Ps#2 key

# Ps#2 key - < Problem Set 2 Answer Key >(ECON 2 Spring...

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< Problem Set 2: Answer Key > (ECON 2: Spring 2008) ( Market Imperfection and Policies; Prof. Young-Han Kim ) 1. Assume that SDGE (San Diego Gas & Electricity) is a monopolist in supplying electricity in San Diego region. The demand curve of the electricity is given as: Q D = 1000 – 2P The long run average cost (LRAC) of SDGE is given as: LRAC = 400 – (Q/4) The marginal cost of producing each unit of electricity is: MC = 200 i) Assume that the regulation by San Diego government can be explained by social interest theory. What is the level of price cap the government should impose, and the resulted output level while keeping electricity is supplied stably in San Diego region to maximize the social welfare? (10 points) P Q D LRAC MR MC a b c O According to the social interest theory, the government regulation targets to maximize the social welfare or to minimize the deadweight loss by imposing the regulation. With the downward sloping LRAC, SDGE is the case of the natural monopoly. Therefore, the government regulation should take the form of average cost pricing regulation. If government tries to minimize the deadweight loss by regulating the firm to produce electricity such that the marginal cost is equal to social demand curve, SDGE makes losses and will not produce at all. To make electricity provided stably, government has to guarantee 0 economic profits to MS, not loss by regulating to choose average cost pricing. Therefore, government should impose the regulation to produce at the point where “LRMC = D”, which is Q= 400, and P=300 ( Å inverse Demand function = LRAC Æ 500 – Q/2 = 400 – Q/4) 1

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ii) What is level of deadweight loss (compared to the competitive market equilibrium) caused by the regulation of a government that is fully captured by the monopolist, which can be explained by the capture theory of regulation? P
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Ps#2 key - < Problem Set 2 Answer Key >(ECON 2 Spring...

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