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February 23, 2005

Regulation of Natural Monopolies;: P=MC or P=AC?

I've been teaching the subject of public utility regulation this past week. There are two ways to regulate an industry which is a natural monopoly, with economies of scale (decreasing average cost):

1. P=AC. Set the price to equal the average cost.

2. P=MC, Subsidy. Set the price equal to the marginal cost. The firm will then have operating losses, so make up for that with a subsidy. . . .

. . . Method 1 is what is most commonly used in the United States, and is the basis for "rate of return regulation".

A third method, government ownership, is similar to method 2, with the disadvantage of government's usual operating inefficiency but the advantage that it is harder for someone to make money off it if the government is corrupt. So let us stick to methods 1 and 2.

A problem for both methods of regulation is that it is hard to estimate what the company's costs should be. If the company can charge P=AC, or if it can get a subsidy to make up losses, it has no incentive to keep costs low, and it does have an incentive to make costs appear to be higher than they really are.

Somehow it seems as if this should be a more severe problem for Method 2: that there would be a greater risk of government failure if the government is allowed to give a yearly subsidy than if it merely allows the firm to charge a high price. I have not been able to pin down the source of that feeling, though, and maybe it is wrong.

A definite advantage of Method 1 is that it prevents the firm from operating at all if efficiency requires it to be shut down. Some natural monopolies could not survive as unregulated firms, because even the monopoly price yields negative profits. Those firms should certainly shut down, if value maximization is our goal. Under Method 1, such a firm would be allowed no more than the monopoly price, and so would shut down as it ought. Under Method 2, the government might mistakenly give the firm too large a subsidy, and keep it in operation. We see that frequently, as with "Essential Air Service".

But even that argument has one chink in it. It can happen that a firm might not be able to survive as an unregulated monopoly even though it should for maximizing value. That would happen if the monopoly price yields a negative profit, but also yields a consumer surplus greater than that negative profit. Then, the problem is that the firm cannot extract all the surplus from its operation, as it would be able to if it could perfectly price discriminate.

So I am left slightly uncomfortable with the standard prescription of P=AC.

Posted by erasmuse at February 23, 2005 07:56 PM

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