Price Regulation of Natural Monopolies

1
Price Regulation of Natural Monopolies
2
Natural Monopoly
Price/unit
Industry characterized by declining ATC
0
Output/hr ??/??
3
Recall relationship between MC and ATC
Price/unit
3.50
3.00
2.50

2.00

1.50
1.00
MC and AC intersect at ATC minimum
0.50
0.00
0
2
4
6
8
10
12
Output/hr
4
The Problem of Setting Regulated Prices for a
Natural Monopoly
Price/unit
Problem Competitive-based pricing (PMC) does
not allow adequate cost recovery (lt AC).
Demand
AC
Pc
MC
Output/hr
0
Qc
5
Setting Regulated Prices for a Natural Monopoly
Price/unit
Solution 1 PR AC(Q) Quantity sold QR
Demand
AC
PR
MC
Pc
Output/hr
0
QR
Qc
6
Problem with setting P AC

• Loss of price signal to consumers
  
• Increases need for (expensive) peak capacity
• Increases costs and prices
  

7
Setting Regulated Prices for a Natural Monopoly
Solution 2 Two-part tariff Usage charge PR
MC Fixed charge AC (Qc)-MC (Qc) Qc
Price/unit
Demand
AC
AC (QR)
FIXED CHARGE ????
PR
MC
Output/hr
QR Qc
0
8
Cost-Based Regulated Price for Natural Monopoly
Regulated price Fixed costs (amortization in
current year)
Operating costs
return on equity and debt capital
9
Problems with Cost-Based Regulated Pricing
Setting regulated price fixed costs operating
costs return on capital invested

• Inadequate incentives for efficiency
• Need for significant regulatory supervision
• Tendency for gold-plating

10
Price Cap Alternative to Cost-Based Regulated
Prices
Revenues in base year Rb costs in base
year Revenues in following year Rb (1
Ab) Revenues in year t Rt Rt-1 (1 At) t
2,.n At adjustment in firms prices based on
inflation and technological change OR average
cost increase for sample of comparable firms. If
firms increase in costs in year t lt At ? the
firm gets to keep the difference ? incentive to
be cost efficient However, firm must be subject
to quality standards. Otherwise it can cut
costs and reduce quality.
11
Strategic Positioning

• Prefer cost-based or price cap regulation?

Risk
Reward
Corporate Mentality
Strategic Outlook