Microeconomics and Corporate Analysis State Intervention, Public choice and Economic Regulation Lecture Slides Rui Baptista.

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