Theory of Natural Monopoly and Its Control

I. What is natural monopoly?

II. The pricing problem: rate levels

A. P = MC B. P = ATC

Next topic: The economics of multiple prices

Note: This week’s lectures will be extremely theoretical. The political and administrative side are well covered by Greer, chapter 14. We need to know BOTH views.

Theory of Natural Monopoly and its Control

I. What is natural monopoly?

A. Long-run average cost that decreases

as the output rate increases.

B. Temporary v. permanent

C. Subadditivity

1. Economies of scale

2. Economies of scope

3. Economies of vertical integration

D. The “sustainability” problem

Theory of Natural Monopoly

II. The pricing problem: rate levels

A. P = MC

1. Implications for efficiency

2. What to do with the loss?

a. Is subsidy warranted?

b. Incentive problem

c. Should nonusers (taxpayers) pay?

Natural Monopoly II. Rate level

B. TR - TC = 0; Price = ATC

1. Relation to the standard regulatory model

2. Welfare loss

3. Incentive problems, again

C. The general regulatory framework:

1 Profit limitation, which implies

2. Revenue adequacy, which implies

3. Cost recovery ===> TR = VC + sK.

C. “Nonlinear” pricing

1. Relation of quantity and expenditure

2. Two-part tariff

3. Declining-block tariff

The Economics of Multiple Prices

Prologue: Economics and Politics of Regulation.

I. Price discrimination, revisited.

A. Price discrimination without regulation.

1. Example: AIDS drugs for southern Africa

2. Example: discounted air fares.

3. Competitive concessions and

the Robinson-Patman Act.

4. Moral: discrimination v. restriction

Economics of Multiple Prices

I. B. But is it discrimination? Cost element.

C. “Third degree” discrimination

1. Requirements

a. Pricing power

b. Separate markets

c. Different elasticities

2. Result: MR1 = MR2 = MC

Economics of Multiple PricesI. Price discrimination, revisited

D. Prices and elasticity

1. Under profit maximization

2. Under “Ramsey pricing”

E. Some regulatory vocabulary:

1. Cost of service vs. value of service

2. FDC vs. marginal cost

3. Value-of-service pricing

Economics of Multiple Prices

I. Price discrimination, revisited

F. Output-related discrimination

G. When regulation requires discrimination.

1. Cross-subsidization of favored users.

2. Uniform prices when costs aren’t equal

3. A way to pay those fixed costs?

Economics of Multiple Prices

II. Cross-subsidization

A. Strict definition

B. Cross-subsidization in the unregulated context:

1. Pricing of related products.

2. A weapon of predation?

Economics of Multiple Prices

II. Cross-subsidization

C. Why regulation may require it

1. “Fairness”

2 “Entitlement”

3. Relation to political power

D. The efficiency problem

E. ALL cross-subsidization is price discrimination, but .....

Economics of Multiple Prices

III. Peak-load pricing

A. The basic peak-load problem

B. System load and marginal cost.

C. Who pays for peak capacity?

D. Is marginal-cost pricing feasible?

IV. Discrimination vs. peak pricing--it’s sometimes hard to tell the difference.