DELHI SCHOOL OF ECONOMICS

COURSE # 608: ECONOMICS OF REGULATION

Mid-Term Exam, Winter Semester 2015-16
Answer all questions in 1 hr and 10 min. Write your name and roll no. clearly on the answer
sheet. Be legible and brief while answering. Distribution of marks for questions: 10+5.
1st March 2016 Total marks: 15.

1) A monopoly can sell to 2 types of consumers, whose demand functions are:

q1 = 50 – p1 ,
q2 = 70 – 2p2 ,
The monopoly’s cost function is c(q1, q2) = 1400 + 20(q1 + q2).

a) Suppose there is a regulator. Assume that the regulator, perfectly knowing buyers
type, proposes a Ramsay pricing scheme. What are the Ramsey prices and quantities
(assuming firm breaks even)? Justify your answer by checking second order
conditions.
b) Now suppose that the regulator insists on quantities and prices that maximises social
welfare but can’t pay a transfer, can he achieve that? What are these SW maximising
prices and quantities? What kind of pricing strategy it would adopt? [ Hint: Perfect
information scenario prevails.]
c) Compare the welfare outcomes in the above two situations – which one better?
d) If the regulator does not know the buyers’ type only knows that there is 30%
probability that it is of first type and 70% probability for the other, then what would be
her optimal pricing strategy?

Or,

Consider a transaction between a buyer and a seller, which is governed by a regulator. The
regulator does not know perfectly how much the buyer is willing to pay only knows the
distribution of the type of buyer.
The buyer utility function is given by u(q, T, θ) = θ.v(q) – T, where q = the number of
units purchased and T = the total amount paid to the seller. The buyer's characteristic is
represented by θ, which is already and only known to the buyer: θ = θL with probability β
∈ (0, 1) and θ = θH > θL with (1 – β). Define Δθ = θH – θL . We impose technical
assumptions as follows: v(0) = 0, v’(q) > 0, and v’(q) < 0 for all q. The buyer does not
have any outside utility.
The seller's cost function is given by C = F – cq; where c is the seller's production cost
per unit and F is fixed cost, such that her pay off function turns out to be π = T – C.

Now answer the followings when regulator does not discriminate between the seller
and the buyer –

a) When the regulator tries to maximize social welfare, what is the first best outcome
under perfect information? Does it depend upon the fact when regulator can pay a
transfer or not?
b) Derive the optimal non-discriminatory 2-part tariff when regulator can’t pay any
transfer to the seller?
 c) Derive the optimal non-discriminatory 2-part tariff when the regulator can pay a
transfer that is half of the seller’s fixed production cost?
d) How this case (c) is different from case (b) above? Is there any welfare impact?
e) When the regulator can pay a transfer that is half of the seller’s fixed production
cost, what is the second best optimal tariff? What are the characteristics of this
tariff (how it is different from case (d) above)?

2) Consider a firm that produces two commodities X and Y; the cost function is C(x, y)
where x and y are respective quantities. Now consider the following cost cases, does the
cost conditions alone sufficiently justify a natural monopoly in each case or market
demand also plays a role? Justify your answer in the light of economies of scale and scope
and subadditivity concepts.
a) C(x, y) = x + y
b) C ( x, y ) = xy + 100