Topic five

1
Topic five

• The direct regulation of firms

2
Overview

• Optimal price regulation
• Problems with setting price equal to short run
  marginal cost
• Moral hazard
• Adverse selection
• Incentive contracts and benchmarking
• Other issues government commitment and quality
  of product.

3
Regulating prices in the short-run

• Take a firm with
• Fixed production costs
• Increasing marginal cost technology
• Suppose that the government wanted to set the
  optimal price for that firm (in the sense of
  maximising economic surplus). What price should
  the government set?

4
Optimal price regulation
Notes If no information constraints and no long
term profit constraint then first best solution
involves setting price equal to short-run
marginal cost (i.e. where demand curve and SRMC
curve intersect) and require firm to sell all
product that is demanded at this price. Why?
Because this maximises economic surplus.
5
What if set price above SRMC?
Red area is the deadweight loss from setting
price too high. The regulated firm makes more
profits but there is too little trade.
6
What if price set below SRMC?
Red area is deadweight loss from too much trade.
Note that the excessive trade involves people
buying products when their personal value of the
product is less than the resource cost of making
the product.
7
Problems with SRMC price regulation

• As with all cost-based price regulation, it
  removes incentives to lower costs (moral hazard)
• The government might not know the true marginal
  cost, and the firm might not tell the truth
  (adverse selection).
• Pricing at SRMC might not allow the firm to cover
  all its production costs.

8
Performance based regulation to overcome moral
hazard

• Moral hazard simply means that I want you to do
  something, but without the correct incentives you
  will not do it!
• The government would like a regulated firm to
  operate efficiently and minimise marginal cost,
  but if price is always set equal to marginal
  cost, why bother?
• Performance based regulation lets the regulated
  firm keep some of the benefits when it lowers
  production costs (note also, confusingly,
  called incentive regulation).

9
Incentive regulation to overcome adverse selection

• Adverse selection means that I want to know
  something that you know, but without the correct
  incentives you might lie!
• For example, if ask the firm we expect them to
  overstate SRMC
• Could use a form of incentive regulation
• Could use benchmarking (yard stick regulation)

10
Simple incentive regulation
Say MC could be 5 or 10. If ask firms, and they
believe that regulator will set price MC, they
will say 10. But what if bribe firm? Say give
firm 255 if say MC 5 and nothing if say MC
10. Now firm has incentive to tell the
truth. Problem where does the 255 come from
if the firm really is a low cost producer?
11
Benchmarking

• Suppose that there are five different regulated
  firms (e.g. electricity distribution in
  Victoria). Could ask each firm its marginal cost
  (subject to auditing) but make each firms own
  price depend on other firms reported costs.
• Gives each firm the incentive to minimise costs
  as keep all the profit gain.
• Gives firms little reason to lie.
• Can use statistical techniques to correct for
  inter-firm differences.
• Possibly open to collusion.

12
What if SRMC pricing does not let firm make a
profit?

• What if it lets the firm cover it operating costs
  but not sunk costs?
• Effect on future investment
• Could set uniform price equal to average cost
• But this has all the other problems
• How does regulator know average cost?
• How do we give incentives to lower average cost?
• And it distorts prices.
• Could set non-linear prices but raises the
  amount of information needed by the government!

13
First lesson of regulation

• Efficient regulation always lets the firm keep
  some economic profits. This is the only way to
  get the firm to operate efficiently and to get
  the firm to provide relevant information to the
  government.

14
Can the government commit to efficient regulation?

• The ratchet effect if the government learns
  true marginal cost today, then they might force
  you to set price equal to marginal cost tomorrow.
• The government can change the rules
• Legislation is interpreted by regulators and
  courts
• Political incentives could the Californian
  electricity crisis occur here?

15
Quality and regulation

• How do you regulate to avoid firm reducing
  quality of product to raise profits?
• e.g. reduce reliability of electricity supply
  raise probability of congestion in phone network.
• Risks of simple quality measures.
• e.g. evaluate airports by number of flights
  leaving and arriving on time.
• How do you get correct trade-off of quality
  features?

16
Summary

• All regulatory regimes set incentives
• High-powered incentives can lead to more
  efficient production and increased economic
  surplus benefiting the firm and customers
• Issues
• Can the regulator commit to the incentive scheme?
  
• Can the regulatory regime specify the key
  performance criteria?