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# lec10 - Problem Regulator does not know costs and demand...

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1 4 Regulation of Natural Monopoly 1. Is there a natural monopoly? 2. What is optimal price for a natural monopoly? 3. How to regulate to attain optimal price? 5 Is there a natural monopoly? Compare min AC with demand. 7 Natural Monopoly: \$ Q AC D M Allow one firm and regulate its price. 9 Not a natural monopoly: \$ Q D M AC Encourage many firms. Allow market forces to determine price. 10 Example: Telecommunications Local Origin Central Office Central Office Destination Long Distance Local 13 Example: Electricity Now: Generation is not natural monopoly. Transmission is natural monopoly. Distribution might or might not be. Generation Transmission Distribution

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2 15 Direct Regulation of Natural Monopoly What is optimal? First-best: P = MC 17 At P=MC Natural monopolist loses money: \$ Q AC D M MC First best P Loss 18 Direct Regulation of Natural Monopoly What is optimal? First-best: P = MC Second-best: P = AC 19 \$ Q AC D M MC First best P Second best P Optimal Prices 21 How to attain optimal price?
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Unformatted text preview: Problem: Regulator does not know costs and demand curve of firm. Firm has incentive to deceive regulator. 23 Forms of regulation: Rate-of-return regulation Price cap regulation 3 26 Rate-of-Return Regulation Firm is allowed to earn a “fair” return on investment.- Regulatory decides what return on capital is fair.- Prices are set at average cost using fair return on capital. 30 Regulator does not know true cost of capital. Suppose regulator sets “fair” return at true cost of capital: P = true AC Monopoly has no incentive minimize costs. above true cost of capital: P > true AC Monopoly has incentive to use too much capital. below true cost of capital: P < true AC Monopoly becomes insolvent. 33 Price Cap Regulation Commission sets a price cap. Firm can charge any price below that cap. Firm keeps whatever profits it earns....
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lec10 - Problem Regulator does not know costs and demand...

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