ENERGY ECONOMICS. 28 March - 05 April MICROECONOMICS part 2

Transcription

1 ENERGY ECONOMICS 28 March - 05 April 2016 MICROECONOMICS part 2 1

2 Summary MINIMUM EFFICIENT SCALE (MES)... 3 MARKET CONCENTRATION: THE HERFINDAHL HIRSCHMAN INDEX (HHI)... 4 NATURAL MONOPOLY...5 ECONOMIES OF SCALE...5 NATURAL MONOPOLY: PRACTICE APPLICATION... 6 SUNK COSTS... 7 CONTESTABLE MARKET: subadditivity without sunk costs... 7 MOTIVATION AND GOALS OF REGULATION NATURAL MONOPOLY: STRATEGIC BEHAVIOR OF THE INCUMBENT Blockaded entry Deterred entry Accommodated entry MOTIVATION OF REGULATION: MARKET FAILURE HOW REGULATOR RESPONDS TO INTEREST GROUPS GOALS OF REGULATION NATIONAL REGULATORY AUTHORITIES

3 MINIMUM EFFICIENT SCALE (MES) We have seen earlier that the Pareto efficient amount of output in an industry occurs where price equals marginal cost. A monopolist produces where marginal revenue equals marginal cost and thus produces too little output. It would seem that regulating a monopoly to eliminate the inefficiency is easy: the regulator has to set price equal to marginal cost, and profit maximization will do the rest. Unfortunately, this may cause that the monopolist would make negative profits at such a price. The crucial factor is the size of the minimum efficient scale (MES), the level of output that minimizes average cost, relative to the size of demand. Consider the following figure where we have illustrated the average cost curves and the market demand curves for two goods. In the first case there is room in the market for many firms, each charging a price close to p and each operating at a relatively small scale. In the second market, only one firm can make positive profits. We would expect that the first market might well operate as a competitive market and that the second would operate as a monopolist. Figure 1: Demand relative to MES Thus the shape of the average cost curve, which in turn is determined by the underlying technology, is one important aspect that determines whether a market will operate competitively or monopolistically. If the MES of production is small relative to the size of the market, we might expect that competitive conditions will prevail. We can t do too much about the MES, that is determined by the technology, but economic policy can influence the size of the market. 3

4 MARKET CONCENTRATION: THE HERFINDAHL HIRSCHMAN INDEX (HHI) The Herfindahl index (also known as Herfindahl Hirschman Index, or HHI) is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them. It is defined as the sum of the squares of the market shares of the firms within the industry where the market shares are expressed as fractions. The result is proportional to the average market share, weighted by market share. Typically, it is expressed in percentages. Increases in the HHI generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite. Being q i the output produced by the i th of N firms, we can define: market share α i = q i N i=1 q i N HHI = α i 2 i=1 i = 1,, n In case of monopoly, the overall amount of output is produced by only one firm, which implies HHI = So the HHI ranges turns out to be: HHI [0; 10000] Depending on the value of HHI we have: < 1500 low concentrated market HHI = { medium concentrated market > 2500 highly concentrated market Another important parameter we can define is the concentration ratio: it is a measure of the total output produced in an industry by a given number of firms in the industry. The most common concentration ratios are the C 4 and the C 8, which means the market share of the four and the eight largest firms. Concentration ratios are usually used to show the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is oligopolistic. 4 C 4 = α i i = 1,,4 i=1 4

5 NATURAL MONOPOLY Let us consider a market with a unique homogenous product. The market is characterized by the presence of k firms, each producing an amount of product q i. The total output is then given by Q = k i=1 q i. Each firm has an identical cost function TC(q i ). According to the technological or cost-based definition of natural monopoly, a natural monopoly will exist when: TC(Q) < TC(q 1 ) + TC(q 2 ) + + TC(q k ) This is the so called subadditivity property and it is a necessary condition for a natural monopoly. If this property holds for every level of Q which is relevant for the demand on the market, the total cost function is said to be GLOBALLY SUBADDITIVE. ECONOMIES OF SCALE When a firm s average cost of production declines as its output expands its production technology is characterized by economies of scale. A cost function for a single-product firm characterized by declining average total cost over the relevant range of industry output from 0 to qi = Q is subadditive over this output range. Accordingly, in the single product context, economies of scale over the relevant range of q is a sufficient condition to meet the technological definition of natural monopoly. Now we want to demonstrate this. Assuming that the total output y is divided between two firms which then produce: o x o y-x they both face a quadratic total cost function:tc = a + bq 2 the overall total cost is given by: TC = TC 1 + TC 2 = a + bx 2 + a + b(y x) 2 = 2a + 2bx 2 + 2by 2 2bxy First of all we have to minimize the total cost, so we have to set: which leads to dtc dx = 0 x = y 2 that means that the optimum allocation is the one obtained dividing the overall production equally. 5

6 Now we want to determine the level of output for which subadditivity property holds: TC(y) 1 firm < TC ( y 2 ) + TC (y 2 ) 2 firms a + by 2 = 2 (a + b ( y 2 ) 2 ) 0 < y < 2a b On the other hand, the economy of scale holds up until the MES which can be determined as: dac dx = 0 y = a b Figure 2: comparison between MES and subadditivity NATURAL MONOPOLY: PRACTICE APPLICATION The case of natural monopoly is very important for the energy industrial sector since some of its blocks (the ones related with the networks) show these characteristics. Inputs need to be adjusted in terms of price in order to obtain the optimum level of production. In this sense we consider the total cost function as a long run cost function so that all the costs can be modified and there are no fixed costs by definition. If the market shows features of natural monopoly, we want to have only one firm. The issue is that the monopolist, being alone on the market, would set both the price and the quantity of the product. However, as we have already seen, this behavior is not Pareto efficient. So in case of natural monopoly price and quantity have to be set by an external authority which means that they are regulated. 6

7 SUNK COSTS The most important cost attribute that is not reflected explicitly in the traditional technological definitions of natural monopoly is the existence and importance of sunk costs Sunk costs are associated with investments made in long-lived physical or human assets whose value in alternative uses (i.e. to produce different products) or at different locations (when transportation costs are high) is lower than in its intended use. At the extreme, an investment might be worthless in an alternative use. Sunk costs are cost that cannot be recovered at all (e.g. painting of a flat). Therefore, disinvestments do not give back to the investors any amount of money: they represent a barrier to enter/exit the market. Sunk cost considerations are important both to explain why some industries naturally evolve to a point where one or a very small number of firms survive and to measure the social welfare consequences of the market structures in the absence of price and entry regulation. CONTESTABLE MARKET: subadditivity without sunk costs Consider a market with the following features: single product n identical firms (where n is large) all the firms have identical cost functions TC(q i ) = F + cq i cost function exhibits economies of scale over the entire range of q and thus is subadditive one of the n firms (the incumbent) is in the market and the remaining (n 1) firms are potential entrants. F is assumed initially to be a fixed cost but not a sunk cost: it is not a sunk cost in the sense that firms can enter or exit the market freely without facing the risk of losing any of these fixed costs until the production starts. If prices are not high enough to cover both a firm s operating cost and its associated fixed cost, the firm will either not enter the market or will exit the market before committing to produce and avoiding incurring the associated costs. Thus, assuming that fixed costs are not sunk costs is equivalent to assuming that there is hyper-free entry and exit into and out of this market: the fixed costs of production can be avoided by a firm that has entered the market by simply not producing any output and effectively exiting the market without incurring any entry or exit costs. We are looking for a market equilibrium that is: (a) PROFITABLE for one or more firms to enter (or remain in) the market and produce output: 7

8 p qi > TC(qi)) (b) FEASIBLE: supply and demand are in balance: Σqi = Q = D(p) (c) SUSTAINABLE: no entrant can make a profit given the price charged by the incumbent, there does not exist a price pa < p and an output Qa < D(pa) such that paqa > C(qa). At price pc and output Qc the incumbent firm exactly covers its costs and earns zero economic profit since pc = F/qc + c = ACc: Π = 0 means that the firm is able to collect capital (from the banks) and give out dividends. It is not profitable for a second firm to enter with a price lower than pc since it could not break even at any output level at a price less than pc. The incumbent cannot charge a price higher than pc (that is, pc is not sustainable) because if the incumbent committed to a higher price one of the potential entrants could profitably offer a lower price, enter the market and take all of the incumbent s sales away. Moreover, with the incumbent committing to p > pc, competition among potential entrants would drive the price down to pc and it would be profitable for only one of them to supply in equilibrium due to economies of scale. So, under these conditions the industry equilibrium is characterized by a single firm (a natural monopoly ). However, the price pc is the lowest uniform per unit (linear) price consistent with a firm breakeven (zero profit) constraint, so this price allows to just cover its total costs of production. This price and output configuration is both feasible and sustainable. Thus, the threat of entry effectively forces the single incumbent supplier to charge the lowest uniform (linear) per unit price consistent with a breakeven constraint. The following graph represents the situation obtained if we try to set a different price: Figure 3: Situation obtained trying to set a different price 8

9 Note, that even in this peculiar setting, an equilibrium with these attributes may not be sustainable. Consider the average cost function depicted in Figure 4 that has increasing returns up to point q and then enters a range of decreasing returns (perhaps due to managerial inefficiencies, as the firm gets very large). The market demand curve crosses the AC curve at the output level q a and the average cost at this output level is equal to AC a. In this case, the price that allows the single firm supplying the entire market to break even and that balances supply and demand is p a. = AC a. However, this price is not sustainable against free entry. An entrant could, for example, profitably enter the market by offering to supply q 0 at a price p 0 equal toac 0 + ε. In this case, the entrant would have to ration demand to limit its output to q 0. The incumbent could continue to supply to meet the demand that has not been served by the new entrant, but would incur very high average costs to do so and would have to charge higher prices to break even. If we assume that the entrant supplied the consumers with the highest willingness to pay, there would not be any consumers willing to pay a price high enough for the incumbent to cover its average costs. Thus, the zero profit natural monopoly equilibrium is unstable. Figure 4: Subadditivity and diseconomy of scale 9

10 MOTIVATION AND GOALS OF REGULATION NATURAL MONOPOLY: STRATEGIC BEHAVIOR OF THE INCUMBENT Considering an industry showing the features of natural monopoly, the most efficient solution is to have only one firm in the market, the so-called incumbent. If the total cost function of the incumbent includes a big amount of sunk costs (which cannot be recovered at all), then the incumbent is leaded to act strategically in order to improve its profit and so to compensate the loss caused by the sunk costs. Many different models can describe these strategic behaviors but the most important are: Blockaded entry There can be situations where there is a single firm in the market and it can set the pure monopoly price without attracting entry. The incumbent competes as if there is no threat of entry. A situation like this may emerge where economies of scale are very important compared to the size of the market and where sunk costs are a large fraction of total costs. In this case, potential entrants would have to believe that if they entered, the post-entry competitive equilibrium would yield prices and a division of output that would not generate enough revenues to cover the entrant s total costs. Therefore, in case of blockaded entry, there is no competition in the market since there does not exist any potential competitor: it represents a market failure. Deterred entry There is still no entry to compete with the incumbent, but the incumbent had to take costly actions to convince potential entrants that entry would be unprofitable. This might involve wasteful investments in excess capacity to create artificial barrier to entry or sign long-term contracts to limit the market available for a new entrant profitable to serve. Accommodated entry It is more profitable for the incumbent to engage in strategic behavior that accommodates profitable entry than to deter them. Therefore, the incumbent allows other firms to enter the market but limits the profitability of the entrants to a small amount of production. The incumbent will always hold most of the production. 10

11 MOTIVATION OF REGULATION: MARKET FAILURE Blockaded entry is just an example of market failure, which requires that an external authority, typically the government, must intervene to regulate the market in order to restore the market equilibrium. The standard normative economic case for imposing price and entry regulations in industries where suppliers have natural monopoly characteristics is that: (a) industries with natural monopoly characteristics will exhibit poor economic performance in a number of dimensions (b) it is feasible in theory and practice for governments to implement price, entry and related supporting regulations in ways that improve performance compared to the economic performance that would otherwise be associated with the unregulated market allocations. That is, the case for government regulation is that there are costly market failures whose social costs can theoretically be reduced by implementing appropriate government regulatory mechanisms. Concerning the economic performance, it can arise because of different factors: Inefficient pricing: measured by the Deadweight Loss Not optimal choice of input: the incumbent does not face any competition so it is free set investments in terms of: o Physical capital o Labor o Allocation of variable costs o Uptodate technology X-inefficiency (inefficiency in terms of production) A parte from these, the regulator can intervene to fix and control other situations such as: Income distribution inefficiency: usually the regulator aims to maximize the total surplus (minimize the deadweight loss) but in some situation the external regulation can take place to redistribute it between consumer and supplier; Essential service access (e.g. energy): some services and/or goods are essential and the regulator acts to guarantee physical and monetary access to them (they have to be both reachable and affordable) Cross subsidization: the regulator can charge higher prices to one group of consumers in order to subsidize lower prices for another group, without any loss for the incumbent HOW REGULATOR RESPONDS TO INTEREST GROUPS In case of deterred entry, the incumbent could lobby with the regulator to obtain a certain strict constraint that actually provides the firm to remain the only firm in the market. In this particular situation, the regulator authority does not respond to a problem of market failure but it responds to a pressure applied by an interest group. 11

12 GOALS OF REGULATION The regulatory authority acts pursuing some main objectives: EFFICIENT PRICING: the regulator sets p = MC like in a perfectly competitive market since it represents the most efficient way of pricing EFFICIENT COST OF PRODUCTION: the regulator creates incentives for the firm to avoid any act of inefficiency, which means optimize the use of inputs and technology EFFICIENT LEVEL OF OUTPUT & INVESTMENTS EFFICIENT LEVELS OF QUALITY: concerning electricity and natural gas industries quality is measured in number of interruption occurring since continuity is a fundamental aspect LOW DIRECT & INDIRECT REGULATORY COSTS NATIONAL REGULATORY AUTHORITIES Regulatory institutions represent a way to regulate the market. One of the tasks of the regulatory authority is about LEGISLATION: it has to translate into national laws the Directives and the Regulations issued by the European Union. (E.g. Letta Decree for liberalization of electricity market). Before the liberalization the regulator acted also on the aspect of OWNERSHIP: it instituted a specific department for a given service with the task of creating a company, owned by the government and vertically integrated which can set all the aspects related to the industry involved (price, quantity, quality). The regulatory authority composition is established by law: it is made up of three to seven commissioners (including the president) and of a staff that can include experts of many fields (engineers, accounting economists, administrative law). They are appointed by the executive power (the government and the President of the State). Each commission can decide its own procedure for making decisions; the most usual instruments are consultation process, public hearings and private meetings. Typically, the NRA involves its own stakeholders (consumers system operators, market participants, trade unions and industrial associations) in the decision proceeding through public consultation and audition, offering them a time window to give their opinion. The key point of the NRA is that it has to be independent from both government (and so any political party) and regulated company. The activity of the NRA is very complex since it has to take decisions that affect industries characterized by long lasting infrastructures. The NRA recovers its entire costs from the companies it regulates (0,03%). One principal guideline is transparency: the main legal acts are published on the official website and in a bulletin and each year, it sends to the Parliament a report regarding its activity. 12