1. monopoly market power and market failures.pdf

8/14/2019 1. monopoly market power and market failures.pdf

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Prof. Carlo [email protected]

Monopoly, Market Power

and Market Failures


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Review of Perfect Competition

Large number of buyers and sellersHomogenous product

Perfect information

Firm is a price takerSolution

P = (L)MC = (LR)AC

Normal profits or zero economic profits in thelong run


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Review of Perfect Competition


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Microeconomics: a review


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Individual demand: consumerbehavior

Under the local nonsatiation assumption, the optimal

consumer demanded bundle of goods (i = 1, .., n) is given bythe following problem:

where pis the vector of market prices and mthe income levelof the consumer.

v(p, m) is the maximum utility achievable at given prices andincome and is called indirect utility function. The optimal x(p,m) is therefore the consumers demand function.

mpxts

xumpvx

=

=

..

)(max),(


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The Lagrangian for the Utility maximization problem

can be written as:

The FOC is given by:

And it can be re-elaborated as:

)()( mpxxuL =

nipx

xui

i

,...1for0)(

==

njip

p

x

xu

x

xu

j

i

j

i,...1,for

*)(

*)(

==


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The indirect utility, i.e. the maximum utility asa function of pand mhas the followingproperties:

It is non increasing in p, that is if p p, thenv(p, m) v(p, m). Similarly, v(.,.) is nondecreasing in m.

It is continuous and quasi-convex


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The quasi-linear utility function

Partial equilibrium analysis: analyse the market

functioning of a good that has a relatively low weighton the global economy.

Hence, we can introduce two simplifying assumptions: 1. the impact of a change in consumers income on the

expenditure of the good is limited (no income effect); 2. the substitution effect on the other goods is small too.

The prices of the rest of goods can then be consideredas fixed and we can be assume them as a numeraire,normalised to 1.

We can then simplify our utility function in the followingway (yi is the rest of goods, i.e. the numeraire):

yxuyxU += )(),(


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The quasi-linear utility function

u(xi) is a continuous, increasing, twice-differentiable,

and convex function. The optimization problem becomes:

FOCs:

This leads to the following optimal condition:

mypxts

yxuyxU

=+

+=

..

)(),(

01

0)(

==

=

=

y

L

px

xu

x

L

pxu

x

xu==

)(

)(


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Surplus: a review

Consumer surplus is the total benefitor value that consumers receive beyondwhat they pay for the good

Producer surplus is the total benefit orrevenue that producers receive beyond

what it costs to produce a good


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Marginal effects of a price/quantity

changes on Consumer Surplus

Consumer surplus, as a function of price, is given by:

Hence, it results:

Intutition: the demand has a negative slope, the minusis needed in order to have a positve quantity

==*

)()(p

dppqpVCS

)()(

pqdp

pdV=


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Marginal effects of a price/quantity

changes on Consumer Surplus

Consumer surplus, as a function of quantity,

is given by:

Hence, it results:

==

*

0)(where

)()(

q dqqpS(q)

qqpqSCS

)()(

qpdq

qdS=


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Perfect competition and Welfare


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Welfare economics

What are the welfare properties of the perfect

competitive equalibrium? The representative consumer approach: suppose

that the market demand, x(p), is generated bymaximizing the utility of a single representativeconsumer who has a quasi linear utility function u(x)+y,where xis the good under examination and yeverything else.

Under this utility function, we know that:

Hence, the direct demand function x(p) is simply the

inverse of the above condition Note that in case of a quasi-linear utility the demand

function is independent of income!!

pxu = )(


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Welfare economics

Consider now a representative firm having a costfunction c(x), with c > 0, c> 0 and c(0) = 0.

In a perfect competitive market, the profit maximizing(inverse) supply function of a representative firm isgiven by p= c(x).

In equilibrium demand = supply

Hence, the equilibrium level of output of the x-good issimply the solution to the equation:

This is the level of output at which the marginalwillingness to pay for the x-good just equals its marginalcost of production.

)()( xcxu =


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Welfare analysis

What is the optimal amount of output that maximizes therepresentative consumers utility?

Let w be the consumers initial endowment of the y-good. Theconsumers problem is:

Intuition: the welfare maximizing problem is simply to maximizetotal utility consuming x-good and y-goods. Since xunits of the x-good means giving up in a competitive market - c(x) units of they-good, our social objective function becomes:

The Foc is given by (as before):

The competitive market results in exactly the same level ofproduction and consumption as does maximizing utility directly.

)(..

)(max,

xcwyts

yxuyx

=

+

)()(max,

xcwxuyx

+

)()( xcxu =


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Welfare analysis

Another way to look at the same problem.

Let CS(x) = u(x) - pxbe the consumers surplus and PS(x)= pxc(x) be the producers surplus.

The total surplus, or welfare, is:

We can conclude saying that the competitive equilibriumlevel of output maximizes total surplus!

[ ]

)()(

)()()()(max

xcxu

xcpxpxxuxPSxCSW x

=

=+==+=


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Welfare analysis: a generalization

Suppose there are i= 1,, nconsumers andj = 1,,m

firms. Each consumer has a quasi-linear utility functionui(xi)+yiand each (perfectly competitive) firm has a costfunction cj(xj).

An allocation describes how much each consumer

consumers of x-good and the y-good, (xi, yi), i= 1,, n,and how much the firm produces of the x-good, zj,j =1,,m .

The initial endowment of each consumer is taken to be

some given amount of the y-good and 0 of the x-good. The sum of utilities is given by:

= =

+n

i

n

i

iii yxu

1 1

)(


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The total amount of the y-good is the sum of

initial endowments, minus the amount used upin production:

Observing that the total amount of the x-goodproduced must equal the total amountconsumed, we have

===

=m

j

jj

n

i

i

n

i

i zcwy111

)(

==

===

=

+

m

j

j

n

i

i

m

j

jj

n

i

i

n

i

iizx

zxts

zcwxuji

11

111,

..

)()(max


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Let the Lagrangian multiplier on the

constraint, we have

where p* = since the market is perfectlycompetitive!

Hence, market equilibrium necessarilymaximizes welfare for a givenpattern of initialendowments (wi).

=

=

)('

)('

jj

ii

zc

xu


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Consumer Equilibrium in a

Competitive Market

First Theorem of Welfare Economics

If everyone trades in a competitivemarketplace, all mutually beneficial tradeswill be completed and the resulting

equilibrium allocation of resources will beeconomically efficient

Welfare economics involves the normative

evaluation of markets and economic policy


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Competitive Market

Pareto Optimality

An outcome is Pareto optimal if it is not possibleto make one person better off without makingone another worse off

If this is possibile, we face a potential Paretoimprovement(PPI)

The adoption of the PPI criterion means that wecan focus on what happens to total surplus.

Hence an outcome that maximizes total surplusis Pareto optimal.


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Competitive Market

Difficult for efficient allocation with manyconsumers and producers unless allmarkets are perfectly competitive

Efficient outcomes can also be achievedby centralized system

Competitive outcome preferred since

consumers and producers can betterassess their preferences and supplies


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Equity and Efficiency

Although there are many efficient

allocations, some may be more fair thanothers

The difficult question is, what is the most

equitable allocation?We can show that there is no reason to

believe that efficient allocation from

competitive markets will give an equitableallocation


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Equity and Perfect Competition

Must a society that wants to be more

equitable necessarily operate in aninefficient world?

Second Theorem of Welfare EconomicsIf individual preferences are convex, then

every efficient allocation is a competitive

equilibrium for some initial allocation ofgoods


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Equity and Perfect Competition

Any equilibrium that is equitable can beachieved by redistributing resources andmay be efficient

Typical ways to redistribute goods,however, are costly

Taxes lead to bad incentives

Firms devote fewer resources to production inorder to avoid taxes

Encourage individuals to work less


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Market Failures


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Why Markets Fail

Market Power

Those with market power choose the priceand quantity

Less output is sold than in competitive

markets

Inefficiency

Can have market power as producers or as

inputs


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Why Markets Fail

Externalities

Market prices do not always reflect theactivities of either producers or consumers

Consumption or production has indirect

effect on other consumption or productionnot reflected in market prices

May be impossible to get insurance because

suppliers of insurance lack information


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Why Markets Fail

Public Goods

Nonexclusive, nonrival goods that can bemade available cheaply but which, onceavailable, are difficult to prevent others from

consumingCompany thinking about researching a new

technology if cant get patent

Once its made pubic, others can duplicate it


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Why Markets Fail

Incomplete Information

Consumers must have accurate informationabout market prices or production quality formarkets to operate efficiently

Lack of information can change supply Buy products with no value

Dont buy enough of products with value

Some markets may never develop


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Market Failures

Economic motivations

Existence of market power (monopoly, naturalmonopoly, collusive oligopoly)Externality (positive or negative)Market incompleteness (asymmetric information)

Social motivations:Redistributive concerns (urban to rural areas; rich to

poor citizens)Merit goods (essential services should be provided to

everybody at affordable prices)

need of State policy in the form of ex ante(regulation) or ex post (antitrust) interventions


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Monopoly

Monopoly

1. One seller - many buyers

2. One product (no good substitutes)

3. Barriers to entry

4. Price Maker


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Monopolists Output Decision

1. Profits maximized at the output level

where MR = MC

2. Cost functions are the same

MRMCor

MRMCQCQRQ

QCQRQ

=

===

=

0///

)()()(


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Lostprofit

P1

Q1

Lostprofit

MC

AC

Quantity

$ perunit ofoutput

D = AR

MR

P*

Q*


P2

Q2


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1. Profits maximized at the output level

where MR = MC

2. Cost functions are the same

+=

+=

+=

DEPPMR

QP

PQPP

QPQPMR

1


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Equilibrium Pricing

1

1

MCMRwheremaximizedis

D

D

EP

MCP

MCEPP

=

=

+

=


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Elasticity of Demand and Price

Markup

P*

MR

D

$/Q

Quantity

MC

Q*

P*-MC

The more elastic isdemand, the less the

markup.

D

MR

$/Q

Quantity

MC

Q*

P*

P*-MC


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Measuring Monopoly Power Could measure monopoly power by the extent

to which price is greater than MC for each firm

Lerners Index of Monopoly Power

L = (P - MC)/P

The larger the value of L (between 0 and 1)the greater the monopoly power

L is expressed in terms of EdL = (P - MC)/P = 1/EdEd is elasticity of demand for a firm, not the

market


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Monopoly Power

Pure monopoly is rare

However, a market with several firms,each facing a downward sloping demandcurve, will produce so that price exceeds

marginal costFirms often product similar goods that

have some differences, thereby

differentiating themselves from otherfirms


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Sources of Monopoly Power

Why do some firms have considerable

monopoly power, and others have little ornone?

Monopoly power is determined by abilityto set price higher than marginal cost

A firms monopoly power, therefore, is

determined by the firms elasticity ofdemand


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Sources of Monopoly Power

The less elastic the demand curve, the

more monopoly power a firm hasThe firms elasticity of demand is

determined by:

1) Elasticity of market demand2) Number of firms in market: entrybarriersand entry deterrence

3) Strategic behaviour by incumbent4) New Technology


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Elasticity of Market Demand

With one firm, their demand curve is market

demand curveDegree of monopoly power is determined completely

by elasticity of market demand (ex. OPEC)

The presence of alternative suppliers or substitute

products reduces market power (supply and demandside substitution)

With more firms, individual demand may differfrom market demand

Demand for a firms product is more elastic than themarket elasticity


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Demand elasticity in telecoms under

a Monopoly: evidence from Italy

Dependent Variable Price Income

SIP (1988) National calls 0,12 0,5-0,9Cappuccio(1990)

Revenues from calls (annualbase 1973)

0,11 0,52

Gambardella

(1991)

Revenues from calls (annual

base 1964)

0,35 0,25

Ravazzi (1991) Membership 0,1 0,3Mosconi (1994)e Colombino(1998)

Urban callsNational callsInternational calls

0,190,250,52


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Demand elasticity in telecoms under

Monopoly: evidence from US

Bodnar et al.(1988) Taylor e Kridel (1990)

Dimension

(000

Price

Elasticity Economic Position PriceElasticity

of inhabitants)> 500 0,007 Poor and rural 0,071100 500 0,006 Poor and urban 0,07730 100 0,010 Poor black rural 0,089

< 30 0,013 Rich white urban 0,026Rurale 0,014 State Price Income

Age Elasticity Elasticity< 26 0,024 Arkansas 0,059 26 44 0,009 Kansas 0,023 45 64 0,007 Missouri 0,031 > 64 0,008 Oklahoma 0,034

Income($ 000)

Texas 0,037

< 12 0,026 Average 0,037 0,04212 20 0,01220 28 0,00628 38 0,002

> 38 0,0005


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Number of Firms

The monopoly power of a firm falls as the

number of firms increases; all else equalMore important are the number of firms with

significant market share

Market is highly concentrated if only a fewfirms account for most of the sales

Firms would like to create barriers toentry to keep new firms out of marketPatent, copyrights, licenses, economies of

scale


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Number of Firms

Entry barriers are of interest from two perspectives: (i)corporate strategy and (ii) public policy.

Incumbents want to protect not only their market sharesbut also their profits

A key objective of corporate strategy is profitable entrydeterrence.

Profitable entry deterrence occurs when incumbent firmsare able to earn monopoly profits without attracting entry Profitable entry deterrence depends on the interaction

between structural entry barriers and incumbentsbehaviour

Public policy should aim at eliminating entry barriers anddetect entry deterrence


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Government Restrictions on Entry

Governments create entry barriers when

they grant exclusive rights to produce toincumbent preventing additional entry

Forms of exclusive franchises:

Natural Monopoly;Source of revenues (from State owned

companies);

Redistribute rents among citizens;

Intellectual Property Rights (IPRs)


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Structural Barriers to Entry

Structural characteristics that protect market

power without attracting entry, such as:Economies of scaleSunk expenditures of the entrantAbsolute cost advantage: incumbent may face lower

costs or a better access to existing facilities (i.e. the

use of the network in the telecoms industry)Sunk expenditures by consumers and product

differentiation: If a consumer faces a large cost for switching to a

new product, he could decide not to switchswitching costsand creation of brand loyalty.

Finally, consumer might not view the offerings ofother firms as substitute.


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Strategic behavior by Incumbents

Incumbents may behave in order to enhance

barriers to entry to rivals. Potential strategies:

Aggressive postentry behavior: commit to beaggressive; ex. Investment in sunk capacity

Raising rivals cost: raising cost of a potential entry orreducing the profitability of entry

Reducing rivals revenues: again reduce the

profitability of entry increasing the consumersswitching costs and so the market demand for theentrant


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New Technology

Technological change can generate new

products and services, and theintroduction of these products reducesthe market power of producers of

established products.Nintendo in 80 was a monopolist, but the

monopoly ended after the entry by Sega

and later on by Sony (Playstation) andMicrosoft (X Box)

The Social Costs of Monopoly


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Power

Monopoly power results in higher prices

and lower quantitiesHowever, does monopoly power make

consumers and producers in the

aggregate better or worse off?From a social point of view, the effects of

the monopolistic inefficiency can be

appreciated if we look at the Marshallssurplus


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Monopoly Dead Weight Loss


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Monopoly Dead Weight Loss

The DWL area measures the surplus that could

have been created with a competitive market,but goes loss due to level of the price which isfixed by the monopolist

The deadweight loss decreases with EDwhenthe elasticity is large, but it vanishes when thedemand is perfectly rigid, because in this case

moving prices simply correspond to a surplustransfer between firms and consumers

The determinants of Deadweight


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loss

Assume constant marginal cost. The

deadweight loss associated with a monopolypricing is approximately equal to:

DWL = 1/2dPdQ

It can rewritten as:

=

P

P

Q

Q

P

P

dP

dPdPdQDWL

2

1



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loss

Since marginal cost is constant, dP= Pm-c, it results

Harbergers loss: the inefficiency of a monopoly isgreater the larger the elasticity of demand, the largerthe Lerner Index and the larger the industry(measured by industry revenues) however L is

inversely related to Ed

2

2

1LQPEDWL mmd=



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loss

Since for a monopolisitc firm L = 1/Ed

Loss in the US long distance telecomsmarket: entrants of RBOC into the long

distance market (mid 1990s) decreases thewelfare loss by $2.78 billion

22

1

2

1 2 =

==

m

mmmmm

dP

cPQPLQPEDWL


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Durable Goods Monopoly

A durable good is a good which provides

a stream of sustained consumptionservices: it can be used more than once.

Two complicating factors:

Monopoly creates its own competition! Theexistence of a second-hand market limitsmonopoly market power

The price consumers are willing to pay todaydepends on the expectations about the priceof the good tomorrow


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Durable Goods Monopoly

Assume that the good last forever and so

that it does not depreciate over time.Example: land

Competitive supply: the supply curve isfixed; supply and demand determine theequilibrium price for a lifetime

consumption. Alternatively, the price canbe transformed in a yearly rental price.


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Durable good in perfect competition


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Durable good in monopoly

The monopolist sets the marginal revenues

equal to the marginal cost (= 0) and determinethe first year consumption and price (Q1 and P1)

In the second period, the monopolist faces aresidual demand given by QcQ1 where

consumers have a willingness to pay larger thanmarginal costs but lower than P1.

In order to sell additional units of the good anduse its stock, the monopolists cannot do betterthan reducing the price up to the competitiveprice!


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Durable good in monopoly

Durable goods: the Coase


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g

conjecture

The monopolist has therefore the

incentive to practice intertemporal pricediscrimination: it increases its profitdecreasing prices over time.

Initially, monopolist only supplies thoseconsumers having a high willingness topay.

Then, the monopolist increases its profitby moving down the demand curve


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Durable goods and strategic actions

Strategic consumers: Incentives to delay purchasing if they anticipate that the

monopolist will lower prices in the future

Cost of waiting depends on the discount rate, i.e. on theactual cost of consumption tomorrow: the larger it is, thegreater the preference of consumers for a dollar today as

opposed to a dollar tomorrow. Assume that the adjusting period is very small and the

discount rate equal to 0 (the discount factor is equal to 1):a durable goods monopolist has no monopoly power if

the time between price adjustment is vanishingly small

the Coase Conjecture


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Durable goods and strategic actions

Strategies to mitigate the Coase Conjecture:

Firms might convince consumers that prices donot decrese over time thoughLeasing, since the good is returned to the firm

Investment in reputationnot to increase supply (ex

Disney movies)Limit capacity

New customers, i.e. expected increase in the demand

Planned obsolescence, decreasing the durability of its

good, and so enhacing the demand tomorrow keepingthe price high!

Durable goods and Pacman


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g

economics

Is it true that the monopoly always loose its

market power? No, it is the contrary, monopolycomes perfectsince the firm can now extract allsurplus from consumers!

Monopolistic firm only needs to move down the

demand selling to consumers sequentially inorder of their reservation prices : this is thePacman Strategy

This results is more likely when the number ofbuyer is finite and the willigness to pay ofconsumers highly differs.


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Durable goods: Coase vs. Pacman

Study by Von der Fehr and Kuhn (1996):

When the number of buyers is very large andthere are small differences in willingness topay, then Coase outcome is more likely

when the number of buyer is finite and thewilligness to pay of consumers highly differs,Pacman discriminatory outcome emerges.


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Natural Monopoly and

Government Intervention


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The Social Costs of Monopoly Social cost of monopoly is likely to exceed the

deadweight loss

No allocative efficiency, no incentive to minimize costX-inefficiency

Hickss statement: The best of all monopoly profit is aquite life!!

Rent Seeking Firms may spend to gain monopoly power Lobbying Advertising Building excess capacity

Dynamic efficiency? Shumpeter vs. Arrow approach onthe effect of the market structure on investment


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Government can regulate monopoly

power through price regulationRecall that in competitive markets, price

regulation creates a deadweight loss

Price regulation can eliminate deadweightloss with a monopoly

Regulation vs. Competition policy


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CP attempts to avoid situation where market powercan be exploited; regulation deals with thesituation.

Prices/profits/quality are not usually explicitlycontrolled with CP

Regulation specifies precise details of what firmcan and cannot do (ex ante intervention); CPissues guidelines and uses precedent (ex post

intervention) Typically have sector-specific regulators, and a

generalist competition policy authority

If left alone, a monopolistproduces Q

mand charges P

m.

For output levels above Q1

,the original average and

marginal revenue curves apply.


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AR

MR

MCPm

Qm

AC

P1

Q1

Marginal revenue curvewhen price is regulatedto be no higher that P

1.

If price is lowered to PC

output

increases to its maximumQ

Candthere is no deadweight loss.

Price Regulation$/Q

Quantity

P2 = PC

Qc

Any price below P4resultsin the firm incurring a loss.

P4



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Power

Natural Monopoly

A firm that can produce the entire output ofan industry at a cost lower than what it wouldbe if there were several firms

Usually arises when there are largeeconomies of scale

We can show that splitting the market into

two firms results in higher AC for each firmthan when only one firm was producing

Regulating the Price of a Natural


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MC

AC

AR

MR

$/Q

Quantity

Setting the price at Pr

giving profits as large aspossible without going

out of business

Qr

Pr

PC

QC

If the price were regulate to be Pc,

the firm would lose moneyand go out of business. Cant

cover average costs

Pm

Qm

Unregulated, the monopolistwould produce Q

mand

charge Pm

.

Monopoly

Some definitions on Natural Monopoly


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Single product contest: presence ofeconomy of scale, i.e. ATC should bealways decreasing

Is this definition sufficient also in a

multiproduct setting? NOT AT ALL!! In a multiproduct setting, given a vector of

quantities i= 1,.., n, the cost function C(.)

should be sub additive, i.e.

Some definitions on Natural Monopoly


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Sufficient conditions to have a naturalmonopoly in a multiproduct setting are:

Presence of economies of scope:C(q

1

,0) + C(0,q2

) > C(q1

,q2

)

Average incremental costs should be decreasing(Baumol, Panzar and Willig, 1982)

where IC1(q1,q2)= C(q1,q2) - C(0,q2)

C(0,q2) is the so called stand alone cost of product 2AIC= IC1(q1,q2)/q1

Questions that need to be addressed:


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Whether (and how) to privatise?

Whether to break up monopoly (or allowmergers)? Structural regulation(vertical or

horizontal separation)

Which parts of the industry to regulate?

Example: Telecommunications


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Local telephony

Long distance

tele hon

International

telephony

Internet

Mobile telephony

Naturalmonopoly

Example: Electricity market


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Production and Import

National Transmission

(high voltage)

Local transmission (lowvoltage

Final market

Natural

Monopolies

Example: Gas industry


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Production and Import

National transmission

Local transmission

Retail market

Natural

monopolies

Reserve in stock

Structural Regulation: the US example


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But then mergers among Baby Bells


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The current situation


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Conduct regulation: price control


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First best pricing: price equal to marginalcost (as in a perfect competitive

environment)

Public transfer to cover firms loss

P

Q

PAC

PCm

QCm

D

AC

C

QAC

m



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Demo: consumers have a quasi-linear utility

function Uh

= Rh

+ Sh

(p), such thatUh/p = Sh(p)/ p(no revenueeffect)

In a monoproduct setting:Maxp W= S(p) T+

where = pq(p) + T- C(q) F

Thus, W= S(p) + pq(p) - C(q) FDeriving w.r.t. p, we get: p= C(q)



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In absence of any kind of transfer from

regulator to the firm, what could happen?The regulator should set prices in order to

let the firm reach its break even

Second best solution: price = AC

The average cost pricing rule


Fi fi b h i l


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Firms profit are zero, but there is always adeadweigh loss (squared area in figure)

q

D

MC

AC

$

qAC

pAC


M lti d t tti ti l th d f ll


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Multiproduct setting: practical methods, fullydistributed costs (FDC)

Suppose to have a cost function:

Price equal marginal cost leads to losses.How to cover them?

A rule to share the fixed cost Fshould bedefined by the regulator.


F ll di t ib t d t (FDC) i h ld


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Fully distributed costs (FDC): price shouldcover not only direct (marginal) cost, but alsoa share of the fixed costs, i.e.

where fi is the so called cost driver:

=

=

=

=

Method)Costable(Attribuitif)(

Method)Output(Relativeif)(

Method)Revenues(Grossif)(

1

1

1

n

iii

n

i

ii

n

iii

i

CDCDc

QQb

RRa

f

Conduct regulation: price control/6

It i t h th t ll th th th d


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It is easy to show that all the three methodsabove described leads to define a equalmark up rule.

In fact:

Is this efficient?


The answer is NO!


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The answer is NO!

A+B = Extra-revenues to cover fixed costC+D = deadweight loss!!

q q

MCMC

DR

DE

pp

A BC DA B



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How to minimize deadweight loss?

Mark up on prices should be different according to

the different demand structure of the goods:

Even if A+B = A + B, C+D< C+D

q q

MCMC

DR

DE

pE

pR

BD

A C

B



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Immagine that no public transfer could be used andij= 0

Regulator should set prices such that: MaxpiS(pi) + s.t. 0

Denoting with the lagrangian multiplier of the

constraint we have: L = S(pi) + (1+ ) = S(pi) + (1+ )(piqi C(qi))

What is ? It can be interpreted as the shadow price ofpublic funds.



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Optimal second best solutions: Ramsey-Boiteaux Pricing rule

i.e. the price-cost margin (in percentage ofprice) should be inversely related to the

price elasticity of demand:

ii

iii

p

cpL

1

1+=

=

i

i

i

ii

q

p

p

q

=

Cross subsidization


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In many Utilities, the price in some servicesare set lower than their marginal cost mainly

for distributional concerns.

Example: in Telecoms, USO implies thatprice for urban calls and the fixee fee havebeen set for long time below marginal cost,while long distance calls (national andinternational) have been set above costs inorder to recoup the losses on other services.

Cross subsidization


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Problem: cross subsitization could bestrategically used by the incumbent

operator in order to prevent entry in themarket or to induce exit of new entrants.

Potential anticompetitive behaviour:

incumbent could set price above cost in themonopolistic segment of the market (i.e.Local telephony), in order to reduce its pricein the more competitive ones (Longdistance or Internet)

Cross subsidization


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How to avoid or detect cross subsidization?

Faulhabers Test (1975).Two services (p1and p2).

I^ test on incremental cost:

p1q1IC1(q1,q2)= C(q1,q2) - C(0,q2)

p2q2IC2(q1,q2)= C(q1,q2) - C(q1,0)

Cross subsidization


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II^ test on incremental cost:

p1q1 C(q1,0)p2q2 C(0,q2)

If the two tests have success, then retail tariffs aresubsidy free. Otherwise, Incumbent could have setits tariffs anticompetitively, and so more scrutiny isneeded (from Competition or Regulatory Authority)

1. monopoly market power and market failures.pdf

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