Class 7 Platforms and Network Industries Spring 2019 Pricing: Price Caps Randal C. Picker James Parker Hall Distinguished Service Professor of Law The Law School The University of Chicago Copyright 2014-19 Randal C. Picker. All Rights Reserved. Natural Monopoly: Production and Cost Function Available to anyone
Given by: cq + K 2/11/20 q is quantity of good produced c is the cost of producing one unit of each good (marginal cost) K is fixed cost of production A producer must pay K regardless of how much of the good is produced Idea: An entry fee to get into the business 2
Natural Monopoly: Production and Cost Function 2/11/20 A producer must pay K regardless of how much of the good is produced Idea: An entry fee to get into the business How many firms would an all-powerful social planner have? 3
Understanding Natural Monopoly Production Cost Focus: One Firm 2/11/20 Any quantity of the good can be produced at the lowest cost by having a single firm The costs of producing each unit of the good is the same regardless of the number of firms (fixed marginal cost of production) 4
Understanding Natural Monopoly 2/11/20 Two firms = two entry fees (2K) and the second entry fee is wasted We might see that this cost function creates a natural monopoly 5 Understanding Natural Monopoly Competition Focus: More than One Firm?
2/11/20 Prior example makes clear that monopolist will reduce output with deadweight loss All-powerful social planner needs to control exercise of monopoly power Does this through regulation 6 Understanding Natural Monopoly Natural Monopoly and Regulation
2/11/20 This production function provides natural basis for singlefirm situations with regulations controlling exercise of market power. 7 Natural Monopoly and Entry Situation 2/11/20
Suppose that we have one firm producing with this cost function and no regulation. Will other firms enter? Put differently, does this production function give rise to monopoly at all? 8 Natural Monopoly and Entry Answer It depends on what the entrant believes will happen Three Scenarios
2/11/20 The Tough Incumbent Price Competition Quantity Competition 9 No. 1: The Tough Incumbent 2/11/20
Entrant believes that Incumbent monopolist will slash prices to c, marginal cost, in response to entry Will E enter? 10 No. 1: The Tough Incumbent Answer 2/11/20 No, just covers marginal costs, and loses fixed cost of K 11
No. 2: Price Competitors 2/11/20 E believes and E and I will compete on price More precisely, an outcome of their interaction will be a situation in which E is happy with her price, given Is price, and vice versa. Will E enter? 12 No. 2: Price Competitors
Answer 2/11/20 Probably not. Most natural outcome of this process, called Bertrand competition, is P = c. Lowering prices slightly diverts the entire market to the seller and increases profits. This repeats scenario 1 outcome and no reason to enter 13
No. 3: Quantity Competitors 2/11/20 Switch from prices to quantities (Cournot competition) Look for an outcome in which E is happy with her quantity, given Is quantity, and vice versa. Will E enter? 14 No. 3: Quantity Competitors
Answer 2/11/20 Specify demand curve: P = a bQ End point: Firms will enter until all profits are gone (zero profits condition) 15 How many firms will enter? With cost function and demand curve, solution has form
N FE 2/11/20 a c bK bK 16 Bottom Line Duh: Answer depends on precise values But
2/11/20 Depending on competition assumptions, Bertrand v. Cournot, good chance that we will have more than one firm competing Remember, this is in a case where the lowest cost way to produce every quantity of output is by having a single firm 17 Bottom Line 2/11/20 So, key point, natural monopoly costs will not necessarily give rise to a monopoly at all
18 Evaluating Entry Are we better off or worse off as a result of this entry? Pros Cons 2/11/20 Entry buys us competition
Comes at cost of duplicative investment in fixed-cost infrastructure 19 1974 U.S. Antitrust Suit 2/11/20 20 NYT (21 Nov 1974) AT&T Breakup 2/11/20
21 NYT (4 Aug 1983) Local Exchange Carrier1 (LEC1) A long distance call is carried by IXC between customers in LEC1 and LEC2. How much does the IXC have to pay to LEC1 and LEC2 for their services in completing the call? Interexchange Carrier (IXC) Local Exchange Carrier2 (LEC2) 2/11/20
22 Natural Monopoly: Two Key Pricing Issues Above MC Pricing Loses Welfare 2/11/20 Pricing above marginal costs entails a loss of welfare. There are consumers who would be happy to pay more than what it costs to generate the next unit who will be denied access to the good. 23
Natural Monopoly: Two Key Pricing Issues MC Pricing Causes Insolvency 2/11/20 At the same time, if price is set at marginal cost, the firm loses money. It recovers only the marginal costs of production and does not recover its fixed costs. 24 Ramsey Pricing: Max Welfare Subject to Solvency
Goal Question 2/11/20 Set prices so as to maximize consumer welfare while ensuring that the firm is just solvent. How do we price in the best way while recovering the fixed costs? 25
Ramsey Pricing: Max Welfare Subject to Solvency Intuition 2/11/20 Lose less social welfare by trying to recover the fixed costs from the relatively inelastic market 26 Key Ideas
Goal Price Discrimination 2/11/20 Maximize consumer surplus subject to a solvency condition Markets are assumed to be separable (meaning that we can set different prices for different consumers) (Seniors dont buy and resell to youngsters) 27 Graphics
Demand Curves P A1 A2 C2 Demand C1 Demand Q 2/11/20 28 Using the Demand Curves
Shape of Demand Steep = Insensitive 2/11/20 Pay attention to how steep or flat the demand curve is Steep means that the consumer is not sensitive to price changes, flat the opposite Basic idea is to stick price-insensitive with fixed costs 29
The Inverse Elasticity Rule General Ramsey Formula with Linear Demands P1 MC 1 P2 MC 2 1 2 P1 P2 2/11/20 Where i is the elasticity of demand for market I
30 The Inverse Elasticity Rule 2/11/20 Elasticity of demand for a market is the percentage change in quantity divided by the percentage change in price for a given price change Gap between P and MC is where we recover fixed costs 31 Intuitions
Gross Multiplication Try Again 2/11/20 Small x big = big x small Big x small = small x big Put differently, the greater the relative elasticity of demand in
market 1, the smaller the difference should be between prices and marginal cost for that market That gap represents the extent to which the firm is trying to recover fixed costs from that market 32 Issues and Limitations Single-Part Pricing Information Limitations Technical Limitation
2/11/20 Need lots of info to implement This version assumes that there is no cross-elasticity of demand between the two markets. (Price in one market does not effect demand in the second.) 33 Issues and Limitations Fairness Limitations 2/11/20
Individuals with reduced choices may have relatively inelastic demands, and they will get stuck with a disproportionate share of the fixed costs. 34 Expected Savings from Price Caps 2/11/20 35 FCC Chair Statement (16 Mar 1989) Problems with Rateof-Return Regs 2/11/20
36 FCC Chair Statement (16 Mar 1989) Dynamic Reg Structure 2/11/20 37 FCC Chair Statement (16 Mar 1989) Price Caps v. Rate of Return Regulation Perverse or Missing Incentives under Rate of Return
Regulation 2/11/20 Utilities just pass through costs (subject to prudence); no incentive to reduce costs or innovate If utility has regulated and unregulated components, will dump costs from unreg to reg 38 Price Caps v. Rate of Return Regulation
Price Caps FCC Process 2/11/20 Set maximum price and let utility keep profits under that Commences study in 1987 Eventually sets based on rates of 1 July 1990 And then it goes on and on and on 39
Price Caps with Only One Product Hypo M, a monopolist, sells one product Regulator controls monopoly power by setting a maximum price for the product 2/11/20 We should expect M to go to the cap Not very interesting
40 Price Caps with Two Products Hypo M, a monopolist, sells two products Regulator sets a maximum price for each product 2/11/20 Same situation: expect M to set max price Not interesting still
41 Price Caps with Two Products and Trade-Offs Hypo M, a monopolist, sells two products Regulator sets a maximum price schedule for the products, allowing trade-offs between the products 2/11/20 What price does M charge for the products?
Now we have something more interesting 42 Price-Caps with Two Goods: National Rural Example First Period 2/11/20 Two Goods: A and B A sells for $1, B for $2 Faced with those prices, Consumer buys 100 units of A and 100 units of B spending $300
43 Price-Caps with Two Goods: National Rural Example Second Period Pricing Decision 2/11/20 Utility can set any prices for A and B such that at those prices, Consumer could still buy the same (100 A, 100 B) bundle for $300 44
Implementing Price Caps 2/11/20 This means that prices for A and B are given by the formula: 100 * PA + 100 * PB = 300. So set PA = 0.75 and PB = 2.25 Or set PA = 0.50 and PB = 2.50
45 Implementing Price Caps Consumer Revealed Preference and Price Caps 2/11/20 Our abstract consumer is necessarily no worse off, and perhaps better off when the utility resets its prices. 46 Consumer Welfare under Price Caps
First Period Consumer faces PA (1) and PB (2) and ultimately chooses QA (100) and QB (100) for a total expenditure E (300) This gives us a budget line equation of: 2/11/20 PA * QA + PB * QB = E 47
Budget Line: Amount consumer can purchase of each product for a given budget First Period QB 150 100 Utility Isoquant: Along a given curve, consumer is indifferent between different bundles of goods A and B. Utility Isoquant 100 2/11/20
Budget Line 300 Q A 48 Second Period: Swivel the Budget Line : Set PA = 2, PB = 1 QB What can we say about the utility of our representative consumer? 150 Gained Utility
Isoquant 100 Lost Budget Line 100 300 QA 2/11/20 49 Consumer Welfare Key Idea: Consumer at least well off and might be better off
2/11/20 Preferred original selection to lost area, so lost area irrelevant (inferior) to preserved choice from first period Might prefer new area to original choice, so not worse off and maybe better off 50 Consumer Welfare Limitations 2/11/20
Different Consumers Other price changes 51 Statutes Section 201(b) of the Communications Act (47 U.S.C. 201(b)) 2/11/20 Charges for interstate or foreign communications shall be just and reasonable
52 Statutes Section 202(a) of the Act (47 U.S.C. 202(a)) 2/11/20 Bars carriers from engaging in unreasonable discrimination, giving any undue or unreasonable preference, or subjecting persons or localities to any undue or unreasonable prejudice or disadvantage. 53 Price Caps: General Structure
General Structure PT+1 = PT * (1+g) where G is Inflation X-Factor X-Factor up for grabs 2/11/20 Originally, X-factor was 3.3%, reflecting historical productivity gains of 2.8% plus a consumer dividend of 0.5% 54
National Rural Telecom: Baskets and Bands Baskets How many budget lines will we have? 2/11/20 One: permits trade off across prices of all services provided by
the utility Two or more: limits flexibility What is this about and what should drive this? Allocation of fixed cost question again 55 National Rural Telecom: Baskets and Bands Bands 2/11/20 Streamlined review procedures for small changes in prices
Design to minimize wide swings in prices that might be allowed within the basket 56 Baskets and Bands 2/11/20 57 AT&T Price Cap Order (17 Apr 1989) Baskets and Bands 2/11/20 58
AT&T Price Cap Order (17 Apr 1989) Sharing and Price Caps Limits on Profitability Under a Price Cap Rule For specified rate of return: Keep everything if within 1% of that return Give back of profits above a return between 1% and 5% Give back all of incremental profit if exceed 5%
2/11/20 What incentives result? 59 Regulatory Menus: Choosing the X Factor Rule gave regulated firm choice about X factor 2/11/20
If choose 3.3%, 50% sharing kicked in at returns above 12.25% and 100% at 16.25%. If choose 4.3%, 50% sharing started at 13.25% and 100% at 17.25%. How should a firm choose? What will the regulators learn? 60 Regulatory Menus Theoretical Framework of Asymmetric Information
2/11/20 The regulated know things that the regulator would like to know but cannot Regulator makes screening offer, so that firms will effectively reveal information through their choices 61 Regulatory Menus 2/11/20 Think of X-Factor Choice Menu in that Framework How does the fact that the choice communicates information alter the choice itself?
62 Bell Atlantic (D.C. Cir. 1996) Actual Practice under the 1990 Price Cap Regime 1994 Revisions 2/11/20 Sharing ubiquitous
Re-evaluate original data and original methodology Toss 1984 data and keep original methods on interim basis 63 Bell Atlantic (D.C. Cir. 1996) 2/11/20 Moves from 3.3% min to 4.0% Reinitializes caps to put them going forward at the 4.0% rate Sets 4.7% and 5.3% as sharing cutoffs
D.C. Circuit blesses this 64 Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea 2/11/20 Suppose initial cap is 100 at time 0 and X factor is 3 Then at time 1, cap is 97, time 2 cap is 94, time 3 cap is 91 (ignoring compounding as the opinion does)
65 Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea 2/11/20 With reinitialization, once we learn that the X factor should have been, say, 4, we dont retroactively reset the cap to apply to the past, but we do set it going forward as if the X factor had been 4 all along 66 Bell Atlantic (D.C. Cir. 1996)
Reinitialization Idea 2/11/20 Meaning the time 4 cap isnt 88, but is instead 100 (4x4) = 84 67 U.S Tel Assn (D.C. Cir. 1999) 1997 Rulemaking
2/11/20 Abandons sharing Sets historical X-Factor of 6% and keeps 0.5% consumer productivity dividend Reinitializes price cap again, but just for 1996 68 U.S Tel Assn (D.C. Cir. 1999) D.C. Circuit Rejects
1995 1996 -2 Year 2/11/20 71 Understanding Incentives with Dynamic Regulation Issue
Regulators adjust the X-Factor in response to actual events The industry should anticipate this response How will this alter behavior? 2/11/20 Does it matter if we tie price cap change to individual firms behavior? Average firms behavior? 72 Understanding Incentives with Dynamic Regulation
Analysis 2/11/20 With ties to individual behavior, firms will likely factor regulatory response into decisions This weakens incentives of price caps to reduce costs 73 Understanding Incentives with Dynamic Regulation Analysis
2/11/20 With ties to average behavior, individual firm cant control what competitors will do, and average will largely be controlled by others (collective action problem) Individual firm should save as much as it can 74 USTA (1999) Too Many Changes?
2/11/20 The situations are somewhat similar, but the FCC adequately distinguished them. It rested its 1997 decision to limit reinitialization on the need to limit harm to LEC productivity incentives that could result from the perception that our regulatory policies unnecessarily lack constancy. 75 USTA (1999) 2/11/20
It seems clear that a second extensive reinitialization would considerably aggravate such a perception. Universal, complete reinitialization would impair the supposed incentive advantages of price capswhich derive from firms supposing that their efficiencies will not come back to haunt them. 76 TOPUC (5 Cir. 2001) and FCC Follow Up th Setup
FCC Response 2/11/20 FCC stays with 6.5%, but just as transitional mechanism no longer tied to productivity 5th Cir: No explanation for 6.5% Industry participants agreed and presented no other number 77
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