Monopoly and Regulation

1. Monopoly and Regulation Filipe Janela Miguel Martins Sónia Romão Tiago Martinho Master of Engineering and Management of Technology – 9th Edition - Microeconomics

2. Definition of Monopoly • Monopoly Behaviour • Natural Monopolies • Characteristics • The Problem of Natural Monopoly • Regulation • Economic Theory of Regulation • Basic Problems and Effects • State ownership vs Privatisation and Regulation • Privatization, De-regulation and Barriers to Entry • Examples of Monopolies

3. Definition of Monopoly

4. Monopoly Definition • A single firm selling all the output in a market • It´s a model – it rarely exists in pure form • But many firms have some degree of monopoly power • Example: Can a cinema, in a local village, be considered as a monopoly according to these definition? Definitions Monopoly Behaviour Natural Monopoly Regulation Examples Depends on the alternatives. If the product (film) can be substituted for another one or not. If the local cinema has on exibition a good film and it´s the only one nearby, then a person, as long as interested, has only one place to go (Monopoly).

5. Causes of monopoly power • Control of resources (de Beers over diamonds) • Economies of scale (software) • Patent Protection (AZT, anti-AIDS Drug) • Government Protection Definitions What causes a single firm selling all the output in a market? Monopoly Behaviour Natural Monopoly Regulation Examples

6. Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

7. Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

8. Marginal revenue = B - C Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

9. Definitions Maximizing Profit Example Monopoly Behaviour Natural Monopoly Optimum where MR = MC Regulation Examples MR = MC = 12 Q* = 6, P* = 18 AC = 8 Profit = (18-8)6 = 60

10. Definitions Maximizing Profit Example Monopoly Behaviour Natural Monopoly Optimum where MR = MC Regulation Examples MR = MC = 12 Q* = 6, P* = 18 AC = 8 Profit = (18-8)6 = 60

11. Monopoly Behaviour Definitions • For the consumers… • The monopolist operates with prices greater than Marginal Costs  prices higher and output lower than in a competitive environment consumers typically be worse Monopoly Behaviour Natural Monopoly Regulation Consumers typically be worse Examples • For the firms… • In contrast, firms will be better under monopoly, as they can manipulate the price in order to increased profits • An economic arrangement is Pareto efficient if there is no way to make anyone better without making anyone worse, so Is the monopoly Pareto Efficient?

12. Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

13. Monopoly Behaviour Definitions Monopoly Behaviour • Since p > Marginal Costs  extra output could be sold at a price lower than the market price, but still higher than MC  each side gets better • The monopoly is not Pareto efficient because the monopolist cannot lower the price of the extra units without lowering the prices of all units Natural Monopoly Regulation Examples

14. Monopoly Behaviour Definitions Deadweight Loss of the Economy Monopoly Behaviour Natural Monopoly Measure how inefficient is a monopoly Variations of producers’ and consumers’ surpluses by imposing a perfect competition to a monopoly situation Regulation Examples

15. Monopoly Behaviour Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

16. Natural Monopolies

17. Natural Monopolies • DEFINITION A "natural monopoly" is defined in economics as an industry wherethe fixed cost of the capital goods is so high that it is not profitable for a second firm to enter and compete. There is a "natural" reason for this industry being a monopoly, namely that the economies of scale require one, rather than several, firms. Small-scale ownership would be less efficient. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

18. Natural Monopolies • The existence of natural monopolies is determined by theinteraction of twofactors: • Technology • Dimension of the market. SUNK COSTS • Any good whose provision demands a very high level of initial investment which cannotbe recovered will face what is called sunk costs. • Natural monopolies are typically utilities such as the distribution of electricity, gas orwater supplies, telecommunications services, rail and air transports.These activities demand a large initial investment in the establishment of a network serving all thepotential customers. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

19. Natural Monopolies SUNK COSTS Sunk Costs characteristics: • They cannot be recovered and demand regular maintenance activities that, to a certainpoint, are independent of the output (fixed costs); (when the network is workingbelow full capacity) • Once the network isset up, the additional cost of serving a new customer is very small when compared to the investment (sunk) cost. • The larger the number of consumers, thelower will be the average cost of production, since the amount of costs independentof the quantity produced (both sunk and fixed) is much larger than the marginal cost. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

20. Natural Monopolies Definitions • The most advantageous way to organise a market such as this(given the dimension of the demand) is the establishment of a monopoly, since the existenceof two or more competing firms would mean the building of many different networks, andwould multiply sunk costs • It would be very costly to build a second set of water and sewerage pipes in a city. Water and gas delivery service has a high fixed cost and a low variable cost. • Electricity is now being deregulated, so the generators of electric power can now compete. But the infrastructure, the wires that carry the electricity, usually remain a natural monopoly, and the various companies send their electricity through the same grid. Monopoly Behaviour Natural Monopoly Regulation Examples In these cases, we have a situation where the joint supply of several different products/services can be done at a lower cost than would be the case if these products were supplied separately. The concept of scale economies is then joined by that of economies of scope.

21. Natural Monopolies Even though monopoly is inefficient, forcing themonopolist to equate price to MC will sometimesdetermine negative profits. That happens whenever thedemand curve intersects the MC curve beneath the ACcurve. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

22. Regulation

23. Economic Regulation Theories of Regulation • Public Interest: responds to market failures; insure competitive conditions; • Capture Theory of Regulation: regulation in activities which do not seem to present any need for regulation and yet are subjective to extensive intervention; tend to substitute public interest for the private; • Economic Theory of Regulation: regulation is subject to economic laws of demand and supply. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

24. Economic Regulation Keep in mind: • Regulatory activities are costly, since they call for the supervision and monitoring of the firms’ internal activities (cost structures) and of the performance of the market; • Agency discretion should be limited, since the agency might act according to interests different then the society’s; • Positive economic theory, and not political convenience or ideology, should be the main basis of regulatory activity. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

25. Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: Concept:Rate Of Return (ROR) - regulation, a firm is allowed to earn no more than a “fair” rate of return on its capital investment, defined as the level of profits per unit of capital used. Analysis: i) ROR above the current cost of capital (the interest rate r) ii) ROR below the present cost of capital iii) ROR equal to the interest rate Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

26. Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: • The firm is allowed to earn no more than a “fair” rate of return on its capital investment • The regulated firm will choose a higher capital-labour ratio than it would without regulation, thus being internally inefficient • It is not certain that output will increase • If the regulator sets the maximum rate of return below the cost of capital, the firm will shut down • Under any type of rate of return regulation, the regulated firm will always over-utilise the rate base Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

27. Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

28. Regulation of Natural Monopoly: Basic Problems and Effects Regulation through the Rate of Return Capital: There is a logical explanation for this outcome: by imposing a constraint on the rate of return to capital, defined as the ratio between revenues minus non-capital costs and the level of capital used, the regulatory agency is providing an incentive for the firm to increase that level thereby keeping within the constraint with a minimum loss in terms of profits: K - the rate base – increases | profits before capital costs (P.Q - w.L) allowed within the constraint will be larger. Any reduction in the ROR will lead to further over-utilisation of capital. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

29. Regulation of Natural Monopoly: Basic Problems and Effects Other Regulatory Mechanisms Based on Returns: i) Regulation of the return on output: here the firm is constrained on the level of profit per unit of output sold. ii) Regulation through the rate of return on sales: the regulatory agency imposes a limit on the amount of profit per unit of revenue. iii) Return on cost regulation: the firm is allowed a certain amount of profit per each unit of cost. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

30. Regulation of Natural Monopoly: Basic Problems and Effects Price Cap Regulation: Characteristics: • the regulator sets a maximum price for the market, called the price cap; the firm can set a price equal or below this one, and is able to retain all profits; • the regulator might specify that the price cap will be adjusted over time by a preannounced adjustment factor that is exogenous to the firm - for instance some form of general price index RPI –X ; • at long intervals, the price cap is reviewed by the regulator and possibly changed, considering the profits, cost and demand conditions. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

31. Regulation of Natural Monopoly: Basic Problems and Effects Price Cap vs. Rate of Return Regulation Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

32. State ownership vs Privatisation and Regulation REASONS FOR STATE OWNERSHIP Definitions Monopoly Behaviour Natural Monopoly • Social ownership of strategic means of production should be ensured Regulation This only make sense in politically unstable societies • It facilitates the planning of key sectors of economy Examples All companies plan and planning is nor alternative, but complementary to the market system • It facilities income redistribution, making fundamental utilities and services available to all Leave the provision to the market and make the appropriate transfers through taxes and price controls

33. State ownership vs Privatisation and Regulation REASONS FOR STATE OWNERSHIP Definitions Monopoly Behaviour Natural Monopoly • Redistribution Issues – it may be easier to enforce the reduce of the prices charged to smaller users of electricity or gas directly through public provision than by finding appropriate specific forms of assistance Regulation Examples Public ownership allows for the practice of specific pricing policies - Cross-subsidies that, although not maximizing profit in the sense that they allow for profitable areas of clients to subsidise others.

34. State ownership vs Privatisation and Regulation REASONS FOR PRIVATISATION Definitions Monopoly Behaviour • Demands from the government an acceptance of the firm’s objective of profit maximization and a mind to pursue other objectives through regulation and in the case of public utilities, possibly also taxation and subsidisation Natural Monopoly Regulation • It increases the cost efficiency of firms, that is, the internal process of cost minimisation is better achieved Examples • Private firms are more efficient in terms of cost structure than public firms producing the same goods, even if they are under regulatory constrains and have similar technology The main cause of these differences is a change in management behaviour, resulting from the profit-maximizing pressure and from the management concern with the market value of the firm’s shares in the stock market.

35. State ownership vs Privatisation and Regulation Definitions The second best equilibrium – resulting from price regulation, for the private firm (P=AC) in point P is actually a better solution in terms of total welfare for the market than the first best equilibrium achieved by the state-owned firm in point S, with lower price and a higher output Monopoly Behaviour Natural Monopoly Regulation Examples

36. Privatization, De-regulation and Barriers to Entry Definitions Public Utility   providing one product or service telecommunications, gas or electricity distribution Monopoly Behaviour Natural Monopoly Game - theory Privatise but independently of any regulation, a new firm should be allowed to enter the market, in case it wants Regulation Examples Promote competition and lower prices in the market, benefiting the consumers Scale Economies

37. Efficient Pricing in Multi-product Natural Monopolies Definitions Multi-Product Single-Product Monopoly Behaviour Natural Monopoly • The cost structure of the firm will lead to a constrained social welfare optimum in which the price the consumers were willing to pay for the last unit consumed is still above the marginal cost of producing that unit (P=AC) • The design of prices involves balancing the welfare losses across product markets as prices deviate from marginal costs Regulation Examples • Price structure will be dependent both on the cost structure of the firm and on the different demand functions faced in each market Assume the firm is a natural monopoly Marginal Cost pricing is unsustainable Ramsey Prices

38. Efficient Pricing in Multi-product Natural Monopolies Definitions Monopoly Behaviour Natural Monopoly Cross-subsidisation↓ Policies in which profits in some markets will subsidise eventual losses made in others Welfare loss in market i – more rigid demand Regulation Welfare loss in market j – more elastic demand Examples

39. Structural Efficiency, Competition and Vertical Economies  Definitions  Economies of Scope Providing a variety of products or services using the same network (Telecommunications) Joint production is done at a lower average cost than when done separately Monopoly Behaviour Natural Monopoly On the other hand… Regulation  Growth in demand for several services Range across which average costs are decreasing for an industry does not anymore cover all the dimension of the market Examples HORIZONTAL BREAK-UP These two circumstances have led to situations in which the regulatory agencies have chosen to break-up natural monopolies in terms of market dimension

40. Structural Efficiency, Competition and Vertical Economies Example of generation and distribution of electricity… Definitions • Economies of scale in generation are more limited than in distribution VERTICAL BREAK-UP Monopoly Behaviour • Unlike distributors, it is possible for generation to store energy and inputs Natural Monopoly • Distribution has been broken up into regional networks, thus creating a market for generators Regulation On the other hand… Examples • Uncertainty associated with equipment failures in input process and demand • exhaustion of scale economies in generation might not be enough to guarantee a truly competitive • Incentives for large investments hindered by opportunities behaviour • A firm joining different stages in the vertical chain will have a wider technological knowledge

41. Examples of Monopolies

42. Examples of Monopolies Salt Until common salt (sodium chloride) was mined in quantity in comparatively recent times, its availability was subject to the vagaries of climate and environment. A combination of strong sunshine and low humidity or an extension of peat marshes was necessary for winning salt from the sea - the most plentiful source - by solar evaporation or boiling. Mines and inland salt springs being scarce and often located in hostile areas like the Dead Sea or the salt mines in the Sahara desert, they required well-organised security for transport, storage and highly monopolised distribution. Changing sea levels flooded many of these sources during certain periods and caused salt “famines” and communities were left to the mercy of those who monopolised these few inland sources. The “Gabelle", a notoriously high tax levied upon salt, played a role in the start of the French Revolution and is possibly the most cruel example in recent history. Anyone was allowed to purchase salt; however, strict legal controls were in place over who was allowed to sell and distribute salt. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

43. Examples of Monopolies Definitions AT&T For many years, AT&T had been permitted to retain its monopoly status under the assumption that it was a natural monopoly. The rise of cheap microwave communications equipment in the 1970s opened a window of opportunity for competitors--no longer was the acquisition of expensive rights-of-way necessary for the construction of a long-distance telephone network. In light of this, the FCC permitted MCI (Microwave Communications, Inc) to sell communication services to large-businesses. This technical-economic argument against the necessity of AT&T's monopoly position would hold for a mere fifteen years until the beginning of the fiber-optics revolution sounded the end of microwave-based long distance. Monopoly Behaviour Natural Monopoly Regulation Examples

44. Examples of Monopolies Standard Oil By 1890, Standard Oil controlled 88% of the refined oil flows in the United States. Gradually, its market share fell to 64% by 1911. Standard's oil production as a percentage of total market supply fell to 11 percent by 1911, down from 34 percent in 1898. By 1911, it was in competition with Associated Oil and Gas, Texaco, Gulf Oil, and 147 independent refineries. (DiLorenzo, Thomas The ghost of John D. Rockefeller) Nevertheless, it was claimed by many to be a monopoly. As the public became more aware of the Standard Oil trust in allowing its oil companies in different states to be headed by the same board of directors, there was more public support in calling for its dissolution. Eventually, the company was broken up after the United States Supreme Court declared the trust to be an "unreasonable" monopoly under the Sherman Antitrust Act. Thus, on May 15, 1911, though Standard Oil's share of the market had been steadily declining from 1900 to 1910 (Standard's share of oil refining was 64% at the time of the trial and in competition with over 100 other refiners), the Supreme Court of the United States ordered the dissolution of Standard Oil Company into 34 smaller companies, each with their own board of directors. John D. Rockefeller in 1897 had completely retired from the Standard Oil Company of New Jersey, though he continued to own a large fraction of its shares. The notion that Standard was a monopoly is rejected by some economists. And, no one claims that they harmed consumers but rather the reverse --that their aggressively competitive practices drastically lowered prices. Definitions Monopoly Behaviour Natural Monopoly Regulation Examples

45. Bibliography http://www.egwald.com/economics/econpage.php3 http://in3.dem.ist.utl.pt/master/05micro/ http://in3.dem.ist.utl.pt/master/04micro/lecture6.pdf http://in3.dem.ist.utl.pt/master/03micro/lecture_notes_4.pdf http://in3.dem.ist.utl.pt/master/02micro/lecture6.pdf José Mata, Economia da Empresa, Fundação Calouste Gulbenkian, Lisboa, 2000