly market power

• EXAM QUESTION SUBJECT, often on this chapter

Page 8: Long-Run Investments and their Importance

Components

• CAPEX (Capital Expenditure): Installation and reinvestment costs

• OPEX (Operational Expenditure): Daily maintenance costs

Considerations

• Relation between expenditures and scale of production

• Need for forecasting demand to set appropriate scale

• the scale of capex influences afterwards opex

• in the long run: difficult to forecast demand to set up infrastructure at the right scale

• short run problem: scale is given/ capacity is given in the short run , and to set quantity price

  => 2 types of mistakes: underestimate/overestimate demand => undercapacity/overcapacity

• if undercapacity=>cost can rise (implies also possible rise in opex costs)

Page 9: Demand Forecasts and Capacity Issues

Capacity Management

• Demand forecasts can be underestimated or overestimated

• Underestimated demand leads to capacity shortages

• Overestimated demand results in under-utilized capacity

Challenges

• Adjusting capacity can be difficult, especially in infrastructure scenarios

Page 10: Capacity and Marginal Costs

Cost Dynamics

• Assessing short-run marginal costs based on existing capacity levels

• Marginal cost aligns when production equals installed capacity

• golden rule=where the volume of operation will be, the moment where we approach short term capacity we have to invest

Page 11: Welfare Implications of Monopoly Regulation

Key Questions

• What are the welfare consequences of unregulated monopolies?

• Factors include market concentration and elasticity of demand

• 2 elements ffected by the monopolists

Page 12-15: Monopoly Profit Maximization

Profit Maximization Model

1. Demand Function: Formulated as p(q) where p is price and q is quantity

   if price decreases, the monopolist sets q1, if lower price pushes volumes, monopolist is trading off both areas

2. Marginal Revenue and Cost: Relation established between revenue and cost functions

3. Optimization Condition: Usually stated as MR = MC (Marginal Revenue equals Marginal Cost)

4. Lerner Index: Measures market power, defined as price-cost margin relative to price elasticity

   markup/by price = inverse of elasticity. of demand, you price product taking into account own price elasticity

   => if you want to gather info on firm you want to regulate, i need to know about the elements of this final equation (cost function,elasticity, price)

   =>distortion of the monopoly is qp’(q) an d p(q)=c’(q) is actually the perfect competition condition, will produce int he elastic part of the demand function

Page 16-19: Assessing Market Power of Monopoly

Elasticity of Demand

• Matter of market power: Low elasticity implies greater markup potential

Welfare Losses and Natural Monopoly Regulation

1. Monopoly Quantity (QM) vs. Regulated Quantity (QF) and Competitive Quantity (QC)

2. Welfare loss represented graphically in models (Harberger triangle)

≠have to be linear= a fixed part and a linear part

Page 20-22: Solutions for Regulating Monopolies

Marginal Cost Pricing

• Balancing fixed costs with maintenance and ensuring consumer protection

Alternative Strategies

• Setting up competition for the market via procurement procedures and auctions for efficiency

• competition for the market: for telecommunication, there is a limited range of frequencies(property of the state), buy your license for certain number of years and range of frequencies where you become a monopoly, but a for the wole range of fr we have an oligopoly (also common for highways, if a section is run by a private company)

  => here want to select the best company that fits best all cst, quality criteria

  => pitifalls: need to esure frequencies of auctions is sufficiently high/ also needs ot asess the size of spectrum

• competition in the market:

Page 23-26: Role of State-Owned Enterprises (SOEs)

Importance & Representation

• SOEs prevalent in network industries (electricity, water)

• Challenges include balancing user costs with provider profits

• ports are one of the exceptions of public infrastructure which is mostly private

Page 27-30: Goals of the Regulator

Governance Objectives

• Efficiency, equity, and financial viability considerations

• Addressing profitability constraints and consumer/taxpayer interests

• obv want to achieve efficiency + equity + also viability for taxpayers

• the assumptions, want taxes to be efficient that’s why they are parametrized as opportunity costs

• welfare of consumer is w-tilda, since it’s not the overall welfare only for consumers

• might ask the exam the problem of a firm, so should know the mathematical models!!

• costs have 2 dimension, technical costs ( C(q) ° and then ther is the cost of taxation (lambda-t)

  

  => 2 implication sof the final welfare equation:

  • can get a bit of intuition on what impacts welfare

    1. intuition: this partial derivative is actually a positive lambda, welfare goes up if the firm makes larger revenues, further comments in next slide taxation is distortionary, the more firm can finance through fees, the better it is from a efficiency pov, don’t want to finance too much through transfers, however that would mean that poorer people would have to pay more out of pocket than if more taxes were involved

    2. intuition: less controversial, don’t want rents, bc they come for sure from high prices+low q or high subsidies

Page 31-34: Design of Regulation under Full Information

Cost Structure

• Detailed examination of CAPEX and OPEX in relation to firm operations in the cost function now

Pricing Models

• Introduction of Ramsey-Boiteux pricing to balance social welfare and financial viability

• in blue; revenue side and lilac; costs side

• the result, is adjusted by the term lambda, which is capturing the impact of taxation on economic efficiency, it is used to set prices

• further explanation on 2 extreme cases

Page 35-39: Cost Efficiency in SOEs

Key Drivers

• Problems stemming from inefficiencies in public operations and managerial decisions

Analysis of Pricing Margins

• Influence of cost efficiencies on profitability and regulation of prices

• p38, (22) is describing the optimum,

• however, effort cannot be correctly measured, a lot of scope for moral hazar bc of information asymmetry, the company knows more about the effort than the regulator

• this analysis started off from a welfare pov, not considering incentive or such

• independence of regulators and political pressure has recently been questioned, (is it even possible?)

Page 40-46: Moral Hazard and Regulatory Challenges

Ex-Post Information Disadvantage

• Evaluating management’s efforts to contain costs and implications for pricing

Contractual Implications

• asymmetric information is especially interesting on the supply side (so related to the cost side),

• Designing contracts to incentivize efficiency in both high and low-cost firms

• p43, if regulator ‹ill not choose high type, so clients bring home more surplus

• if don’t know the type though, and propose different contracts, firms have incentive to lie, low-cost will pretend to be high cost

• p 40: always very probable on the EXAM!! now we have informational constraints

• p 46, have to give up informational rent, so that efficient firm chooses its own contract, contract cannot be the one proposed by the naive player (its modified/adjusted contract now and is bit more profitable than the previous one)

• the previous slides was the framework, from p.47 more detailed like in the book

• p47 the formula, the t = transfer of the government for the firm’s contract

Page 47-60: Generalization of Asymmetric Information Models

Insights on Information Rents

• Designing incentives under uncertainty, managing risk of rent-seeking behaviors

Applications and Practical Considerations

• Addressing moral hazard through effective contract structures and regulatory frameworks

Recommendations for Effective Regulatory Practices

• Estimation and monitoring strategies to reduce uncertainties and align incentives

• p50, will put some formula seen on p50 and thenwhta can be found through them, and explain them,