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This document, presented at the ACCC Annual Regulatory Conference in 2008 by Darryl Biggar, challenges the conventional economic rationale for monopoly regulation and proposes an alternative explanation based on protecting the investment in sunk complementary assets on the part of users and consumers of the monopoly service. the limitations of the deadweight loss hypothesis and the role of regulation in ensuring stable prices and preventing adverse movements in prices.
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Slide 218 July 2008
The conventional economic rationale for why we regulate naturalmonopolies is inadequate.^ –
Many policy prescriptions which are soundly based in conventionaleconomic theory are routinely rejected by regulators in practice.
-^
Is this because regulators are economically illiterate? Or that they are notseeking to maximise economic welfare? Or is it that the conventionaleconomic approach to monopoly somehow misses the key point?
I propose an alternative explanation as to how natural monopolyregulation promotes economic welfare.^ –
This alternative explanation is based on protecting the investment in sunkcomplementary assets on the part of users and consumers of the monopolyservice.
-^
In my view this alternative does a better job of explaining how regulatorsactually behave in practice (and how they should behave).
-^
-^
developing countries)
more worthwhile in larger markets
regulation
Simon Cowan Presentation ACCC Regulatory Conference July 2007
© Covec Ltd 2007
July 2007
www.covec.co.nz
5
Economic motivation:•^
improve allocative efficiency
This creates extra welfare•^
because there is more trade, inthis market
But, there are offsetting costs•^
Direct costs of regulation•^
Mostly fixed, so scale matters
-^
Indirect costs•^
May deter efficient investment
P
M PC
Demand^ Q
M^
Q
C WelfareGain
John Small Presentation ACCC Regulatory Conference July 2007
marginal cost pricing
Bonbright (1988): “While most people in the public utility community are aware of and^ Bonbright (1988): “While most people in the public utility community are aware of andwould probably acknowledge the validity of marginal cost pricing many would minimizewould probably acknowledge the validity of marginal cost pricing many would minimizeit in actual ratemaking on grounds of either practicality or of a lack of singlemindedness toit in actual ratemaking on grounds of either practicality or of a lack of singlemindedness toeconomic efficiency … It is no secret that ratemaking in the United States has historicallyeconomic efficiency … It is no secret that ratemaking in the United States has historicallydeviated significantly from the first-best marginal cost ideal”deviated significantly from the first-best marginal cost ideal”
marginal cost pricing
perfect price discrimination
marginal cost pricing
perfect price discrimination
Ramsey pricing
-^
stable prices
over time?
marginal cost pricing
perfect price discrimination
Ramsey pricing
-^
stable prices
over time?
adverse movements
in prices?
Slide 1318 July 2008
Regulation is not about reducing DWL
-^
shouting loud enough? Are regulators pursuing non-welfaremaximising objectives?
resources obtaining a monopoly?
investment by the regulated firm?
Slide 1418 July 2008
Sunk investment by the regulated firm
-^
There is a strand of the economics literature which argues that aprimary task of regulation is protecting the sunk investments of theregulated firm:^ –
The story is: Natural monopolies must make substantial sunk investment
-^
Once sunk, this investment is subject to the risk of “expropriation” or“hold-up” through attempts by the government to force lower prices.
-^
Regulation is primarily about preventing this “opportunism” in order topromote sunk investment by the regulated firm. Spiller and Tommasi:
Slide 1618 July 2008
-^
state rail terminal, or to build a rail spur to its depot…
transmission pipeline…
requires one year’s water) or to plant an orchard which wouldrequire irrigated water for many years in the future…
electricity or gas (or both) as a fuel…
station..
Slide 1718 July 2008
It is efficient for the customers to make these investments^ –
but the customer will be reluctant to make a substantial sunk investment if themonopolist can raise the price (or lower the quality, or threaten to cut off theservice), in the future.
This problem could be solved by long-term contracts…^ –
This does occur in some industries (such as in the natural gas industry) but formany industries the number of customers is sufficiently large that thetransactions costs of negotiating such contracts makes them infeasible.
-^
The role of the regulator is to re-create that long-term contract which, byensuring the customer a long-term stable path of prices facilitates sunkinvestment by the customer.
Note that this is an
efficiency
argument rather than a fairness or
distribution argument.
Slide 1918 July 2008
-^
stable prices
preventing adverse movements
in prices
-^
Price discrimination
and
Ramsey pricing
Slide 2018 July 2008
-^
stable prices
preventing adverse movements
in prices
-^
Price discrimination
and
Ramsey pricing
-^