Economic Foundation. Dr. Christoph Stork. Monday, 2 July 12

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1 Economic Foundation Dr. Christoph Stork

2 Introduction Purpose of this lecture is to place competition policy and regulation in its economic context Regulatory requirements and the need for a competition policy depends on market configuration A perfectly competitive market does not need any outside interference Not all markets are competitive and they might be inefficient if unregulated We need to understand: Efficiency Limits of regulation Instruments of regulation

3 Table of Contents Theory of the Firm Demand and Supply Definitions of Efficiency Market Failure The Natural Monopoly & Social Obligations Theory of Regulation

4 Theory of the Firm

5 Theory of the Firm Firms convert factors of production (land, labour, capital and knowledge) into goods and services Firms usually intend to make profit in the short-term, medium-term or long term (exceptions are Section 21 companies) Firms are better equipped than governments to produce goods and services in most cases since they are trading with their own capital and not public funds - incentive structure towards efficiency A Firm s interest (profits) and public interest (consumer protection, prices) often differ

6 Perfect Competition Assumptions: There are many sellers There are many buyers Firms sell homogeneous goods and services Firms and consumers can freely enter and exit the industry (no barriers to entry or exit) Consumers and firms have perfect information There are no transaction costs There are no externalities in production and consumption (water and air pollution etc) In such a world neither a competition policy nor a regulator would be needed Valuable as a benchmark but not very realistic

7 Perfect Monopoly Assumptions: There is only one seller in the market There are many buyers in the market The Firm s product is unique and has no close substitutes The firm only chooses one price There are barriers of entry to the industry There is asymmetric information No pressure/incentive to deliver best quality at lowest possible prices Prices usually based on costs - therefore usually too high since there are no incentives to cut costs *Monopsony = Only one purchaser of a good or service

8 Monopolistic Competition Assumptions: There are several firms Products are differentiated There are no barriers to entry or exit Typically large number of firms offering slightly different products (potato chips, TVs, cars) Firms can reduce competitive pressure by, e.g. branding and product differentiation Firms cannot make excess profits since that would attract new competitors and erode prices and profits

9 Oligopoly (few suppliers) Suppliers: Factors determining bargaining power of suppliers and the price sensitivity of the firm include Size and concentration of suppliers Firm s switching costs Ability to backward integrate Customer power: Size and concentration of buyers Firm s costs to develop new markets, Ability to forward integrate (buy the distribution channel e.g.) Threat of new entry: Economies of scale Access to distribution channel Government and legal barriers Threat of substitutes: Buyers propensity to substitute Relative price performance of substitute

10 Demand and Supply

11 Cost Terms Average Cost Total cost / goods produced Price may be lower than average cost due to marginal cost pricing Average cost will vary in relation to the quantity produced unless fixed costs are zero and variable costs constant Total Cost Total economic cost of production: variable + fixed costs Marginal Cost Change in total cost that arises when the quantity produced changes by one unit May change with volume, at each level of production, the marginal cost is the cost of the next unit produced MC = TC Q

12 Demand Price P0 Q0 D0 Quantity

13 Change in Demand When people change the quantity they demand at given price Change in price of another good Substitutes: Taxi or municipal bus; Ster Kinekor or DVD rental Complements: DVD and DVD players, Cars and Petrol Disposable income changes Economic growth Recession Expected future prices: buy now before too expensive... Change in number of demanders in Market: Example Fax...network effects Change in preferences: Music CD...iPod

14 Increase in Demand Price P1 P0 Q0 Q1 D0 D1 Quantity

15 Supply Price S P0 Supply schedule - more supply at higher price Q0 Quantity

16 Change in Supply Change in prices for factors of production (Cost) Labour Raw material Electricity... Expected future prices: more supply if high prices for good is expected Number of producers (increasing competition) Changing Technology (production) Firms want to max profits: (P-C)*Q

17 Change in supply Price Decrease in supply at given price (increase in factor cost...) S1 S0 S2 P0 Increase in supply at given price (lower production cost...) Q1 Q0 Q2 Quantity

18 Price as regulator in the market Price Demand schedule - less demanded at higher price S Supply schedule - more supply at higher price D Quantity

19 Price as regulator in the market P0 Price S Supplier cannot sell all they produced at initial price, they will hence reduce price in equilibrium D=S Qd Qs D Quantity

20 Consumer Surplus Pchris Price Demand curve as WTP curve Expenditure: P* x Q* consumer value placed >= price Chris surplus: Pchris - P* x Qchris P* Qchris Q* D Quantity

21 Producer Surplus Price S P* PMTC Producer Surplus Revenue: P* x Q* MTC s surplus: P*-PMTC x QMTC Price >= Cost Q* Quantity

22 Consumer & Producer Surplus Price S P* Consumer Surplus Producer Surplus At equilibrium price: Consumer Surplus + Producer Surplus = Maximum Q* D Quantity

23 Regulating prices

24 Regulated Price: if price floor is higher than equilibrium... Price S PF P* D QFD Q* QFS Quantity

25 Regulated Price: if Price Cap is lower than equilibrium... Price S P* PC D QCS Q* QCD Quantity

26 Tax Impact (Consumer pass through) Price P+0.5 t P* P-0.5 t lost consumer surplus Q t Q* S D lost supplier surplus Quantity t=p d- P s P d =new equilibrium price for consumers P s =new equilibrium price that firms receive Total Tax Revenue=Q t *t

27 Monopoly Behaviour Price/Cost P m Consumer Surplus loss to economy P c Abnormal Profit D MC Q m Q c Quantity

28 P= MC Price/Cost Willingness to pay exceeds cost of production Deadweight loss (DWL) to society P 1 P* Cost of production exceeds price (DWL) MC P 2 Q 1 Q* Q 2 D Quantity

29 Definitions of Efficiency

30 Pareto efficiency No individual can be made better off without another being made worse off Ensuring that nobody is disadvantaged by a change aimed at improving economic efficiency makes sense However, it may require compensation of one or more parties Problem: Pareto efficiency does not require an equitable distribution of wealth

31 Kaldor-Hicks efficiency An outcome is more efficient if those that are made better off could in theory compensate those that are made worse off and which leads to a Pareto optimal outcome Every "Pareto improvement" is a "Kaldor-Hicks improvement, however not every Kaldor-Hicks improvement is a Pareto improvement Situation 1: Person A has $10 and Person B $100 Situation 2: after policy change Person A has $20 and Person B $99 Not a Pareto improvement since Person B is now worse off But Kaldor-Hicks improvement since Person A could theoretically pay Person B anywhere between 1 and 10 dollars to accept this alternative situation

32 X-efficiency If a firm is producing the maximum output it can given the resources it employs and the best technology available it is said to be x-efficient Under conditions of perfect competition there will be no x-inefficiency because if a firm is less efficient than the others it will not make sufficient profits to stay in business in the long term

33 Allocative efficiency Allocative efficiency is the market condition whereby resources are allocated in a way that maximises the net benefit attained through their use Situation in which the limited resources of a country are allocated in accordance with the wishes of consumers A firm is allocatively efficient when its price is equal to its marginal costs (P = MC) in a perfectly competitive market If a market is not Pareto efficient, then it cannot be allocatively efficient (ie someone can still be made better off without someone been made worst off) However, it is possible to have Pareto efficiency without allocative efficiency When a market fails to achieve allocative efficiency and resources are not allocated efficiently, there is said to be market failure

34 Distributive efficiency Goods and services are received by those who have the greatest need for them Based on the law of diminishing marginal utility Poorer people will gain more utility from money for additional spending than the wealthy

35 Productive efficiency Highest possible output of one good, given the production level of the other good(s). Output produced at minimum cost possible No wastage, efficient choice of inputs Structure of industry such that any scale opportunities are exploited Firms make optimal investments in cost reduction

36 Best Outcome: Perfect Competition Competition between a large number of firms: Drives price down to marginal cost Causes inefficient firms to exit the market and efficient ones to remain Provides incentives for firms to invest in cost reduction

37 Worst Outcome: Private Monopoly Maximise their profit by pricing above cost Incentive to reduce costs depends on the contestability of the monopoly (public monopolies not contestable) Other market structures: cartels try to act like a monopolist Many believe the degree of competition is related to the number of firms which is not always true

38 Market Failure

39 Public goods Consumed jointly or communally with everyone else Domestic security: police External security: National defence Parks Roads Public schools Telecommunication networks???

40 Externalities Third party benefit or cost from an economic decision (pollution, neighbour upgrades his front garden) Social benefit or cost differs from the private benefit or cost Private decisions give a result different to the social optimum Usually resolved through taxes and or subsidies

41 Pollution Externalities Price/Cost P* P D Social MC Private MC Q* Q Quantity

42 The Natural Monopoly and Social Obligations

43 Natural Monopoly One firm can produce a desired output at a lower social cost than two or more firms Fixed costs are high relative to variable costs (railways, telecommunications, water, electricity, mail delivery) Creates conflict between productive and allocative efficiency Productive efficiency requires a single firm A single firm will price like a monopoly causing allocative inefficiency Case for price and entry regulation - restrict entry to get productive efficiency and control price to prevent monopoly abuse Changes in either technology or demand can change natural monopoly status (e.g. telecoms)

44 Social Obligations Market often fails to provide for: uneconomic areas - high cost areas (uniform pricing - low population density) uneconomic customers - low-income uneconomic services - overall loss-makers (public payphone) Rationale for social obligations: Social benefits exceed private benefits Political decision groups without access are harmed by lack of access Ultimately a political and budgetary decision on what level of universal service to provide and to whom What level of telecoms connectivity is appropriate and affordable?

45 Theory of Regulation

46 Objectives of Regulation Promote universal access to basic telecommunications services Foster competitive markets to promote: efficient supply of telecommunications services good quality of service advanced services, and efficient prices Prevent abuses of market power Create a favourable climate to promote investment to expand telecommunications networks Promote public confidence in telecommunications markets through transparent regulatory Protect consumer rights, including privacy rights Promote increased telecommunications connectivity for all users through efficient interconnection arrangements Optimize use of scarce resources, such as the radio spectrum, numbers and rights of way

47 Tools of Regulation Price Regulation (Wholesale & Retail): Rate of Return / Price Caps Entry control: Various types of licences with various powers and obligations Vertical disintegration (e.g. AT&T) Legislative prohibition: eg rules compelling operator to provide interconnection and governing the provision of that interconnection (Unbundling of network components) Transparency: Prescribing cost accounting procedures and requiring operators to publish prices of products for usage baskets

48 Producer & Consumer Surplus Price/Cost Consumer Surplus (difference between willingness to pay and price) P Producer surplus (abnormal profits) Q D MC Quantity

49 Regulator prescribes cost based termination rates: Impact of Information Asymmetry Price/Cost Producer profits from information asymmetry DWL from information asymmetry P 1 MC high P 2 D MC low Quantity

50 Dynamic issues in Regulation Regulatory lag: A lag between rate reviews = incentives for cost reduction under rate of return regulation, more profit... Ratchet effect: The use of information on past profits in deciding future price caps lowers incentives in price cap regulation Operator might act contrary to regulators objective : Lowering the quality of access to the network (delay upgrades that allow rival to offer new services, degrading rival quality) Increasing their access price to the network (refusing to unbundle network components, require rivals to get interface equipment) Denying access to the network altogether (arguing that no spare capacity, tech choice that favours own operations) Tying: Monopolist can make sale of regulated service dependent on purchase of unregulated service. This permits pricing above MC on unregulated service as tie prevents competitive entry

51 Conclusion

52 Conclusion Fixed line telephony has been seen traditionally as a natural monopoly Technological change means that it is no longer so Wireless and fixed-wireless are alternative technologies with different fixed cost- variable cost mechanics Nature of industry is such that high investments are required and there will only be few players Hence the need to regulate the industry to protect consumers and the investments of operators

53 Exercise Work Groups: Identify segments of the telecommunication sector that are competitive, oligopolies and monopolies Particular: Mobile Telephony ADSL Leased Lines Fixed-line Telephony Call termination ISPs (Internet Service providers) International voice services