EC337 Industrial Economics 2

Department of Economics, University of Warwick

Market Economics, Competition and Regulation
PROBLEM SET 1
Answer all the questions in the space provided – insert your answers electronically or by hand. Upon
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deadline: before midnight on Wednesday 29 October 2014.

1. The following question deals with elements of the Peltzman private interest theory of regulation
model discussed in Lecture 2. Assume a regulator maximizes its welfare: where ceteris paribus
a lower price it regulates in the market results in higher welfare and allowing higher profit for the
regulated firm also results higher welfare. Assume that the regulated firm’s profit is a function of
the regulated price p and its cost technology type C which is one of two values: CH or CL and CH
> CL for any given output level.
a. Show in a diagram the nature of the optimal solution for both regulated firm cost
types. 1 mark

Answer:
The optimal solution for a regulation occurs when the profit function

π

= f(p,c) is tangential to the

iso-political support function. In other words, the politician will lower the price to gain consumer votes
until the marginal vote gain equals the marginal power loss from dissatisfying consumers. Both of
these functions are as follows.

EC337 Industrial Economics 2 Department of Economics.e towards top left of the graph For a given level of profit. University of Warwick Iso-political function: M (p. or combinations of price and profit that yields equal political support. the politician or regulator is better off with a lower price and vice versa as shown below.c)) i) ii) iii) A set of. Firms yield the maximum profit when the price is set at the maximum point of the function For a given level of price.f(p. a firm yields lower profit if it has a higher cost as shown below. .c) i) ii) iii) Price Π2 (high cost) Π1 (low cost) A function that shows the relationship between price and profit for a given cost. The P1 profit function shifts away from the origin to the bottom right of the graph the higher cost it bear. M2 implies a higher iso political function compared to M1 Profit M2 M1 Π2 Π 1 P1 Π2 P2 Profit Price Profit Function: π = f(p. The politicians preference is for a higher iso-political support i.

Provided that the firm was provided with a substantial support. we can conclude that the optimal solution for a high cost firm type: i) ii) Has a higher price (p2 instead of p1) Has a lower profit (Π2 instead of Π1) Relative to the low cost type. 2 marks Answer: Yes. b. Is it possible at an optimal solution for the regulated price to be lower for the high cost firm compared against the low cost firm? If yes.c) with respect to price. and achieve a lower cost function compared to an existing low cost firm. it might be able to get support from the government such as subsidy in order to keep down its cost. Due to its influence.f(p. This is illustrated as follows: M1 P1 P2 Π1 (low cost) M2 From the above diagram. The tangential value is calculated f(p. The optimal solution for the regulated price for this particular firm would then also be lower. For example. it may be able to shift its profit function to the left. briefly explain what might cause this.Π2 Π1 Profit. a high cost firm has a large influence in the government. vice versa. .c)). say. Π EC337 Industrial Economics 2 Department of Economics.c) is tangential to the iso-political support Π2 (high cost) by maximising M(p. University of Warwick Hence. This could be due to the influence that a particular firm has that enables them to pressure the politician into giving them a favour and reduces their cost. the optimal solution for a private interest regulation occurs when the profit function π = Price function M (p.f(p.

Is there a difference in predictions about regulation and market structures between the private and public interest theories of regulation? Provide a brief reason for your answer. politicians face a trade-off between gaining votes from the consumers (which advocates for a lower P) and gaining votes from the producers (which advocates for a higher Π). P Private Interest Theory of Regulation on the other hand. we would expect that the market would be either relatively competitive such as agriculture. depending upon the shape of the profit and iso political function. In other words. and taxi industry or relatively monopolistic in nature such as network industries. and the regulation implies that a substantial market imperfection is occurring and it needs to be corrected by having a regulation M1 without compromise. regulation is supplied by utilitymaximising politicians and regulators in response to demand for regulation by interest groups. It is mainly done to correct market failures Π by internalising externalities that are present. can be defined as the regulatory intervention as a result of powerful interest groups exerting pressure on politicians and regulators to capture rents at the expense of more dispersed groups. Public interest regulation normally occurs in a monopoly market. 2 marks Pc Pm Public Interest Theory of Regulation Price can be defined as regulatory intervention that occurs in the interest of the public at large.EC337 Industrial Economics 2 A BΠ Profit. . As a result. be some point between ‘first-best’ welfare maximising point (Point B) and Monopoly pricing (Point A). we would more likely to observe that most public interest regulation are executed in a monopoly or in a highly concentrated market. Π Department of Economics. The optimal solution would hence. University of Warwick c. In this theory. Since the optimal solution is between these two points.

Given the information structure. The firm could then notify the government that it is a high cost firm so that it receives higher reimbursement for it’s cost. ii) Moral hazard. The government is not able to observe the firm cost type and assumes that there is an equal probability it is dealing with an H or L type. Is a situation where an agent gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. moral hazard can be observed when a firm doesn’t try to reduce it’s cost in providing goods and services knowing that the cost would be reimbursed by the government. A government (principal) is seeking to regulate a firm (agent) by offering a menu of contracts made contingent on an announcement by the agent. What cost arises as a result of the possibility an L type firm might mimic an H type firm? Explain in brief how this cost is addressed in the optimal static mechanism. The firm supplies a procurement contract (for example. Effort is not observable to government. defence services) and can be one of two types “High Cost” H or “Low Cost” L. a. The model is static. higher effort implies a lower cost of service.g Low cost).EC337 Industrial Economics 2 Department of Economics. b. University of Warwick 2. 2 marks . government may not know the firm type (e. Each firm type chooses costly effort and given its type. what two behavioural effects might occur? 1 mark Answer: The two behaviourial effects that might occur are: i) Adverse selection Is a situation where an agent possesses information that the other dealing agent doesn’t have and uses that information asymmetry to gain money or profit at the expense of that other dealing agent. The following question deals with elements of the Laffont & Tirole optimal static mechanism discussed in Lecture 5. In this case. In this context.

However. 2 marks Generally. the cost sharing term would then be negative. this formula also disincentivise a firm to overstate his announced cost. they will be given cost reimbursement represented by the term 0<b(Ca)<1. except for the most inefficient ones will earn information rent of U>0 as long as their β<βhigh. This occurs when a low cost firm was given a large reimbursement by the government as it claims that it is a high cost firm. firms know that the cost overruns are not fully reimbursed. since it is just a fraction (with value of b(Ca) between 0 and 1). University of Warwick Answer: The cost that would arise when an L firm mimics an H firm is a situation called rent extraction. Laffront and Tirole (1986) shows that the optimal contract is linear and having a lump sum transfer and a cost-sharing term as follows. This could be the case as for firms with β>βlow . This is because. all firm types. As a result. Where a(Ca) is the lump sum transfer. if the value of Ca > C. the total t would then be lower. Using words and/or notation briefly describe the constraints appearing in the government’s optimization programme. Ca so that he receives the contract which is appropriate for his type and hence indirectly reveals his true β (incentive compatibility) ii) Next. iii) The least efficient firm receives utility equal to the outside option but all other agent types enjoy information rent in the form of higher expected utility than available outside. As a result. a government would like to maximise welfare as shown below . This cost-reducing incentives contract specify that the government pays a fraction of the realised cost.EC337 Industrial Economics 2 Department of Economics. To address this problem. i) Self-selection requires the manager to truthfully announce his expected cost. c. and b(Ca) is the share or fraction that the regulator pays for any cost overrun Through this mechanism.

and each extra unit of effort lowering cost C by one unit). and Is the transfer made to the firms. β is firm type. This is a participation constraint where the utility of the firm has to be positive in order for it to supply such goods/services to the government or to the public. Is effort function. ii) The marginal cost of effort has to be equal to marginal benefit of effort (which in this case. e is cost reducing effort. University of Warwick Where S is Consumer Surplus. The welfare is then maximised with respect to t subject to: i) U≥0. This is also known as individual rationality-moral hazard constraint iii) where the expected utility of a firm that announced its true type is greater than its expected utility if it announced a different type of firm that it actually is (Incentive compatibility constraint) END Dr.EC337 Industrial Economics 2 Department of Economics. equals to 1 due to linearity. Chris Doyle Module Leader EC337 16 October 2014 .

University of Warwick .EC337 Industrial Economics 2 Department of Economics.