ECW3830

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ECW3830
Competition and Regulation
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Week 7 Hilmer report and industry restructuring
Week 5-6 Regulating monopolies and access to
essential facilities
Week 8 Liberalisation in aviation
Week 4 Theories and practice of privatisation
Competition and Regulation
Week 9 Structural reform and regulation in
electricity
Week 3 Deregulation rationales and experiences
Week 10 Competition and regulation in
telecommunications
Week 2 Theories of regulation
Week 11 Mergers, Cartels and restrictive
practices
Week 1 Rationale for competition policy and
regulation
Week 12 - Research topic. Regulation,
deregulation and privatisation in small open
economies
Week 13 Revision
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Examination

• Two hours
• 4 concise essay style questions based on the
  topics of the unit.
• and
• 1 research question
• All questions are worth equal marks

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Some suggestions

• Equal time for all questions some spare time.
• Concise answers.
• The examiners are not after the word numbers.
  Clear writing is appreciated
• Concentrate on main points
• If one diagram is usable for more than one
  question, dont re-draw it, just refer to it.

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Sample question 1
Week 13 Revision

• Use an appropriate theory to explain, why natural
  monopolies are regulated. What in particular is
  supposed to be regulated? Does regulation always
  serves its purpose? If not what might be a
  reason? Give examples.
• Topics
• Regulating monopolies and access to essential
  facilities
• Hilmer report
• Deregulation, Privatisation
• Theories of regulation

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Regulating Monopolies and Access to Essential
Facilities
The theory of natural monopoly (revising
microeconomics)
Natural monopolies (no optimal scale of
production)
The nature of the industry is a very high level
of costs and sloping downwards AC curve, so that
there is an optimal scale of production.
Cost
AC
Q
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Regulating Monopolies and Access to Essential
Facilities
The theory of natural monopoly (revising
microeconomics)
Natural monopolies (though there is an optimal
scale of production)
The nature of the industry is a very high level
of costs and the optimal scale of production is
beyond the capacity of the market.
D
Cost
AC
Q
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Regulating Monopolies and Access to Essential
Facilities
The theory of natural monopoly (revising
microeconomics)
Natural monopolies How are they established?
Normally it is a public utility with no close
substitute Established Either by the
government as public infrastructure projects
(Electricity industry in Victoria) Or by market
forces (ATT in USA before it was broken in
several eternities)
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Regulating Monopolies and Access to Essential
Facilities
The theory of natural monopoly (revising
microeconomics)
Natural monopolies and essential facilities
An input is essential for manufacturing if there
is no substitute input for the manufacturing of a
particular product And/or if an alternative
product cannot be manufactured at a comparable
price (Stephen King) A utility is essential for
household also is there is no substitute and/or a
substitute cannot be produced at a comparable
price
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What is regulated
Structure, conduct an performance of the industry

• Where the industry structure deviates from a
  perfectly competitive market
• Restricted trade practices
• Cartels, collusions
• Access prising!

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Reasons for regulation
For allocation purposes

• Public goods
• the market mechanism is perceived unable to
  determine the "right" amount which should be
  produced.
• Externalities
• The product attracts too many or too few
  resources, depending on whether the externality
  is negative or positive
• Declining average cost (the case of natural
  monopoly)
• Access regulation

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Regulating Monopolies and Access to Essential
Facilities
Regulatory tasks
Product availability where market fails to
deliver
Product Access where market fails to deliver

• Product availability
• Sufficient quantity
• At the right place
• At the right time
• Access to product
• At a reasonable price.

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Theories of regulation
Towards classification of theories
Positive theories Answer the question How
does regulation work The role of regulation
policies in advantaging of different sectoral
groups
Normative theories Answer the question What
and how to regulate Approaches to and methods
for the correction of market failure
Public interest theories
The Pareto Principle
The problem of second best
Capture theories
Stiglers theory Private interest
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Theories of regulation
Positive theories
Attempts to explain the nature and mechanisms of
regulation Based on multi-disciplinary
studies Include elements of economics, political
science, sociology and social psychology
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Theories of regulation
Positive theories
Public interest theory
The regulation is necessary to compensate
inequitable and/or allocatively inefficient
market outcomes to protect public interest
public interest consumer interest, employment
maintenance,
infrastructure maintenance, etc
The reason of failure of regulatory measures -
mismanagement
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Theories of regulation
Positive theories
Capture theories
The deficiency of public interest theory it
ignores differences in the interests of different
groups of the society (consumers, producers,
policy makers, etc).
Life-cycle theories
Private interest theories
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Theories of regulation
Positive theories
Capture theories
Life-cycle theories
Regulation intended to serve some particular
public interest. However, the groups of
regulated industries become to be able to affect
their regulators (governmental regulatory bodies)

or
Regulation was imposed by a majority political
group to serve public interest. However,
overtime it becomes to serve the interest of the
supporters of that political group.
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Theories of regulation
Positive theories
Stiglers theory
Main ideas The regulation serves industry not
public interest A regulated industry is a
state-sanctioned cartel
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Theories of regulation
Positive theories
Stiglers theory
The Demand for Regulation

• Barriers to entry
• A direct subsidy of money
• State regulation affecting substitutes and
  complements
• State price fixing

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Theories of regulation
Positive theories
Stiglers theory
Supply costs

• Non-profit-maximising form of delivery.
  Equalisation of advantages from regulation
• The very cost of the bureaucracy of regulation
• The distribution of advantages outside the
  industry

The industry seeks for the level and structure of
regulation where benefits superseed costs
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Why regulation is inefficient
Deregulation Rationales and Experiences
Economic regulation of potentially competitive
industries
Regulation

• Barriers to competition
• Hidden costs
• Exclusion of or restrictions on new products
• Delay in the introduction of new technologies
  (Broadbend)
• Effects contrary to intended objective (regulated
  natural monopolies become cost inefficient and,
  therefore, prices increase instead of decreasing
  or maintaining lower ones)

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Theories and practice of Privatisation
The broader privatisation agenda
Common arguments for privatisation

• Develop profit-maximisation initiatives
• Making a privatised industry more
  competitive/efficient
• Reducing costs/prices
• Avoiding over-investment and creation of excess
  capacities
• Testing the activity of a firm by market forces
• Reducing public debt through sales proceedings

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Theories and practice of Privatisation
The broader privatisation agenda
Common arguments against privatisation

• Is it possible to promote competition within a
  natural monopoly
• is it possible to make a privatised industry
  more competitive/efficient or to reduce
  prices/costs if the AC curve is sloping
  downwards
• It is unreasonable to replace a public monopoly
  with a private monopoly
• it is necessary to take into account all the
  costs of privatisation
• the government gives up the revenue of government
  owned enterprise and therefore increases in the
  burden of taxation.

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Theories and practice of Privatisation
The broader privatisation agenda
Natural monopoly privatisation

• Is it possible to promote competition within a
  natural monopoly
• is it possible to make a privatised industry
  more competitive/efficient or to reduce
  prices/costs if the AC curve is sloping
  downwards
• It is unreasonable to replace a public monopoly
  with a private monopoly
• it is necessary to take into account all the
  costs of privatisation
• the government gives up the revenue of government
  owned enterprise and therefore increases in the
  burden of taxation.

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Sample question 2
Week 13 Revision

• Give examples of an industry where the third
  party access regulation is essential. Explain why
  it is required. Does the third party access
  regulation help in promoting competition?
• Topics
• Regulating monopolies and access to essential
  facilities
• Hilmer report
• Deregulation
• One of the following industries
• Telecommunication
• Energy (high voltage transmission)
• Airports

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Access to essential facilities

• Third party access to major infrastructure
  facilities is one of the key regulatory
  components of the National Competition Policy
• Regulated through the mechanisms of ACESS PRICING
• How the access price should be set?
• Rate of return regulation is considered in the
  literature as the most desirable one
• The access provider , through the regulated
  price, is guaranteed a reasonable rate of return
  on capital
• This secures the attractiveness of access
  providers equities to shareholders.

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Access to essential facilities

• Theoretically, there are the following cases
• The access provider does not have an
  interest/shares in the downstream provision of
  services
• No conflict of interest
• The access provider has an interest in the
  downstream provision of services
• Conflict of interest the downstream wing of the
  access provider competes with other downstream
  providers.
• The case of TELSTRA vs OPTUS, PRIMUS in fixed
  line telephony
• TELSTRA vs several competitors in ADSL broadband
  internet services
• As a result, the socially optimal access price
  differs from the one preferred by the access
  provider.

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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Optimal uniformed pricing - advantages

• PSRMC at the point of intersection with the
  D-curve.
• Efficient sends correct signal to buyers
• Socially optimal at any market structure
• Attained by market forces in competitive markets
• Must be regulated if the market is not
  competitive (such as government owned or private
  monopoly)

P, Cost
SRMC
AC
P
P
D
MR
Q
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
The case of below average cost pricing

• The company cannot supply at this price
  quantity demanded exceeds willingness to supply
• Such a level of regulated price assumes a subsidy
  is payed to the company.
• Two form of subsidy
• A bulk operational grant
• A subsidy on each purchase (such as ride in
  public transport)

P, Cost
SRMC
AC
P
P
D
MR
Q
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
The case of below average cost pricing

• A bulk operational grant (OG)
• - the minimum level of operational grant.
  Can be regarded as offset to excessive fixed
  costs.
• TCFC-OG VC
• AC(TC-OG VC)/Q

P, Cost
AC
P
D
MR
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
The case of below average cost pricing
A bulk operational grant (OG) Can be regarded as
a subsidy to the fixed costs TCFC-OG
VC AC(TC-OG VC)/Q Can be interpreted as a
shift of the AC curve downward as the result of
decrease in fixed costs.
P, Cost
AC
AC
P
D
MR
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
The case of below average cost pricing
A subsidy on each purchase (such as ride in
public transport) (S) Can be regarded as a
subsidy to the variable costs TCTFC
TVC-SQ ACTFC/Q VC/Q-SAFCAVC-S Can be
interpreted as a shift of the AC curve downward
as the result of decrease in variable costs.
This option is logical where a public-owned
facility is outsourced to a private operator
P, Cost
AC
AC
P
D
MR
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Two (multi)-part pricing

• P - Per-unit fee is equal to marginal costs (this
  can or cannot recover fixed costs)
• plus
• a fixed fee equal to the amount of consumer
  surplus (membership fee, service fee) if not
  regulated.
• Club membership
• Can be regulated below the whole consumer surplus
  level
• Water
• Telephone
• Electricity
• Gas

Unregulated price
P, Cost
SRMC
P
D
MR
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Two (multi)-part pricing

• P - Per-unit fee is equal to marginal costs (this
  can or cannot recover fixed costs)
• plus
• a fixed fee equal to the amount of consumer
  surplus (membership fee, service fee) if not
  regulated.
• Club membership
• Can be regulated below the whole consumer surplus
  level
• Water
• Telephone
• Electricity
• Gas

Regulated price
P, Cost
SRMC
P
P
D
MR
Q
Q
Q
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Price-cap regulation (see Lecture 4)

• A cap on price is established
• above the SRMC
• Below the optimal monopoly price.
• A normal outcome bargaining between monopoly
  operator and government for increasing the cap
  faster than the rate of inflation
• Electricity in Victoria
• Private health insurance in Australia
• Allows for increase in profit as the result of
  decrease in costs

P, Cost
SRMC
P
PC
D
MR
Q
Q
QC
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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Cost of service average cost regulation

• PQ/TC - at the point of intersection of the AC
  curve with the D-curve.
• Advantages
• Covers all the economic costs (including,
  perhaps, opportunity cost and normal profit)
• Consumer does not pay more than the costs
• Meant to be incentive for cost reduction as it is
  the only degree of freedom for any increase in
  profit

P, Cost
AC
P
D
Q
Q
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Access to essential facilities

• Problems with the rate of return regulation
• Tends to be interventionist with respect to the
  structure of pricing allowed, often placing
  direct constraints on individual prices.
• Resulting pricing structures often reflect
  political rather than economic imperatives.
• This form of regulation tends to be
  informationally demanding. There are inherent
  problems of gathering and interpreting the
  information on operational costs, capital value
  to make efficient decisions about the cost basis
  for allowed pricing.
• There is scope for a substantial amount of
  gaming between the regulator and the essential
  facility provider.
• Rate-of-return regulation can lead to an
  incentive to overcapitalise. Where the allowed
  rate of return exceeds the cost of capital, the
  utility has an incentive to expand the base on
  which the return is reckoned and thereby increase
  profitability within the constraint.

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Regulating Monopolies and Access to Essential
Facilities
Approaches to monopoly regulation
Disadvantages of price-setting regulation

• Requires decision making and monitoring by
  regulator
• Possibility of conflict of interest
• Opportunity for corruption
• Requires data gathering by the regulator
• Submissions in Australia
• Hearing in USA
• Requires cost estimates
• Historic/accounting costs can be misleading
• Projected/forecasted costs can be inaccurate
• Producers are tempted to inflate projected costs
• Disallow for economic profit and, therefore,
  investment in
• Growth, and/or
• Research and development

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Sample question 3
Week 13 Revision

• Outline the moves that Australia has taken to
  reform the telecommunication sector and to
  develop a market of telecommunication services.
  How strong do you expect competition in the
  market to be, and is there a continuing role for
  regulation?
• Topics
• INDUSTRY SPECIFID QUESTION. One of the following
  industries
• Telecommunication
• Energy (high voltage transmission)
• Airports
• Regulating monopolies and access to essential
  facilities
• Hilmer report
• Regulation
• Deregulation
• Privatisation

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Sample question 4
Week 13 Revision

• ACCC has recently rejected the proposal of merger
  between QANTAS an Air New Zealand. Using an
  appropriate theory, explain what could be a
  reason for this decision. Do you agree it was
  justified?
• Topics
• Mergers, Cartels and Restrictive Practices
• Theories of regulation

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Mergers, Cartels and Restrictive Practices
Trade Blocs
Collusion and cartels
Cartel - an organisation of suppliers of a
commodity for quantity restriction and/or price
fixing
Collusion - an agreement between otherwise
independent suppliers of a commodity on price
fixing
Collusions and Cartels are explicitely illigal on
many contires
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Mergers, Cartels and Restrictive Practices
Collusion and cartels
Cartel vs competitive market
Dx - market demand Sx - market supply MCx -
individual firms marginal cost MRx - marginal
revenue of cartel E - equilibrium of perfect
competition C - equilibrium of cartel Pe the
price of perfect competition Pc the price of
cartel Qe the quantity of perfect
competition Qc the quantity of cartel

• Cartel fixes quantity at MRxMCx
• and charges a monopoly price
• The participants of quatas agree on the
• allocation of quotas.

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Mergers, Cartels and Restrictive Practices
Collusion and cartels
Cartel vs oligopolistic market
Two companies, a and b, produce a homogenous
product ar different marginal costs. Under
cartel agreement, they set the price at Pcartel,
corresponding to the intersection of MC and MR,
and allocate the output according to their
individual marginal costs. No economy of scale.
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Mergers, Cartels and Restrictive Practices
Collusion and cartels
Cartel

• Cartel fixes quantity at MRxMCx
• and charges a monopoly price
• The participants of quatas agree on the
• allocation of quotas.

Disadvantages of Cartels for Participants Unstabl
e exit is very simple as the structure is not
backed by law Does not allow for economies of
scale or other cost efficiencies Preferred
option merger
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Mergers, Cartels and Restrictive Practices
The effects of mergers
Merger amalgamation of the capital an
operations of two or more companies

• Legal at certain conditions
• Stable due to contractual obligations
• Allows for economy of scale in production and
  other cost efficiencies
• Combined investments in RD
• Marketing
• Logistics
• Etc
• Allow for synergies and risk spreading.
• provide a mechanism by which underperforming
  firms and managers are replaced by better
  performing ones.
• In some cases mergers may also have
  anti-competitive effects by altering the
  structure of markets and therefore the incentives
  for firms to behave in a competitive manner.

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Mergers, Cartels and Restrictive Practices
The effects of mergers
Merger vs cartel

MCa
MCb
SMC
SMCmerger
Pcartel
If there is economy of scale, quantity supplied
to the market cab inrease at a lower price.
Pmerger
D
Qmerger
Qa Qb Qcartel
Quantity
MR
(QaQb)
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Mergers, Cartels and Restrictive Practices
Is it possible to make competition policy more
effective?
Problem of industry in a small open economy

• In a small open economy regulation of mergers
  restricting competition within the country
  contradicts promoting international
  competitiveness of the industry
• Maintaining two or more smaller size companies in
  an oligopolistic industry may well keep the scale
  of production below the international optimal
  level
• Allowing merger creates a domestic monopoly
• Recent debate on merger between QANAS and Air New
  Zealand.
• No general solution
• Structured forecast of impact is impossible
• Decision making on case by case basis
• The art of decision making vs the science of
  economics
• Creation of regional economic unions similar to
  EU.

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Research question
Week 13 Revision

• Consider any industry (in any country) where the
  price is regulated.
• What kind of market structure is in the industry?
  
• What is the reason for and aim of price
  regulation?
• Which of the known approaches to/methods of price
  regulation is applied? (Use an appropriate
  theory/model for your explanation)
• Is the aim of price regulation achieved?
• In the case you are considering, are there
  negative consequences/side effects of price
  regulation?