Regulation by wuyunyi



Natural Monopoly: One firm would have to produce such a large quantity
in order to realize lower costs that there is not sufficient demand to warrant
a second producer.
     Thus when economies of scale occur over a wide range of output
      levels, a natural monopoly may develop.
     The firm that first takes advantage of the persistent declining LRAC
      (long run average costs) will be able to drive out (and keep out)
      potential competitors (block entry).
          o Public utilities are examples of natural monopolies.

Socially Optimal Pricing yields allocative efficiency (competitive model)

                 P = MCLR sometimes called MC pricing (marginal cost

                      o P represents the marginal value of output.
                      o MC represents society’s opportunity costs in
                        making the good as opposed to making something

But at the socially optimal price, with persistent declining LRAC, the firm
will make loss
                  So AC pricing is used where P = ACLR also called fair
                    rate of return pricing
Case: Electricity Regulation

            Grid                                    Connected to grid
                                                    Transmission Lines

Self-generated you are the (wholesale) producer and (retail) distributor or

You enter into a contract (someone else is producer) to buy electricity in
the wholesale market to resell as a distributor to customers in the retail

Under regulation:

   1. High quality of electricity: no blackouts, brownouts, power surges, or
      interruptions of any kind
   2. P = ACLR should guarantee normal rate of return to resources (normal
           But this encourages capital expansion (embedded in long run
              average costs) as a means of attracting investors’ capital (tend
              to invest in existing technologies not R&D)
           Calculation of demand – does demand justify capital
   3. P = ACLR pricing encourages (does not discourage) cost overruns on
      capital projects
          Creates Jobs!
   4. Encourages P to increase – utilities go to Rate Commissions
           Cover costs?
           In reality P > ACLR
   5. Encourages “contrary” management incentives: not what is best for
      society or consumers
   6. Price should relate to delivering current services to customers
              Need to cross-subsidize due to requirement by government
               for universal provision of electricity e.g. Rural/urban
              Does not relate to peak/non-peak time periods: instead
               charge the same price; no incentive to efficiently utilize

Call for de-regulation
   Complaints of “too high prices” and “poor service” (not poor
   Encourage competition to lower price and improve customer service.
   Regulators were under pressure not to grant P increases
          o Access to financial capital becomes limited
          o No incentive to innovate
          o Industry joins push to de-regulate since it can’t have its way

Case: California De-Regulation
    Increased demand, use of high-tech and consumers’ homes
     “electricity gadgets”
    Under regulation, no incentive or ability to build new power plants
    Existing producers in financial trouble
    Environmentalists “not in my backyard”: no new producers

When De-Regulated: California forced utilities to sell all of their power
plants (utilities become solely distributors)
    Formed the CPE California Power exchange
          o Forced utilities to buy all power needs one day in advance; ISO
               market for last minute purchases
                   Justification (intent) was to make prices transparent
          o Froze retail prices
                   Justification (intent) to provide citizens with low priced
                     electricity (not low cost)
Effect/Reality of De-regulation

    Must buy electricity each day from the wholesale market – volatile
     price changes
    Wholesalers withheld power from the CPE to then sell at the ISO
     (much higher prices)
    Freezing retail prices: caused the utilities (now only distributors) to
     pay high wholesale prices (could not enter into long-term contracts
     with wholesalers to fix prices) and then had to sell to customers at
     much lower retail prices
        o Tremendous losses for the utilities
        o Also no incentive for consumers to “conserve” if retail prices
            are frozen.

Case PJM – runs the power grid and electricity market for the Middle
Atlantic States.

   Under de-regulation:
   1. Utilities were allowed to hold onto their own power plants (could be
      wholesale/producer and retail/distributor) or
   2. Utilities allowed to enter long tern contracts (as producers in the
      wholesale market with distributors in grid or
   3. As distributors buying from producers in the wholesale market.

       This increased competition to the benefit of the consumer
       Demand for electricity is not as great as the West
       New power plants built – no environmentalists “not in my
PJM’s Spot Market
   Buy and sell electricity for immediate consumption; over the Internet
     submit/accept bids
   Set up precautions: power producers (both public and private) must
     have enough capacity to cover all current demand plus 19% reserves
     (in Calif. Requirement was only 1.5%)
   PJM allows power producers to charge special fees for delivering
     electricity to high demand areas in the grid threatening to surpass
         o This is a form of peak-demand pricing
         o Higher profits provide incentive to build more power plants.

Case: Enron: the role of the middlemen “energy merchants”.
                Financialization of energy – creates markets
                Enron produces little power and owned little in the way
                 of hard assets (power plants and transmission lines)
                It sought to deliver just the products and services
                 particular customers wanted
                Only roughly 25% of the US retail market is de-regulated
                 (Enron needed it all to be)
                Enron is in the wholesale market
                      Under federal law, utilities and big industrial
                        customers can choose suppliers
                Enron on-line posted prices for an array of energy
                      Utilities caught short
                      Producers with excess
                      Match the two above in a contract
                      Enron pockets the spread – Enron benefited from
                        price volatility not high prices.
                      Traders were backed by back-office team that
                        scheduled pipeline and transmission capacity to
                        actually deliver electricity (to parts of the grid),
                        check credit, billing, etc.
                      Enron was the first – which was a major advantage
                        and a barrier to entry: they had established
Case: Airlines

     Regulation of the airlines
        For the welfare of consumers
        Flights should be available to and from all major cities
        Also connecting “small” flights should be available to outlying
          towns and suburbs
        Low fares, high quality service, and direct long-distance flights.

     Over time, airline travel increased (D increased)
            Regulated airline price were “too high” especially on
              commuter flights
            Too few airlines, wanted more choice, more flights
            Regulation controlled too much: number of flights,
              destinations, cities served, prices.
            Regulation forced airlines to services many routes they did
              not find profitable
                  1. Cross-subsidizing between profitable long hauls and
                      unprofitable commuters (forced to price below cost
                      even though prices perceived as “too high”

     De-Regulation not equal Competition
           Should be good for consumers: more choice, lower prices,
            increased service due to competition
           Many new airlines enter – big and small with excess
            capacity buildup (competitive model)
           BUT industry giants had many advantages
                2. And now they were free to use them!
           Price Wars waged by “existing big firms” eliminated many
            new entrants and some older less powerful competitors (so
            even “no frills” airlines could not survive)
           Major airlines wanted to drop many unprofitable flights
            (eliminate cross-subsidizing)
 Could new airlines fill-in the gaps? NO
    1. Major airlines connected cross-country flights with
        commuters on the same ticket – low price IF combine
        (had to buy both from the major)
            Drove out small competitors, no frills, etc.
            Then majors reduced the number or got rid of
               commuter flights.
    2. Creation of the Hub System
            More efficient (for airlines in their opinion) to
               use hub than have express flights
            The Hub is a series of connections utilizing
               each aircraft to the maximum
            New airport and airport expansions designed
               with the Hub in mind
            Not the most convenient or time-efficient for
               the consumer
                    i. Overbooking increased
                   ii. Lost connections and lost luggage
            Hub “gate control” by the major airlines
                    i. Airports go along with control – airport
                       are profit maximizing entities
                   ii. To build new airports you need revenue
                 iii. “commitments” from the majors for “X”
                       number of gates
                  iv. enhances major airlines market power
                   v. other lesser airlines get gate access
                       “granted” to them
     But also the major airlines periodically engage in
        price wars to try to drive each other out – financial
     Public pressure to reduce ticket prices
            In order not to decrease profits when airline
               decreases price, must cut costs
            Reduce least profitable routes
            Decrease quality of food and plane
            Overbooking increases (# passengers/flight)
 Latest is “overflighting” (booking too many
  flights for gates – cancel flights that are less

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