Monopoly Market Power and Market Failures PDF

Prof.
Carlo Cambini
carlo.cambini@polito.it
Monopoly, Market Power
and Market Failures
2
Review of Perfect Competition
Large number of buyers and sellers
Homogenous product
Perfect information
Firm is a price taker
Solution
P = (L)MC = (LR)AC
Normal profits or zero economic profits in the
long run
3
Review of Perfect Competition
4
Microeconomics: a review
5
Individual demand: consumer
behavior
Under the local nonsatiation assumption, the optimal
consumer demanded bundle of goods (i = 1, .., n) is given by
the following problem:
where p is the vector of market prices and m the income level
of the consumer.
v(p, m) is the maximum utility achievable at given prices and
income and is called indirect utility function. The optimal x(p,
m) is therefore the consumers demand function.
m px t s
x u m p v
x
=
=
. .
) (
max
) , (
6
behavior
The Lagrangian for the Utility maximization problem
can be written as:
The FOC is given by:
And it can be re-elaborated as:
) ( ) ( m px x u L =
n i p
x
x u
i
i
,... 1 for 0
) (
= =
n j i
p
p
x
x u
x
x u
j
i
j
i
,... 1 , for
*) (
*) (
= =
|
|
\
|
|
|
\
|
7
behavior
The indirect utility, i.e. the maximum utility as
a function of p and m has the following
properties:
It is non increasing in p, that is if p p, then
v(p, m) v(p, m). Similarly, v(.,.) is non
decreasing in m.
It is continuous and quasi-convex
8
The quasi-linear utility function
Partial equilibrium analysis: analyse the market
functioning of a good that has a relatively low weight
on the global economy.
Hence, we can introduce two simplifying assumptions:
1. the impact of a change in consumers income on the
expenditure of the good is limited (no income effect);
2. the substitution effect on the other goods is small too.
The prices of the rest of goods can then be considered
as fixed and we can be assume them as a numeraire,
normalised to 1.
We can then simplify our utility function in the following
way (y
i
is the rest of goods, i.e. the numeraire):
y x u y x U + = ) ( ) , (
9
The quasi-linear utility function
u(x
i
) is a continuous, increasing, twice-differentiable,
and convex function.
The optimization problem becomes:
FOCs:
This leads to the following optimal condition:
m y px t s
y x u y x U
= +
+ =
. .
) ( ) , (
0 1
0
) (
= =
y
L
p
x
x u
x
L
p x u
x
x u
=
) (
) (
10
Surplus: a review
Consumer surplus is the total benefit
or value that consumers receive beyond
what they pay for the good
Producer surplus is the total benefit or
revenue that producers receive beyond
what it costs to produce a good
11
Consumer and Producer
Surplus
Between 0 and Q
0
producers receive
a net gain from
selling each product--
producer surplus.
Consumer
Surplus
Quantity
Price
S
D
Q
0
5
9
Between 0 and Q
0
consumer A receives
a net gain from buying
the product--
consumer surplus.
Producer
Surplus
3
Q
D
Q
S
12
Marginal effects of a price/quantity
changes on Consumer Surplus
Consumer surplus, as a function of price, is given by:
Hence, it results:
Intutition: the demand has a negative slope, the minus
is needed in order to have a positve quantity
= =
*
) ( ) (
p
dp p q p V CS
) (
) (
p q
dp
p dV
=
13
Marginal effects of a price/quantity
changes on Consumer Surplus
Consumer surplus, as a function of quantity,
is given by:
Hence, it results:
=
=
*
0
) ( where
) ( ) (
q
dq q p S(q)
q q p q S CS
) (
) (
q p
dq
q dS
=
14
Perfect competition and Welfare
15
Welfare economics
What are the welfare properties of the perfect
competitive equalibrium?
The representative consumer approach: suppose
that the market demand, x(p), is generated by
maximizing the utility of a single representative
consumer who has a quasi linear utility function u(x)+y,
where x is the good under examination and y
everything else.
Under this utility function, we know that:
Hence, the direct demand function x(p) is simply the
inverse of the above condition
Note that in case of a quasi-linear utility the demand
function is independent of income!!
p x u =
) (
16
Welfare economics
Consider now a representative firm having a cost
function c(x), with c > 0, c > 0 and c(0) = 0.
In a perfect competitive market, the profit maximizing
(inverse) supply function of a representative firm is
given by p = c(x).
In equilibrium demand = supply
Hence, the equilibrium level of output of the x-good is
simply the solution to the equation:
This is the level of output at which the marginal
willingness to pay for the x-good just equals its marginal
cost of production.
) ( ) ( x c x u

=
17
Welfare analysis
What is the optimal amount of output that maximizes the
representative consumers utility?
Let w be the consumers initial endowment of the y-good. The
consumers problem is:
Intuition: the welfare maximizing problem is simply to maximize
total utility consuming x-good and y-goods. Since x units of the x-
good means giving up in a competitive market - c(x) units of the
y-good, our social objective function becomes:
The Foc is given by (as before):
The competitive market results in exactly the same level of
production and consumption as does maximizing utility directly.
) ( . .
) ( max
,
x c w y t s
y x u
y x
=
+
) ( ) ( max
,
x c w x u
y x
+
) ( ) ( x c x u

=
18
Welfare analysis
Another way to look at the same problem.
Let CS(x) = u(x) - px be the consumers surplus and PS(x)
= px c(x) be the producers surplus.
The total surplus, or welfare, is:
We can conclude saying that the competitive equilibrium
level of output maximizes total surplus!
[ ]
) ( ) (
) ( ) (
) ( ) ( max
x c x u
x c px px x u
x PS x CS W
x
=
= + =
= + =
19
Welfare analysis: a generalization
Suppose there are i = 1,, n consumers and j = 1,,m
firms. Each consumer has a quasi-linear utility function
u
i
(x
i
)+y
i
and each (perfectly competitive) firm has a cost
function c
j
(x
j
).
An allocation describes how much each consumer
consumers of x-good and the y-good, (x
i
, y
i
), i = 1,, n,
and how much the firm produces of the x-good, z
j
, j =
1,,m .
The initial endowment of each consumer is taken to be
some given amount of the y-good and 0 of the x-good.
The sum of utilities is given by:

= =
+
n
i
n
i
i i i
y x u
1 1
) (
20
The total amount of the y-good is the sum of
initial endowments, minus the amount used up
in production:
Observing that the total amount of the x-good
produced must equal the total amount
consumed, we have

= = =
=
m
j
j j
n
i
i
n
i
i
z c w y
1 1 1
) (

= =
= = =
=
+
m
j
j
n
i
i
m
j
j j
n
i
i
n
i
i i
z x
z x t s
z c w x u
j i
1 1
1 1 1
,
. .
) ( ) ( max
21
Let the Lagrangian multiplier on the
constraint, we have
where p* = since the market is perfectly
competitive!
Hence, market equilibrium necessarily
maximizes welfare for a given pattern of initial
endowments (w
i
).
=
=
) ( '
) ( '
j j
i i
z c
x u
22
Consumer Equilibrium in a
Competitive Market
First Theorem of Welfare Economics
If everyone trades in a competitive
marketplace, all mutually beneficial trades
will be completed and the resulting
equilibrium allocation of resources will be
economically efficient
Welfare economics involves the normative
evaluation of markets and economic policy
23
Competitive Market
Pareto Optimality
An outcome is Pareto optimal if it is not possible
to make one person better off without making
one another worse off
If this is possibile, we face a potential Pareto
improvement (PPI)
The adoption of the PPI criterion means that we
can focus on what happens to total surplus.
Hence an outcome that maximizes total surplus
is Pareto optimal.
24
Competitive Market
Difficult for efficient allocation with many
consumers and producers unless all
markets are perfectly competitive
Efficient outcomes can also be achieved
by centralized system
Competitive outcome preferred since
consumers and producers can better
assess their preferences and supplies
25
Equity and Efficiency
Although there are many efficient
allocations, some may be more fair than
others
The difficult question is, what is the most
equitable allocation?
We can show that there is no reason to
believe that efficient allocation from
competitive markets will give an equitable
allocation
26
Equity and Perfect Competition
Must a society that wants to be more
equitable necessarily operate in an
inefficient world?
Second Theorem of Welfare Economics
If individual preferences are convex, then
every efficient allocation is a competitive
equilibrium for some initial allocation of
goods
27
Equity and Perfect Competition
Any equilibrium that is equitable can be
achieved by redistributing resources and
may be efficient
Typical ways to redistribute goods,
however, are costly
Taxes lead to bad incentives
Firms devote fewer resources to production in
order to avoid taxes
Encourage individuals to work less
28
Market Failures
29
Why Markets Fail
Market Power
Those with market power choose the price
and quantity
Less output is sold than in competitive
markets
Inefficiency
Can have market power as producers or as
inputs
30
Why Markets Fail
Externalities
Market prices do not always reflect the
activities of either producers or consumers
Consumption or production has indirect
effect on other consumption or production
not reflected in market prices
May be impossible to get insurance because
suppliers of insurance lack information
31
Why Markets Fail
Public Goods
Nonexclusive, nonrival goods that can be
made available cheaply but which, once
available, are difficult to prevent others from
consuming
Company thinking about researching a new
technology if cant get patent
Once its made pubic, others can duplicate it
32
Why Markets Fail
Incomplete Information
Consumers must have accurate information
about market prices or production quality for
markets to operate efficiently
Lack of information can change supply
Buy products with no value
Dont buy enough of products with value
Some markets may never develop
33
Market Failures
Economic motivations
Existence of market power (monopoly, natural
monopoly, collusive oligopoly)
Externality (positive or negative)
Market incompleteness (asymmetric information)
Social motivations:
Redistributive concerns (urban to rural areas; rich to
poor citizens)
Merit goods (essential services should be provided to
everybody at affordable prices)
need of State policy in the form of ex ante
(regulation) or ex post (antitrust) interventions
34
Monopoly
Monopoly
1. One seller - many buyers
2. One product (no good substitutes)
3. Barriers to entry
4. Price Maker
35
Monopolists Output Decision
1. Profits maximized at the output level
where MR = MC
2. Cost functions are the same
MR MC or
MR MC Q C Q R Q
Q C Q R Q
=
= = =
=
0 / / /
) ( ) ( ) (
36
Lost
profit
P
1
Q
1
Lost
profit
MC
AC
Quantity
$ per
unit of
output
D = AR
MR
P*
Q*
P
2
Q
2
37
1. Profits maximized at the output level
where MR = MC
2. Cost functions are the same
|
|
\
|
+ =
|
|
\
|
\
|
+ =
+ =
D
E
P P MR
Q
P
P
Q
P P
Q
P
Q P MR
1
38
Equilibrium Pricing

1
1
MC MR where maximized is
D
D
E P
MC P
MC
E
P P
=
=
(
+
=
Elasticity of Demand and Price
Markup
P*
MR
D
$/Q
Quantity
MC
Q*
P*-MC
The more elastic is
demand, the less the
markup.
D
MR
$/Q
Quantity
MC
Q*
P*
P*-MC
40
Measuring Monopoly Power
Could measure monopoly power by the extent
to which price is greater than MC for each firm
Lerners Index of Monopoly Power
L = (P - MC)/P
The larger the value of L (between 0 and 1)
the greater the monopoly power
L is expressed in terms of E
d
L = (P - MC)/P = 1/E
d
E
d
is elasticity of demand for a firm, not the
market
41
Monopoly Power
Pure monopoly is rare
However, a market with several firms,
each facing a downward sloping demand
curve, will produce so that price exceeds
marginal cost
Firms often product similar goods that
have some differences, thereby
differentiating themselves from other
firms
42
Sources of Monopoly Power
Why do some firms have considerable
monopoly power, and others have little or
none?
Monopoly power is determined by ability
to set price higher than marginal cost
A firms monopoly power, therefore, is
determined by the firms elasticity of
demand
43
Sources of Monopoly Power
The less elastic the demand curve, the
more monopoly power a firm has
The firms elasticity of demand is
determined by:
1) Elasticity of market demand
2) Number of firms in market: entry
barriers and entry deterrence
3) Strategic behaviour by incumbent
4) New Technology
44
Elasticity of Market Demand
With one firm, their demand curve is market
demand curve
Degree of monopoly power is determined completely
by elasticity of market demand (ex. OPEC)
The presence of alternative suppliers or substitute
products reduces market power (supply and demand
side substitution)
With more firms, individual demand may differ
from market demand
Demand for a firms product is more elastic than the
market elasticity
45
Demand elasticity in telecoms under
a Monopoly: evidence from Italy
Dependent Variable Price Income
SIP (1988) National calls 0,12 0,5-0,9
Cappuccio
(1990)
Revenues from calls (annual
base 1973)
0,11 0,52
Gambardella
(1991)
Revenues from calls (annual
base 1964)
0,35 0,25
Ravazzi (1991) Membership 0,1 0,3
Mosconi (1994)
e Colombino
(1998)
Urban calls
National calls
International calls
0,19
0,25
0,52

46
Demand elasticity in telecoms under
Monopoly: evidence from US

Bodnar et al. (1988)

Taylor e Kridel (1990)

Dimension
(000
Price
Elasticity

Economic Position

Price
Elasticity
of inhabitants)
> 500 0,007 Poor and rural 0,071
100 500 0,006 Poor and urban 0,077
30 100 0,010 Poor black rural 0,089
< 30 0,013 Rich white urban 0,026
Rurale 0,014 State Price Income
Age Elasticity Elasticity
< 26 0,024 Arkansas 0,059
26 44 0,009 Kansas 0,023
45 64 0,007 Missouri 0,031
> 64 0,008 Oklahoma 0,034
Income
($ 000)
Texas 0,037
< 12 0,026 Average 0,037 0,042
12 20 0,012
20 28 0,006
28 38 0,002
> 38 0,0005

47
Number of Firms
The monopoly power of a firm falls as the
number of firms increases; all else equal
More important are the number of firms with
significant market share
Market is highly concentrated if only a few
firms account for most of the sales
Firms would like to create barriers to
entry to keep new firms out of market
Patent, copyrights, licenses, economies of
scale
48
Number of Firms
Entry barriers are of interest from two perspectives: (i)
corporate strategy and (ii) public policy.
Incumbents want to protect not only their market shares
but also their profits
A key objective of corporate strategy is profitable entry
deterrence.
Profitable entry deterrence occurs when incumbent firms
are able to earn monopoly profits without attracting entry
Profitable entry deterrence depends on the interaction
between structural entry barriers and incumbents
behaviour
Public policy should aim at eliminating entry barriers and
detect entry deterrence
49
Government Restrictions on Entry
Governments create entry barriers when
they grant exclusive rights to produce to
incumbent preventing additional entry
Forms of exclusive franchises:
Natural Monopoly;
Source of revenues (from State owned
companies);
Redistribute rents among citizens;
Intellectual Property Rights (IPRs)
50
Structural Barriers to Entry
Structural characteristics that protect market
power without attracting entry, such as:
Economies of scale
Sunk expenditures of the entrant
Absolute cost advantage: incumbent may face lower
costs or a better access to existing facilities (i.e. the
use of the network in the telecoms industry)
Sunk expenditures by consumers and product
differentiation:
If a consumer faces a large cost for switching to a
new product, he could decide not to switch
switching costs and creation of brand loyalty.
Finally, consumer might not view the offerings of
other firms as substitute.
51
Strategic behavior by Incumbents
Incumbents may behave in order to enhance
barriers to entry to rivals.
Potential strategies:
Aggressive postentry behavior: commit to be
aggressive; ex. Investment in sunk capacity
Raising rivals cost: raising cost of a potential entry or
reducing the profitability of entry
Reducing rivals revenues: again reduce the
profitability of entry increasing the consumers
switching costs and so the market demand for the
entrant
52
New Technology
Technological change can generate new
products and services, and the
introduction of these products reduces
the market power of producers of
established products.
Nintendo in 80 was a monopolist, but the
monopoly ended after the entry by Sega
and later on by Sony (Playstation) and
Microsoft (X Box)
53
The Social Costs of Monopoly
Power
Monopoly power results in higher prices
and lower quantities
However, does monopoly power make
consumers and producers in the
aggregate better or worse off?
From a social point of view, the effects of
the monopolistic inefficiency can be
appreciated if we look at the Marshalls
surplus
54
Monopoly Dead Weight Loss
55
Monopoly Dead Weight Loss
The DWL area measures the surplus that could
have been created with a competitive market,
but goes loss due to level of the price which is
fixed by the monopolist
The deadweight loss decreases with E
D
when
the elasticity is large, but it vanishes when the
demand is perfectly rigid, because in this case
moving prices simply correspond to a surplus
transfer between firms and consumers
56
The determinants of Deadweight
loss
Assume constant marginal cost. The
deadweight loss associated with a monopoly
pricing is approximately equal to:
DWL = 1/2dPdQ
It can rewritten as:
|
\
|
|
|
\
|
|
\
|
|
\
|
=
P
P
Q
Q
P
P
dP
dP
dPdQ DWL
2
1
57
loss
Since marginal cost is constant, dP = P
m
-c, it results
Harbergers loss: the inefficiency of a monopoly is
greater the larger the elasticity of demand, the larger
the Lerner Index and the larger the industry
(measured by industry revenues) however L is
inversely related to E
d
2
2
1
L Q P E DWL
m m
d
=
58
loss
Since for a monopolisitc firm L = 1/E
d
Loss in the US long distance telecoms
market: entrants of RBOC into the long
distance market (mid 1990s) decreases the
welfare loss by $2.78 billion
2 2
1
2
1
2

=
|
|
\
|

= =
m
m
m m m m
d
P
c P
Q P L Q P E DWL
59
Durable Goods Monopoly
A durable good is a good which provides
a stream of sustained consumption
services: it can be used more than once.
Two complicating factors:
Monopoly creates its own competition! The
existence of a second-hand market limits
monopoly market power
The price consumers are willing to pay today
depends on the expectations about the price
of the good tomorrow
60
Durable Goods Monopoly
Assume that the good last forever and so
that it does not depreciate over time.
Example: land
Competitive supply: the supply curve is
fixed; supply and demand determine the
equilibrium price for a lifetime
consumption. Alternatively, the price can
be transformed in a yearly rental price.
61
Durable good in perfect competition
62
Durable good in monopoly
The monopolist sets the marginal revenues
equal to the marginal cost (= 0) and determine
the first year consumption and price (Q
1
and P
1
)
In the second period, the monopolist faces a
residual demand given by Q
c
Q
1
where
consumers have a willingness to pay larger than
marginal costs but lower than P
1
.
In order to sell additional units of the good and
use its stock, the monopolists cannot do better
than reducing the price up to the competitive
price!
63
Durable good in monopoly
64
Durable goods: the Coase
conjecture
The monopolist has therefore the
incentive to practice intertemporal price
discrimination: it increases its profit
decreasing prices over time.
Initially, monopolist only supplies those
consumers having a high willingness to
pay.
Then, the monopolist increases its profit
by moving down the demand curve
65
Durable goods and strategic actions
Strategic consumers:
Incentives to delay purchasing if they anticipate that the
monopolist will lower prices in the future
Cost of waiting depends on the discount rate, i.e. on the
actual cost of consumption tomorrow: the larger it is, the
greater the preference of consumers for a dollar today as
opposed to a dollar tomorrow.
Assume that the adjusting period is very small and the
discount rate equal to 0 (the discount factor is equal to 1):
a durable goods monopolist has no monopoly power if
the time between price adjustment is vanishingly small
the Coase Conjecture
66
Durable goods and strategic actions
Strategies to mitigate the Coase Conjecture:
Firms might convince consumers that prices do
not decrese over time though
Leasing, since the good is returned to the firm
Investment in reputation not to increase supply (ex
Disney movies)
Limit capacity
New customers, i.e. expected increase in the demand
Planned obsolescence, decreasing the durability of its
good, and so enhacing the demand tomorrow keeping
the price high!
67
Durable goods and Pacman
economics
Is it true that the monopoly always loose its
market power? No, it is the contrary, monopoly
comes perfect since the firm can now extract all
surplus from consumers!
Monopolistic firm only needs to move down the
demand selling to consumers sequentially in
order of their reservation prices : this is the
Pacman Strategy
This results is more likely when the number of
buyer is finite and the willigness to pay of
consumers highly differs.
68
Durable goods: Coase vs. Pacman
Study by Von der Fehr and Kuhn (1996):
When the number of buyers is very large and
there are small differences in willingness to
pay, then Coase outcome is more likely
when the number of buyer is finite and the
willigness to pay of consumers highly differs,
Pacman discriminatory outcome emerges.
69
Natural Monopoly and
Government Intervention
70
Social cost of monopoly is likely to exceed the
deadweight loss
No allocative efficiency, no incentive to minimize cost
X-inefficiency
Hickss statement: The best of all monopoly profit is a
quite life!!
Rent Seeking
Firms may spend to gain monopoly power
Lobbying
Advertising
Building excess capacity
Dynamic efficiency? Shumpeter vs. Arrow approach on
the effect of the market structure on investment
71
Government can regulate monopoly
power through price regulation
Recall that in competitive markets, price
regulation creates a deadweight loss
Price regulation can eliminate deadweight
loss with a monopoly
72
Regulation vs. Competition policy
CP attempts to avoid situation where market power
can be exploited; regulation deals with the
situation.
Prices/profits/quality are not usually explicitly
controlled with CP
Regulation specifies precise details of what firm
can and cannot do (ex ante intervention); CP
issues guidelines and uses precedent (ex post
intervention)
Typically have sector-specific regulators, and a
generalist competition policy authority
73
AR
MR
MC
P
m
Q
m
AC
P
1
Q
1
Marginal revenue curve
when price is regulated
to be no higher that P
1
.
If left alone, a monopolist
produces Q
m
and charges P
m
.
For output levels above Q
1
,
the original average and
marginal revenue curves apply.
If price is lowered to P
C
output
increases to its maximum Q
C
and
there is no deadweight loss.
Price Regulation
$/Q
Quantity
P
2
= P
C
Q
c
Any price below P
4
results
in the firm incurring a loss.
P
4
74
Power
Natural Monopoly
A firm that can produce the entire output of
an industry at a cost lower than what it would
be if there were several firms
Usually arises when there are large
economies of scale
We can show that splitting the market into
two firms results in higher AC for each firm
than when only one firm was producing
75
MC
AC
AR
MR
$/Q
Quantity
Setting the price at P
r
giving profits as large as
possible without going
out of business
Q
r
P
r
P
C
Q
C
If the price were regulate to be P
c
,
the firm would lose money
and go out of business. Cant
cover average costs
P
m
Q
m
Unregulated, the monopolist
would produce Q
m
and
charge P
m
.
Regulating the Price of a Natural
Monopoly
76
Some definitions on Natural Monopoly
Single product contest: presence of
economy of scale, i.e. ATC should be
always decreasing
Is this definition sufficient also in a
multiproduct setting? NOT AT ALL!!
In a multiproduct setting, given a vector of
quantities i = 1,.., n, the cost function C(.)
should be sub additive, i.e.
77
Some definitions on Natural Monopoly
Sufficient conditions to have a natural
monopoly in a multiproduct setting are:
Presence of economies of scope:
C(q
1
,0) + C(0,q
2
) > C(q
1
,q
2
)
Average incremental costs should be decreasing
(Baumol, Panzar and Willig, 1982)
where IC
1
(q
1
,q
2
)= C(q
1
,q
2
) - C(0,q
2
)
C(0,q
2
) is the so called stand alone cost of product 2
AIC = IC
1
(q
1
,q
2
)/q
1
78
Questions that need to be addressed:
Whether (and how) to privatise?
Whether to break up monopoly (or allow
mergers)? Structural regulation (vertical or
horizontal separation)
Which parts of the industry to regulate?
79
Example: Telecommunications

Local telephony
Long distance
telephony
International
telephony
Internet
Mobile telephony
Natural
monopoly
80
Example: Electricity market

Production and Import
National Transmission
(high voltage)
Local transmission (low
voltage
Final market
Natural
Monopolies
81
Example: Gas industry

Production and Import
National transmission
Local transmission
Retail market
Natural
monopolies
Reserve in stock
82
Structural Regulation: the US example
82
83
But then mergers among Baby Bells
83
84
The current situation
84
85
Conduct regulation: price control
First best pricing: price equal to marginal
cost (as in a perfect competitive
environment)
Public transfer to cover firms loss
P
Q
P
AC
P
Cm
Q
Cm
D
AC
C
Q
AC
m
86
Demo: consumers have a quasi-linear utility
function U
h
= R
h
+ S
h
(p), such that
U
h
/p = S
h
(p)/ p (no revenue
effect)
In a monoproduct setting:
Max
p
W= S(p) T +
where = pq(p) + T - C(q) F
Thus, W= S(p) + pq(p) - C(q) F
Deriving w.r.t. p, we get: p = C(q)
87
In absence of any kind of transfer from
regulator to the firm, what could happen?
The regulator should set prices in order to
let the firm reach its break even
Second best solution: price = AC
The average cost pricing rule
88
Firms profit are zero, but there is always a
deadweigh loss (squared area in figure)
q
D
MC
AC
$
q
AC
p
AC
89
Multiproduct setting: practical methods, fully
distributed costs (FDC)
Suppose to have a cost function:
Price equal marginal cost leads to losses.
How to cover them?
A rule to share the fixed cost F should be
defined by the regulator.
90
Fully distributed costs (FDC): price should
cover not only direct (marginal) cost, but also
a share of the fixed costs, i.e.
where f
i
is the so called cost driver:
=
=
=
=
Method) Cost able (Attribuit if ) (
Method) Output (Relative if ) (
Method) Revenues (Gross if ) (
1
1
1
n
i
i i
n
i
i i
n
i
i i
i
CD CD c
Q Q b
R R a
f
91
Conduct regulation: price control/6
It is easy to show that all the three methods
above described leads to define a equal
mark up rule.
In fact:
Is this efficient?
92
The answer is NO!
A+B = Extra-revenues to cover fixed cost
C+D = deadweight loss!!
q q
MC MC
D
R
D
E
p
p
A B C D A B
93
How to minimize deadweight loss?
Mark up on prices should be different according to
the different demand structure of the goods:
Even if A+B = A + B, C+D< C+D
q q
MC MC
D
R
D
E
p
E
p
R
B
D
A
C
B
94
Immagine that no public transfer could be used and
ij
= 0
Regulator should set prices such that:
Max
pi
S(p
i
) + s.t. 0
Denoting with the lagrangian multiplier of the
constraint we have:
L = S(p
i
) + (1+ ) = S(p
i
) + (1+ )(p
i
q
i
C(q
i
))
What is ? It can be interpreted as the shadow price of
public funds.
95
Optimal second best solutions: Ramsey-
Boiteaux Pricing rule
i.e. the price-cost margin (in percentage of
price) should be inversely related to the
price elasticity of demand:
i i
i i
i
p
c p
L

1
1+
=
=
i
i
i
i
i
q
p
p
q
=
96
Cross subsidization
In many Utilities, the price in some services
are set lower than their marginal cost mainly
for distributional concerns.
Example: in Telecoms, USO implies that
price for urban calls and the fixee fee have
been set for long time below marginal cost,
while long distance calls (national and
international) have been set above costs in
order to recoup the losses on other services.
97
Cross subsidization
Problem: cross subsitization could be
strategically used by the incumbent
operator in order to prevent entry in the
market or to induce exit of new entrants.
Potential anticompetitive behaviour:
incumbent could set price above cost in the
monopolistic segment of the market (i.e.
Local telephony), in order to reduce its price
in the more competitive ones (Long
distance or Internet)
98
Cross subsidization
How to avoid or detect cross subsidization?
Faulhabers Test (1975).Two services (p
1
and p
2
).
I^ test on incremental cost:
p
1
q
1
IC
1
(q
1
,q
2
)= C(q
1
,q
2
) - C(0,q
2
)
p
2
q
2
IC
2
(q
1
,q
2
)= C(q
1
,q
2
) - C(q
1
,0)
99
Cross subsidization
II^ test on incremental cost:
p
1
q
1
C(q
1
,0)
p
2
q
2
C(0,q
2
)
If the two tests have success, then retail tariffs are
subsidy free. Otherwise, Incumbent could have set
its tariffs anticompetitively, and so more scrutiny is
needed (from Competition or Regulatory Authority)

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