Economic regulation - 2

Summary

1. Natural monopoly
Concept
Cost function subadditivity
Case i) Single-product firm with average cost not always decreasing
Case ii) Multiproduct firm

2. Regulation of a natural monopoly

Optimal price regulation
Non-linear tariffs

References:
• Church, Jeffrey and Roger Ware (2000), Industrial Organization: A Strategic Approach,
McGraw Hill, chapters 24 and 25.

• Viscusi, W.; Harrington, J. and Vernon, J. (2005), Economics of Regulation and Antitrust –
4thEd., MIT Press.

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What is a natural monopoly?

An industry is a natural monopoly (NM) if production by a single firm

minimizes the cost.

The typical example occurs in the production of a single product when the
average cost decreases (economies of scale).

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AC
MC
D - Demand
D
AC - Average Cost

MC - Marginal Cost

AC

MC

0 Q

For all values of Q, the unit cost (AC) is decreasing.

This is frequent in industries where the fixed costs are very high as, for
example, electricity or natural gas transportation, rail transport network.

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For a single product firm with decreasing average costs, the concept of
economies of scale is enough to characterize a NM.

However:
• if AC is not always decreasing or if
• the firm is multiproduct

the definition of NM requires the concept of cost function subadditivity.

Economies of scale might not be necessary to characterize a NM.

Definition: There is a NM when the cost function is subadditive.

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A cost function is subadditive if the production cost is lower when there

is only one firm producing the total industry output than when there are
several different firms producing the same output (this is the natural
monopoly definition).

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Case i) Single-product firm with AC not always decreasing

Assume that AC decreases when Q < Q’.

AC
Then, there are:
AC
• economies of scale when Q < Q’
• diseconomies of scale when Q > Q’

0 Q
Q'

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Case i) Single-product firm with AC not always decreasing

For Q < Q’ there is a NM.

AC

AC
What if Q > Q’?

Is it possible to say that the industry is a NM

for Q > Q’?

0 Q
Q'

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Exercise: Assume the following total cost function: TC(Q) = 2Q2 + 8. Find
the interval where there is a natural monopoly. Justify.

Resolution:

TC(Q) is a short run cost function as there are fixed costs (8). Marginal cost
(MC) and average cost (AC) functions are:

MC = dTC/dQ = 4Q AC = TC/Q = 2Q + 8/Q

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AC is minimum when MC = AC:

4Q = 2Q + 8/Q  Q=2 or Q = -2

Or,

FOC: dAC/dQ = 0  Q – 8/Q2 = 0  Q=2 or Q = -2

SOC: d2AC/dQ2 > 0 for Q = 2

There are economies of scale for Q < 2 and diseconomies of scale for Q > 2.

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There is a natural monopoly when costs are lower with one firm than with
several firms:

TC(Q, N = 1) ≤ TC(Q, N = 2)

total cost when one total cost when two

firm produces Q firms produce Q (each
firm produces Q/2)

TC(Q, N = 1) = 2Q2 + 8

TC(Q, N = 2) = 2*TC(Q/2) = 2[2(Q/2)2 + 8]

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There is a natural monopoly when:

2Q2 + 8 ≤ 2[2(Q/2)2 + 8] -2.8 ≤ Q ≤ 2.8

Conclusion: There is a natural monopoly when Q ≤ 2.8.

Why for Q > 2.8 the total cost is lower with two firms, even though two
firms imply a duplication of the fixed cost?

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Case ii): Multiproduct firm

Multiproduct firms are the most frequent case in regulated sectors:

• Electricity firms distribute electricity during the day and during the
night, distribute electricity with different voltage, ...

• Some energy firms sell electricity and natural gas.

• Telecommunications firms sell voice calls, Internet access, calls, TV, …

• Rail transport firms transport passengers and freight.

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For multiproduct firms the concept of economies of scale does not capture
all the characteristics of the natural monopoly and therefore the concept
of cost subadditivity is crucial.

One important feature of multiproduct firms are economies of scope, that

result from cost interdependence. There are economies of scope in the
production of two goods if the total cost of joint production is lower than
the sum of total costs when the goods are produced separately:

TC(q1, q2) ≤ TC(q1, 0) + TC(0, q2)

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2. Regulation of a natural monopoly

Natural monopolies may need to be regulated, although that depends on the

specific features of the markets and products (namely if they are essential or
not), on the social goals, …

Price and entry regulation are instruments that can be used to solve the
conflict between productive efficiency and allocative efficiency.

Entry regulation may ensure that there is only one firm in the market which
allows productive efficiency.

Price regulation may ensure that the monopolist set a reasonable price.

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Optimal price regulation

Assume a single product natural monopoly and price regulation by which the
regulator set a linear price.

The first best solution from a social welfare perspective is:

Price = MC (marginal cost)

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However, this solution might lead to negative profits. If that happens the
regulator might set the second-best solution which corresponds to set the
price equal to average cost (AC):

Price = AC

The second-best solution is called Ramsey price.

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Natural monopoly without regulation Natural monopoly with regulation

P P
D D

a a
Pa Pa

b c
AC Pb AC

MC Pc MC

Qa MR Q Qa Qb Qc Q
MR

Linear demand MR = Marginal Revenue

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Point (Qa ; Pa) – no regulation

Without regulation the monopolist sells Qa at price Pa and the profit is

positive, given by (P - AC)*Qa.

When Q = Qa marginal revenue equals marginal cost, which is the first order
condition of the profit maximization problem.

However, price Pa may be considered too high, for instance, because the
product is essential to the population and there are few substitutes.

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Point (Qc ; Pc) in the graph on the right – first best solution

The regulator sets price equal to marginal cost (MC).

The MC curve intercepts the demand curve when Q = Qc.

The monopolist has negative profit represented by the shadow rectangle in

the figure on the right. This area is given by (AC(Q=Qc) – Pc)*Qc. This solution
implies allocative efficiency, but it penalizes firm’s profit.

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Point (Qc ; Pc) in the graph on the right – first best solution

If the regulator implements the first best solution it is necessary to solve the
problem of how to finance the monopoly activity (subsidies from the
Government? revenues from other markets where the monopolist also
operates? ...). The first best solution may imply inefficiency in other parts of
the economy.

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Point (Qb ; Pb) in the graph on the right – Ramsey price (second best solution)

The regulator sets price equal to average cost.

The AC curve intercepts the demand curve when Q = Qb.

The monopolist has zero profit.

The second-best solution is the price that maximizes social welfare under the
constraint that the firm achieves the break even.

The Ramsey price for a firm that only has one product is the average cost.

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Inefficiency of the second-best solution

The second-best solution introduces allocative inefficiency as the price is

above the marginal cost. This inefficiency is high when:

• There is a big difference between AC and MC

• The elasticity of demand is high

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Multiproduct monopolist and second-best solution

Example: Assume the following cost function of a firm that produce two
products X and Y:

TC(X,Y) = 1800 + 20X + 20Y

The demand functions for products X and Y are, respectively:

X = 100 – Px Y = 120 – 2P

Note: in this example (from Viscusi et al., 2005, p. 415) demands are independent, that is, the
demanded quantity of one product does not depend on the price of the other product. To study
the case of interdependent demand see, for example, Viscusi el al., 2005.

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Ramsey prices (second best solution) are the prices that maximize social
welfare under the constraint that the firm obtains zero profits, or equivalently,
the prices that minimize social welfare loss under the same constraint.
Ramsey prices can be obtained by solving the following problem:

(Px − 20)(80 − x ) (Py − 20)(80 − y )

Min +
2 2

s. t. xPx + yPx = 1800 + 2 x + 2y

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