Microeconomics and Corporate Analysis

Microeconomics and Corporate Analysis

State Intervention, Public choice and Economic Regulation

Lecture SlidesRui Baptista

The Economics of Government Intervention: Objectives

• Knowing what kinds of activities the public sector engages in, and how these are organised

• Understanding and predicting, insofar as possible, the reasons for intervention and the full consequences of intervention

• Evaluating alternative policies

Positive vs. Normative Economics

• Positive Analysis describes the operation

of markets and the consequences of

government intervention

• Normative analysis makes judgements on

the design and desirability of economic

policy

Welfare Economics

• Economics measures Welfare in terms of Efficiency, not of Equity

• Two Fundamental Theorems:– Markets with competitive conditions lead to

efficient resource allocations;– Any efficient allocation of resources can be

obtained by means of a decentralised market mechanism

Consumers’ and Producers’ Surplus

Q

P

S = MC (Q)

D = P(Q)

A

BPA

PB

QA QB

A’

B’

Welfare Loss from Monopoly

AC

MC

DMR

PM

PPC

P

M

M

C

M’

Types of Market Failure

• Natural Monopoly

• Public Goods

• Externalities

• Incomplete Markets

• Information Failure

• Merit Goods

Reasons for Government Failure

• Consequences of intervention are hard to foresee

• Private incentives of legislators

• Action of special interests groups

• Bureaucracy

• Costs and decreasing returns associated with the tax system

Pure Public Goods

• It is not desirable (or efficient) to ration their use: the marginal cost of having one more consumer is irrelevant;

• It is difficult or impossible to ration their use: once a unit of the good is provided, it is impossible to exclude individuals from enjoying it and, therefore, impossible to charge a price

Impure Public Goods

• Exclusion is feasible, so it is possible to charge a price

• Social costs are different from private costs, so private provision might not be efficient

• Questions of regional and social equity associated with public provision

Provision of an Impure Public Good

SMC

Bridge CapacityD

Ppr

Ppb

Qpr Qpb

A

C B

P

Q

Publicly Provided Private Goods

• Exclusion is feasible and it is possible to charge a price equal to the marginal cost

• Social benefits are greater than private benefits, so private provision is not socially efficient

• Public and private provisions can co-exist

• Questions of regional and social equity

Provision of a Semi-Public Good

Ds

Ppr

Ppb

Qpr Qpb

A

C

B

MC

Dp

P

QpbQpb Q

Externalities

• The economic activity of an individual/firm has an impact on the costs and/or benefits of other individuals/firms

• Private costs/returns are different from social costs/returns, leading to inefficient resource allocations

• Some externalities are associated with the use of scarce resources

Pollution Externality

QQmQmQe

D

SMC

Spr=PMC

P

Externality Associated with the Use of Scarce Resources

Cost of a Boat

Marginal Social Return

Average Return to a Boat

Output per Boat

Number of BoatsQmQe

Solutions to Externalities

• Internalisation by private forces

• Corrective taxes

• Subsidies

• Regulations

Corrective Tax on Pollution

QQmQmQe

D

SMC

Spr=PMC

P

A

BC

E

Pm

Pe

F G

Public Regulation Theories

• Public Interest theory

• Capture Theory

• Economic Theory

Natural Monopoly: Equilibrium

AC

MC

D

MR

M

C

R

QPCQRQM

PPC

PR

PM

P

C’

ACPC

Q

R’

State Ownership vs. Regulation

Reasons for State Ownership

• Strategic social ownership

• Planning of key sectors

• Availability of services

• Income redistribution

Reasons for Privatisation

• Increases cost efficiency

• Better management

• Stock market pressure

• Entry threat

Gains from Privatisation

MCS

ACS

ACP

D

P

Q

P

S

PS

Pp

QS QP

Regulation of Natural Monopoly

• “Public interest” regulation aims at achieving a second-best solution where price equals average cost

• A regulated firm has an incentive to modify its internal behaviour according to kind of regulation it faces

• There are asymmetries of information between the regulated firm and the regulatory agency

Rate of Return Regulation

• The firm is allowed to earn no more than a “fair” rate of return on its capital investment

• The regulated firm will choose a higher capital-labour ratio than it would without regulation, thus being internally inefficient

• It is not certain that output will increase, and it will never reach the second-best level

• If the regulator sets the maximum rate of return below the cost of capital, the firm will shut down

• Under any type of rate of return regulation, the regulated firm will always over-utilise the rate base

Internal Efficiency under Rate of Return Regulation

L

K

-w/r

(K/L)*

Q*1

Q*2

Q*3

C3

C2

C1

-w/r

A

B

C

L

K

(K/L)*

Q*1

Q*2

-w/rTRSR

A*

B*AR

BR

(K/L)R

Price Cap Regulation

• The regulator sets a maximum price for the market, called the price cap; the firm can set a price equal or below this one, and is able to retain all profits

• The regulator might specify that the price cap will be adjusted over time by a pre-announced adjustment factor that is exogenous to the firm - for instance some form of general price index (RPI-X)

• At long intervals, the price cap is reviewed by the regulator and possibly changed, considering the profits, cost and demand conditions

Price Cap vs. Rate of Return Regulation

MCU = MCPC

MCROR

ACU

ROR = PC

Q

P

QSBQROR = QP

PSB

PROR

(=P)

Barriers to Entry and Limit-Pricing

ACLR

DI

DC

PL

PM

Q

P

QM QL

Multi-Product Natural Monopolies: Ramsey Prices

• The design of prices involves balancing the welfare losses across product markets as prices deviate from marginal cost

• The price structure will be dependent both on the cost structure of the firm and on the different demand functions faced in each market

• Cross-Subsidisation occurs when the profits made in some markets subsidise losses made in others

• The marginal loss to consumers resulting from a price increase from the welfare optimum point should be equal across all markets

Ramsey Pricing

Di

Dj

MC

A

P

P’

Qi , Qj

Pi , P,j

I J

QA QiQj

I’ J’

Cross-Subsidisation, Entry and the Cream-Skimming Problem

ACM

ACE

PM

QEQM Q

P

PE

DM

DE

PL

Vertical Break-Ups, Competition and Market Efficiency

Arguments for Break-Up

• Economies of scale in generation are more limited than in distribution

• Unlike distributors, it is possible for generators to store energy and inputs

• Distribution has been broken up into regional networks, thus creating a market for generators

Arguments against Break-Up

• Uncertainty associated with equipment failures, fluctuations in input prices and demand

• Exhaustion of scale economies in generation might not be enough to guarantee a truly competitive market

• Incentives for large investments hindered by opportunistic behaviour

• A firm joining different stages in the vertical chain will have a wider

technological knowledge