Embed Size (px)
DESCRIPTION
Dr. Alejandro Díaz-Bautista, Professor of Economics and Industrial Organization.Regulation and the Averch Johnson Model.
Citation preview
Industrial OrganizationDr. Alejandro Díaz-Bautista Professor of Economics and Industrial Organization
Regulation
and
Averch Johnson Model
K
L
E : effic ient p o int
F : A verc h-Jo hns o n p o int
Is o q uant fo r Q *
s lo p e = r / w
s lo p e = (r ) / w
Dr. Díaz-Bautista received his Ph.D. in Economics from the University of California Irvine (UCI). He also earned his master's degree in economics at UCI. He was also educated at UCSD and ITAM in Mexico City where he earned his Bachelor’s degree in Economics. His career has involved academics, government service and consulting for private firms.
INTRODUCTION
Regulation limits the actions of economic agents
e.g price controls, standards/qualifications, licences, sale restrictions.
Focus on regulation of ‘natural’ monopolies
usually ‘essential’ industries - telecoms, water, gas, electricity, rail. Usually publicly-owned, statutory monopolies
In last 20 years, privatisation of state-owned monopolies and liberalisation of industries.
In many industries, ‘natural’ monopoly in some sector need for regulation remains (networks).
but other sectors can be competitive, e.g. phone calls, gas supply, rail services.
Why regulate?
Focus on 2 types of market failure
(i) monopoly power: ability to charge p > MC
p > pc dwl > 0
may be excess capacity firms not at min. AC
price regulation pc (1st best)
also the aim of competition policy.
(ii) asymmetric information.
one party has more info. than another.
e.g. firm has more info re. costs, demand, technology.
rational choice not possible as true quality and/or price not known
Focus on situation where ‘natural’ monopoly exists, and there is asymmetric info.
p
competition firms can set profit max. prices, maybe subject to some constraints.
If > 0, expect entry until 0 as p min AC .
May not happen if fixed/sunk costs are large or barriers to entry exist existing firms have monopoly power.
perfect comp. is most efficient (max’s CS + PS)
Monopoly & oligopoly dwl > 0, so entry may be desirable but not feasible.
one firm serving whole market may be most efficient competition feasible but not desirable.
This is the case of ‘natural’ monopoly.
Usually high fixed costs and low marginal costs
requires homogenous good.
necessary that average total cost is decreasing over large range of desired output (ES, IRS)
IRS natural monopoly if hetero. goods (monopolistic competition)
competition duplication of costs and inability to achieve large ES
Nat.Mon. requires that prices and average costs are lower with only one firm serving whole market
i.e. sub-additivity of costs (Braeutigam p.1295)
Suppose there are n products and k firms:
Each firm can produce all n products.
Let be the amount of r produced by firm i, (r = 1,…..,n and i = 1,….,k).
Let be firm i’s output vector. in
ii yy ,.......,1y
iry
A cost function C(y) is strictly subadditive at y if, for any and all quantities of outputs y1,….,yk,
yj y, j = 1,…,k, such that ,
we have
‘An industry is a natural monopoly if, over the entire relevant range of outputs, the firm’s cost function is subadditive’ - Baumol, Panzer and Willig (1982).
subadditivity
k
1j
yy j
k
j
jCC1
)()( yy
k
j
jACAC1
)()( yy
IRS over all output levels
Profit max pricing inefficient as firm sets pm > MC
1st best p = MC < AC < 0 no prod.
Can govt. improve the situation? 4 choices.
1. set = MC but subsidise losses if fixed/sunk costs are positive
2nd best sol. as subsidy from distortionary tax.
2. Public ownership: run at a loss .
2nd best as resources could be used elsewhere.
3. Ramsey pricing: set AC 0 Q > 0
2nd best as > MC.
price set too low may prevent competition and/or innovation in long run.
p is a uniform tariff. Can improve situation by imposing non-linear tariffs,
e.g. bill-pay v ready-to-go on mobile phones
p
p
p
Introduce competition
May be desirable if markets are ‘contestable’ - requires no sunk costs, free entry/exit
p AC to deter entry (still 2nd best)
If competition within market is impossible, govt. can still ensure 2nd best solution w/o fixing prices.
Transfer firm surplus to consumers by auctioning production rights or offering franchises
i.e. competition for the market (Demsetz comp.)
If p* is lowest break-even price, firms bid p p*.
Large no of firms imply winning bid will be p p* = AC > MC (lowest cost firm wins).
Need to enforce contract may be costly - monitoring costs, unspecified contingencies
TYPES OF REGULATORY REFORM
(i) Structural change: can maintain or alter industry structure
e.g. privatise, break up monopoly horizontally and/or vertically .
(ii) liberalisation - open markets to competition.
e.g. allow entry to telecommunications industry .
(iii) conduct regulation - control market power by restricting firms actions/strategies
e.g. fixed access and product prices (telecoms), quality regulations (water, electricity supply).
to be effective, need info. re. future costs and demand
initially, focus on (iii)
In US, rate-of-return regulation.
UK has tended to use price-cap regulation.
Rate of return regulation:
Utility calculates costs and regulator sets r.o.r on capital
regulator then sets prices to ensure the firm raises enough revenue
No incentive to min. costs, price rise if r < r*.
May be solved by imposing a regulatory lag so firms keep cost savings.
r* too high (low) firms may over (under) invest in capital to make higher profits (reduce quality).
Problem of measuring capital - historical or replacement costs?
employed capital
costs total- revenue total* r
Price-cap regulation:
Regulator collects firm info. to determine revenue requirement, then sets form of price control for y years
Price regulation faces trade-off between :
(a) giving firms incentives to minimise costs.
(b) passing cost reductions on to consumers.
Optimal price regulation takes form of price-cap regulation known as
‘RPI-X’ or ‘CPI-X’
thought to give better incentives for cost reduction.
States by how much nominal prices can rise in different periods.
RPI & CPI are measures of inflation.
X denotes expected efficiency/productivity gains (real price changes) - usually firm-specific.
If RPI < X, nominal prices must fall
Expected cost reductions are passed to consumers, while firm keeps reductions > X (‘beats the cap’).
But, how does regulator decide on X?
depends on costs, future demand and productivity.
X too low (high), may high profits (loss).
If X re-set mid-term to offset high profits, may reduce future incentives to cut costs.
For multi-product firms, regulation may be imposed on average prices, e.g. Eircom.
When privatising, X likely to be set in favour of consumers.
After that, due to asymmetric info., lobbying etc., may favour producers.
RPI-X regulation more suited to industries where techno. is changing rapidly
X can be adjusted to changes in cost and market conditions
RPI - X used in telecoms and electricity industries.
RPI - X + Y used in gas industry, where Y is % increased gas costs that can be passed on to consumers, e.g. fuel.
In water industry, have used RPI + K, where K represents cost required to maintain quality standards.
Problems of Regulation
setting 1st or 2nd best price implicitly assumes that regulator and firm have same info.
Firm likely to have better info. re. demand & costs
May be costly for regulator to acquire this info.
Firm may over-state costs in order to benefit from a higher access or final product price.
Also, problem of regulatory capture.
Regulator acts in interests of firms rather than society as a whole.
Likely when regulator depends on firm for info.
may be due to lobbying, corruption.
regulator may be former employee/lobbyist of regulated firm or promised position afterwards
If asymmetric info., principal-agent theory can describe relationship between regulator and firm.
The regulator must design a regulatory policy that induces the firm to act as the regulator wishes it to.
Policy must satisfy the firm’s
(a) Participation constraint – firm’s payoff exceeds some reservation level
(b) Incentive compatibility constraint – firm will act ‘truthfully’, e.g. will not mis-state costs, choose sub-optimal effort.
The Averch-Johnson Effect
H. Averch and L. Johnson (1962) "The Behavior of the Firm Under Regulatory Constraint," American Economic Review, December 1962.
Averch and Johnson developed a model to illustrate that public regulation creates an incentive for the firm to over-invest in tangible assets. Since the "allowed profit" is based on the rate base (RB), the firm has an incentive to augment its capital stock.
Over-investment (or over-capitalization) has obvious implications for rates paid by consumers and also for the efficiency of resource
allocation.
Choose quantities of capital and labor to maximize the following profit ( ) function:
is profitR is the revenue functionK is the quantity of capitalL is the quantity of laborw is the wage rater is the cost of capital
s is the allowed rate of return
The Averch Johnson model
rKwLLKR ),( [1]
sK
wLLKR
),(subject to
[2]
Averch Johnson assumption: s > r
This would seem a logical assumption--why would the firm take positions in
tangible capital goods (like nuclear plants) if r > s?
Meaning the allowed rate of return on capital (expressed in dollars per unit of capital per time period) exceeds the cost of capital (also dollars per unit of capital is the same time interval).
Maximizing [1] subject to [2] using the Lagrangean method yields the following first order condition:
w
r
MP
MP
L
K
1
)( rs
MPk is the marginal product of capital
MPL is the marginal product of labor
is the Langrangean multiplier (a constant).
[3]
[4]
Note that:
It can be shown that > 0
We assume that s > r
Therefore, > 0The regulatory constraint in effect makes capital cheaper relative to labor and therefore induces the firm to substitute capital for labor.
Averch Johnson effect illustrated using the theory of the firm
Definitions:
•An isoquant (meaning “equal quantity”) is a collection of points giving all possible labor/capital combinations that yield the same quantity of output.
•An isocost (meaning “equal cost”) is a collection of points giving all possible labor/capital combinations that enatil the same cost.
Q = 100
Q = 300
Q = 200
Lab
or (
un
its)
Capital (units)0
Isoquants
is a labor intensive technique
is a capital intensive technique
Lab
or (
un
its )
Capital (units)0 20 25
100
Intercept = C/w = $1000/10
Intercept = C/r = $1000/50
Slope = -w/r
r = 40
Let C = wK + rK, where:
C = $1,000w = $10r = $50
The Averch Johnson Effect
0
Capital (units)
Lab
or (
unit
s)
M
M’
isoquant
E
A
Slope = -r/w
Slope = -(r - )/w
E is an efficient point
A is the Averch Johnson point
N
N’
Averch-Johnson model
minimise the firm’s earned rate of return
constraint is that r.o.r. on capital s, where s > r,and s = R(K,L) - wL - sK 0.
Hence, firm’s problem is:
FOC’s
rKwLLKR ),(
),(),(max,,
LKRwLsKrKwLLKRLLK
efficiency
wL
R
cyinefficien1
)(
rrsrK
R
investment-over KK MCVMP
Features of “Old Style” Utility Regulation
Vertically-integrated power companies enjoy regional monopolies but are subject to regulation by state commissions.
State commissions use the “revenue requirement” model to establish electricity rates.
Regulated utilities subject to minimum capacity requirements.
Revenue Requirement Model
ErRBRR )(
RR is the “revenue requirement”
RB is the rate base—an estimate of the value of owners’ investment in the regulated firm.
r is the “allowed rate of return” to owners’ investment.
E is expenses (fuel, wages, etc.)
Electric deregulation is really about the vertical separation of the three
stages of production—or the creation of a multi-
market industry.
Deregulation California Style
Formerly integrated utility giants (Cal. Edison, Pacific Gas & Electric) retain distribution monopoly but required to sell off generating and transmission assets.
Utility companies get $28 billion in “stranded costs” financed by a “competitive transition fee.”
Distribution monopolists subject to rate regulation by California Public Service Commission
Distribution companies must purchase power “spot” on the “power exchange”—no forward contracts allowed.
Independent system operator (ISO) created to manage transmission.
Generation transformed into a competitive industry
Independent System Operator (ISO)
•Operates the transmission grid
•Power generators have access to the grid on equal terms.
•Subject to regulation by California Public Service Commission and FERC
13.922003
13.412002
13.302001
10.422000
10.111999
10.091998
10.061997
9.981996
9.941995
10.231994
First year under new regime
Average Retail Electricity Prices in California (cents per kilowatt hour)
Source: California Energy Commission
Energy “speculators” (several employed by
Enron) took advantage of these unique aspects
of electricity and “rigged” the wholesale
market.Important aspects of electricity
•Inelastic demand
•Non-storable
•Capacity limits on transmission
Regulatory reforms are generalized worldwide
Utilities are concerned Airline Telecommunication Railways Energy: electricity and gas
Liberalization that is inducing potential or effective competition
The position of the European Commission is to abolish any monopoly which is not a " natural monopoly "
Liberalization cannot be a simple transition to free competition because of market failures …
A specialized ex ante regulation is necessary to offset the natural inclination of electricity sectors to become oligopolies
Reaching this aim implies: creating conditions of a real competition between suppliers, to guarantee efficiency & independence of the network operators to allow a fair partition of the productivity gains yield by the
competition between suppliers
Why integrated monopolies before ?
Nationalizations after World War II
Safety of supply and energetic independence
Public integrated monopoly as a tool for energy policy planning
Spatial planning and rural electrification
Internalization of double or triple marginalization (… competition before)
Managing natural monopolies: AC > MC, cost sub-additivity
Drawbacks of monopolizationDead-weight losses: prices are too high
X-inefficiency: incentives to invest or save costs are too low
If ROR regulated : over-capitalization (Averch-Johnson effect)
Inefficient and unfair cross-subsidization between multi-activities
Inefficient regulation in presence of asymmetric information (costs): (too much?) rents are left to informed monopolies
Why competition from now?Because of European treaties … law consistency over EU
Because of OMC … Globalization
Because of competition is related to freedom of choice (philosophical)
Because of the drawbacks of monopoly structures
Because of the rewards of competition, namely final prices may decline
Promoting efficiency, innovations ….
Vices and virtues of pure and perfect competition (1)
Pure and perfect competition Little and numerous agents: firms & consumers (atoms) Price cannot be manipulated Neither information nor quality etc ..
“Welfare Theorems” and Smith Invisible Hand Pure Competition leads to economic welfare where prices are
close marginal costs Any Efficient Allocation (Paretian) can be achieve by means of
competitive market mechanisms
Vices and virtues of pure and perfect competition (2)
Market failures Public goods, services … utilities
this is the case for electricity
Externalities … such as pollution (negative) or network connecting (positive)
Non Convexities (natural monopolies)
In presence of market failures, P&P competition is not a “first best” Other mechanisms can be more efficient …. Public intervention, regulation can be justified one of those.
Electricity as a public utilityPublic utilities in 5 features
their consumption is divisible, unlike pure public goods they are essential goods for which a minimal service is neededthey generate demand externalities (club effect), costumer’s satisfaction is generally increasing w.r.t. the number of costumers connected to the networkthey generate supply externalities which implies that a large number of costumers makes the supply profitable they are subject to congestion risks (externalities)
market failures are expected
What type of competition?Under wholesale competition, generators compete to sell electricity to
the grid.
Under retail competition, suppliers compete to supply electricity to end-users.
Retail competition can be introduced through different mechanisms.
In one, multiple power generators have direct access to the transmission and distribution networks, allowing them to compete to supply final customers regardless of their location and who owns the wires.
In another model, independent retail service providers buy power from generators, contract for use of transmission and distribution facilities, and sell the power to the final customers.
Questions already solved What type of vertical organization ?
Totally free competition ? Regulators Competition authorities
P
D
T
The old paradigmThe integrated firm
A new scheme : separate firms (sometimes with privatisation)
P
D
T
P P
D D
F F F F F F
Competition
Competition(supply)
Natural monopolyTPA
Local monopolies
(generation)
What type of organisation?Reference: Paul Joskow, MIT, 2003,
US Industrial Organisation
Generalized liberalization is designable
Is this design naturally leading to perfect competition?
Can power competitive markets be pure and perfect ?
Production, Generation: wholesale spot markets could be perfect if ISO is benevolent and omniscient and if operators cannot develop strategies, but electricity is not storable …
Distribution: perfection is quite difficult to obtain because markets are geographically segmented (concessions), but distribution may be viewed as a transmission network continuation … in natural monopoly
Supply and Commercialisation:a change in management and operation of a utility to make it similar to a commercial enterprise and subject to corporate laws. Most countries view commercialisation as an intermediate step towards privatization and other reforms.
Imperfect competition is expected
Drawbacks of imperfect competition
• P&P competition is a ideal benchmark
• Competition is not pure, firms try to develop market power that is charging prices (or designing tariffs) greater than marginal costs..
• Imperfect competitive markets (private monopolies, oligopolies…) are not “first best” (British Pool evidence)
• Bertrand paradox (price wars) is not always true (OMEL evidence)
• Collusion, predation or anticompetitive behaviours can arise …
Corrective regulation is then needed (antitrust laws…)
Burning issues arising with the liberalization
Transportation as a natural monopoly
Designing wholesale electricity markets
Universal Service Obligations (USO)
Long Term Investments in competitive settings
A move toward “global competition” logic
Transportation as a natural monopoly (1)
Third Access Party because transportation-distribution network are essential facilities (in the sense of Sherman act), and duplicating fixed costs is sub-optimal
Now, regulated TSO are in charge of this TAP (informational-based inefficiencies are remaining)
TSO are often unbundled from historical monopoly. How and why introduce competition within this segment? Vertical and juridical separation Auctioning for allocation ….
An independent public-owned firm ?
Unbundling/Restructuring: a change in the structure of the power sector. Unbundling involves the separation of a vertically integrated electric utility into legally and functionally distinct firms providing separate generation, transmission, distribution and retail services. England and Wales and Chile pioneered unbundling models in the 1980s. Since then, countries that have separated or are in the process of separating generation, transmission, and distribution assets include Argentina, Australia, New Zealand, Poland, Sweden and the United States.
Transportation as a natural monopoly (1’)
Transportation as a natural monopoly (2)
Pricing of the Transportation TAP
If TSO is not independent (w.r.t incumbent) and the access negotiated, ECPR pricing (a=AIC+Opp.C) is foreclosure-proof but leaves protected rents to the incumbent …and entry is then less efficient
If TSO is independent, the optimal access tariff a is regulated and obeys to the «Faulhaber-Sharkey rule» (1982) ; a must lie between AIC and SAC (bypass logic=fair tariff).
Transportation as a natural monopoly (3)
Nature of tariffs
• Point-wise pricing (distance-based):• impossible for electricity (not for gas)
• Pricing « entry-exit » or « nodal » related to injections et withdrawals (UK or PJM)
•Objective: maximizing collective surplus s.t. non saturation of grid lines•High transaction costs•Fixed costs not recovered•In short run, increases scarcity in under-capacity zones.
• Uniform pricing so-called « single ticket »•often adopted for electricity•simple to use because of Kirchhoff laws•Less efficient then nodal price•Particular case of nodal price
Transportation as a natural monopoly (4)
Two other issues about TAP tariffs
• Fixed cost allocation: • Pricing using a two-part tariff, where fixed part allows fixed cost recovery• Costumer screening in then achieved by indirect interpersonal price discrimination, fixed part is increasing for “big” costumers, but variable part is low.
• Temporal evolution. • Cost-plus (ROR) vs price-cap (RPI-X) • Price-cap => declining prices expected • Hybrid price cap with double-cap price and profit (sliding scale or profit sharing)
• e.g. in France:
Designing wholesaleelectricity markets (1)
Over The Counter markets: Free market with bilateral contracts with brokers as intermediaries
Power Exchange (spot): (dominant) supply and demand meet on an organized and anonymous market NordPool, Powernext, EEX
Pool: mandatory market where total supply meet demand, w.r.t. merit order English Pool until April, 2001 Californian Power Exchange PX until 2001 crisis Pennsylvania, New Jersey, Maryland model Spanish OMEL
Designing wholesaleelectricity markets (2)
Those markets are designed to implement P&P competition but some problem arise
Collusion among few players and repeated “games” (everyday)e.g. English Pool evidence in 2001Re-introducing OTC (NETA in UK) can mitigate collusion but also create foreclosure conditions
Foreclosure by vertical integration or restraintse.g. downstream-integrated private generators could enter and manipulate intermediate price (RRC argument)
Designing wholesaleelectricity markets (3)
Capacity
Needed capacity on the network (10 to 10:30 a.m.)
Kwh price (10 to 10 :30 a.m.)
• Incentives to restrain capacity and make the SMP rising (uniform auctions effect)
• Market volatility implies financial counterparties (forwards, swaps, options…)
Long Term Investments in competitive setting
Loyola de Palacio : «Europe should begin to build a power plant every week to avoid the risks of breakdown»
With competition, investment decisions are decentralized and not coordinated
Strategic withholding are possible (capacity restraints)e.g. California evidence
Moreover with privatizations, short term objectives (profitability and financial rating) contrast with necessary planning objectives
Liberalization impacts (1)Prices are declining indeed
Liberalization impacts (2)
UK case (D. Newbery 2003)
Prices are declining indeed
Liberalization impacts (3)Entries are observed ….But are they all efficient ?(hit and run)
Liberalization impactsEntrant market shares are increasing
Evolution of buys and sales of EDF competitors
-5 000
0
5 000
2001
_09
2001
_10
2001
_11
2001
_12
2002
_01
2002
_02
2002
_03
2002
_04
2002
_05
2002
_06
2002
_07
2002
_08
2002
_09
2002
_10
2002
_11
2002
_12
(GWh)
Export
losses
blocks sites
Sales sites
Import
VPP
generation
Wholesale
PowernextInjections (buys)
withdrawals (sales)
Reference: CRE, France
Stakes for companies on the market• Integrate the market logic: thinking profitability & strategically• Guarantee the security of supply• Manage Income volatility• Target customers: tariff discrimination
Companies are looking for ways :• To reduce uncertainty, thus risks borne,• To maximize their profit (that is : reduction of costs borne to save margins)• To enhance competitiveness of their services and aggressive pricing (commercial stake)• Increasing firm value (for shareholders)• Competition gives opportunity to pursue pro-active or defensive strategies.
Standard Business
Liberalization and companies strategies:
• Retail Pricing and Discrimination: competing in price (or market share) • Product differentiation: green, brown, white electrons, commercial services, competing in products
• Capacity investments: competing in installed Kph
• Mergers and Acquisitions: competing through the financial structure
• R&D and innovation races: technological competition
• Sustainable development of firms: competing in customer’s goodwill
Liberalization:Managing Strategically
Example: Pricing Strategies
Willingness-To-Pay-basedAccurate pricing adapted to costumer’s load profile (ex. Poweo)
Vertical discrimination: pricing according to quality of supply Pricing for «switch-off costumers»
Horizontal discrimination: pricing according to consumer preferences, green and non green costumers (ex. EdF Option «équilibre»)
A dimension of change in the electricity supply industry
Privatisation: a change from public to private ownership of existing electricity sector assets. The electricity industry is typically one of the last ones to be privatised, because it is considered to be vital for the functioning of the state.
Privatising is not a fatal consequence of the liberalization, it is still a political and social choice (and a saving argument)
From an organizational point of view, privatising is a commitment: liberalization could not be renegotiated (at a lower cost)
Expected costs of privatization = social mainly but also economic in case of bankruptcy
Liberalization1.Relative price increase for non eligible (cross-subsidization)
2.Massive redundancy after privatisations (U.K.)
3.Concentration and apparition of new private monopolies with market power
4.High volatility in the values of privatised firm share (bankruptcy risk)
5.Vertical Integration and foreclosure
6.Price volatility and incertitude qui penalize capacity investment
7. Asymmetric information promote speculative strategies on spot markets
8. Market failure is costly for taxpayers
1.Price decline for eligible (in short run)
2.Productivity gains
3.Communication efforts from operators towards costumers
4.Industrial restructuring (M&A mainly) leading to more efficient firm
5.Fiscal returns for State budget through privatisations
6.Prices become good signals (internalising extern effects)
7.Regulation penalizes anticompetitive behaviours
8.Electricity becomes a commodity
VICESVERTUES
Investment: the Averch-Johnson effect
Firm chooses capital K and labour L to maximise = R(K, L) – wL – rK
where R = revenue fn, w = wage rate, r = cost of capital allowed rate of return on capital [R(K, L) – wL] / K = s assume allowed rate of return s > r
Solution: where
m = Lagrange multiplier (shadow value of s) (0, 1) efficient production requires MPK/MPL = r /w regulated firm over-invests in capital: “gold plating”
Regulatory response: “used and useful” test
w
αr
MPL
MPK
0
1
m
rsm
Industrial OrganizationDr. Alejandro Díaz-Bautista Professor of Economics and Industrial Organization
Regulation
and
Averch Johnson Model
K
L
E : effic ient p o int
F : A verc h-Jo hns o n p o int
Is o q uant fo r Q *
s lo p e = r / w
s lo p e = (r ) / w
Dr. Díaz-Bautista received his Ph.D. in Economics from the University of California Irvine (UCI). He also earned his master's degree in economics at UCI. He was also educated at UCSD and ITAM in Mexico City where he earned his Bachelor’s degree in Economics. His career has involved academics, government service and consulting for private firms.
