Introduction to the Economics

of Public Services Regulation

Lecture 1
Setting the stage
Antonio Estache
ECARES
ULB
Chaire Bernard Vanommeslaghe

Introduction to the Economics of Public Services Regulation 1

Overview if what well cover today
The definition and the context of regulation
A quick reminder of the basic theory on monopolies
A first look at the regulation of monopolies
How to assess the size of the problem a regulators faces?
On the diversity and evolution of the theory of regulation

Introduction to the Economics of Public Services Regulation 2

 First.what exactly is regulation?
Government regulation of an industry is
1. local, federal or state government control
2. of individual or firm behavior
3. via 3 main instruments
Prices (level and structure)
quantity (of service, environmental, safety,)
quality of goods and services produced.

E.g. setting rates for electricity service.

E.g. imposing service obligations such as the number of stops on a bus or rail
itinerary
E.g. setting emission standards for cars

Introduction to the Economics of Public Services Regulation 3

A 1st look at why public services are regulated
The main economic case for regulation of public services stems from
the concern that, without some type of government intervention,
firms operating in the market will NOT provide:
the right quantity of service
at the right quality
at the right price

This class shows what all this means in a more precise way
But also shows that regulating is not a perfect, nor easy, exercise
there is a lot of more technical and relevant stuff we will not be able to
cover
but that can be quite important for some specific industries

Introduction to the Economics of Public Services Regulation 4

Think of a few common related very practical questionsand
you will start to have a sense of the relevance of regulation
Are energy providers supplying enough electricity?
Are water providers charging too much for water and sanitation?
Are railways and telecoms companies making enough investments?
Are companies transmitting energy from electricity generators to distributors paying a fair price?
Should rich and poor consumers pay the same for water and electricity?
Should residential and non-residential pay the same for a public service?
Could quality of service be excessive?
Should environmental concerns be built in the economic regulation of natural monopolies
delivering water or energy services?
Are hospitals oversupplying health services?
Are education programs covering the right content?

WHAT would you answer to these questions?

and just as importantly, HOW would you answer them analytically?

Introduction to the Economics of Public Services Regulation 5

How would an economist think about these questions?
FIRST: look for the characteristics of the market you study
Think of how much detail on costs and of the nature of demand for the goods
and/or services your would need to know what and how to regulate
SECOND: try to figure out if and how the market fails
THIRD: If you find that the market failed in some way
=> government could have a reason to kick in
In fact, government could have many reasons to kick in when markets fail
and if thats the case, the ranking of these reasons will influence the way the government will intervene

In many instance, regulation is going to be one of the main ways in

which governments will intervene
But there again, we will see that there are various ways in which it can do
so and this will be driven by the specific ranking of government
motivations
(e.g. is a social concern more or less important than an environmental concern
and clearly, this should have an impact on how you need to assess the
regulatory performance of a government
Introduction to the Economics of Public Services Regulation 6
When and how do markets for public services fail?
Three main reasons why markets fail:
1. Imperfect competition
=> market power enjoyed by a firm will lead to misuse of resources and manipulation of demand

2. Imperfect access information by market participants, in other words: when producers

and regulators or when producers and consumers do not have access to the same
information on costs and on demand for the public service
This is labelled asymmetric distribution of information in the academic literature
Why do we care? Because there is scope for under-provision or overconsumption or any combination of these
excesses as well as risks of overcharging or offering the wrong mix of goods and services

3. Technological characteristics of production that favors limiting competition

=> case for a natural monopoly

NOTE that there are also some characteristics of some public goods or services that makes
hard to recover costs from users (public goods characteristicsthink about how to recover the
costs of building a road unless you limit access through a toll booth
Note also, that externalities (e.g. un-penalized pollution) also lead markets to fail but will not
deal with this in this course

EACH OF THESE SITUATIONS ARE RELEVANT TO THE DESIGN OF REGULATION AS YOULL

SEE IN THIS CLASS
Introduction to the Economics of Public Services Regulation 7
 The big picture on monopolies many of you
should already be familiar with (1)
2 broad types of monopolies:
Natural
Legal

Lets start with legal monopolies,

An industry enjoying a legal barrier to entry in an activity and for which there are no
close substitutes
ie. those due to
a legal decision to grant sole ownership of a resource or service to a specific actor;
e.g. an exclusive subsidized high speed train or toll highway
This concept of monopoly is more about market power than about costs structures
SO its more about competition policy than about regulation
but most of the technical tools I will teach are useful also in that context as youll see
Introduction to the Economics of Public Services Regulation 8
The big picture on monopolies (2)
What about Natural monopolies
One general definition: an industry is said to be a natural monopoly if a single firm can produce
a desired output at a lower social cost than two or more firms
NOTE: more formal models focus on sub-additivity of costs
=> clear payoffs to increasing the scale of operations of a single firm rather than sharing the
production between smaller firms
=>having many companies providing the service as in competitive markets would imply having
higher average costs (AC) than you would get from having a single provider with AC declining
with the size of production
SO whats clear is that this natural monopoly is associated with a predictable COST STRUCTURE
high fixed cost,
extremely low constant marginal cost
=>declining long run average cost (LRAC),
=> marginal cost (MC) always below LRAC.
BUT ADDED ISSUE if a monopoly prices at MC IT LOSES MONEY!
Typical examples include rail, telecoms, water, electricity, ports

Introduction to the Economics of Public Services Regulation 9

Let me remind you how to find out how a monopolist will try
to maximize its profit
2. THEN, from the D curve, find out
what P the monopolist will charge
Costs
for that Q. . . .
and
Thats point B Marginal cost
Revenue
1. To find the profit maximizing quantity Q, FIRST, look
for the intersection of MR and MC . . .(i.e. MR=MC)
Monopoly B
Thats point A
price
Long run average total cost
A (LRAC)

Demand

Marginal revenue

0 QMAX Quantity

Introduction to the Economics of Public Services Regulation 10

 So what does the monopolists profit look like graphically?

Costs
Revenue
And Price Marginal cost

Monopoly E B
Long run average total cost
Price (Pm)
(LRAC)
Monopoly
profit
Average Demand
total
cost D C
0 A Quantity
Marginal revenue
Price (Pm) is set by the point on the demand curve corresponding to the quantity (OA=DC) at which
Marginal revenue = Marginal Cost
Profit per unit sold = price (Pm= AB) minus long run average total cost (LRAC=AC) = AB-AC =BC
> Total Monopoly Profits = per unit profit * quantities sold = BC*DC
Introduction to the Economics of Public Services Regulation 11
 Note: all monopolists do not make a profit:
A monopolist making a profit vs. a monopolist breaking even
it depends on the LRAC at the quantity for which MR=MC!
Cost Cost
Revenue MC Revenue
& Price & Price
LRAC
LRAC
A
PM LRAC=PM --------------- A
Profit =>ZERO
LRAC
B profit

MR D
QM 0 QM Quantity
Quantity
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And a monopolist could actually be making a loss
this is what that situation looks like

Euros MC LRAC

LRACM B
Loss A
PM

MR D
0 QM Quantity
Introduction to the Economics of Public Services Regulation 13
Lets me remind you why imposing on a monopoly to price
at MC to achieve an efficient level of production does not
work financially when we have a natural monopoly (
without a subsidy)
If the regulator wants to push for
Euros
efficient production as under
Unregulated monopoly perfect competition (D=MC)

the monopoly would lose

money
Pm A Unless the government is willing to
subsidize the higher production
level
C
Pe
F LRATC
Pc MC
B
MR D
Qm Qc Number of
Households
Qe Served
Introduction to the Economics of Public Services Regulation
14
 The big picture on monopolies (3)
Sowhy do we worry about the natural monopoly even if it is better
than competition in terms costs for some specific industries?
BECAUSE it leads to other forms of inefficiencies if it is not
controlled
Insufficient production and excessive prices
they usually go hand and hand of course
AND the problems is that these negatives offset the gains from declining
average costs
=> Governments are worried because the country/region/city is
underproducing and/or underconsuming the goods and services
provided by these firms

Introduction to the Economics of Public Services Regulation 15

NOTE:
Most of the basic theory on natural monopolies is taught in terms of a
monopoly providing a single product
In practice, you and I know that many of the public service monopolies sell
several services or products
=> in addition to economies of scale, we need to look at economies of scope
E.g. is it cheaper to allow a single firm to provide a range of related services or should be force
an unbundling of all of these services
Think of your phone, tv and internet providerwhy is it ok to have 1 firm providing the 3 services
I will not be able to cover this in this classbut you need to be aware that
these economies of scope are part of the concern of many regulators as
well
For those of you interested, the integration of the scope and scale concerns have been
addressed through the concept of subadditivity of the cost function
And the message is stick to 1 firm, whether you are dealing with 1 product or service or
more.IF that firm can deliver these products and services at a lower costs than several firms,
no matter how you split the various goods and services between the various possible firms
If this condition is satisfied, the cost function is being said to be sub-additive and this makes the case
for a monopoly.and hence for a regulator to make sure there is no abuse!

Introduction to the Economics of Public Services Regulation 16

 Summing up the big picture on monopolies (3)
Monopolies are potentially good
If they can help cut cost because of scale economies
They help improve productive efficiency by ensuring that there is no wasteful duplication of fixed costs
without any obvious technological benefits or innovations (e.g. we dont need to have 2 parallel rail
companies running on separate rail tracks)

Monopolies are potentially bad

If they are allowed to decide on their own how much to produce and how much to charge
BECAUSE this leads to
Insufficient production and excessive prices
they usually go hand and hand of course since they are related through the demand function
which links prices to quantities
Conceptually, allowing poor pricing is allowing allocative inefficiency since allowing prices to be
above marginal costs will lead to some of the resources to be not used to maximize societys
welfare but to increase excessive profits (rents) for the operators enjoying the right to provide
the servicethats what economist have in mind when they talk about a deadweight loss

In practice, without regulation the bad is often worse than the good
=> Strong source of concern for key public services since monopolies could lead to a
country/region/city being underprovided and overcharged
Which is socially and politically just as bad as it is economically inefficient

Introduction to the Economics of Public Services Regulation 17

Whats the essence of the political problem with monopolies
If monopolies are allowed to enjoy rents (i.e. excess profits) from
their control of quantities and prices, these rents are like taxes on
society captured for private interest thanks to their control of a
service often considered to be essential
This does not suit well many the usersand voters
(even if these rents are too often supported by other actors some politicians and specific
consumer groups if they manage to get their share)
This is why some argue for public service monopolies to be public: if
there is going to be a rent, it may as well go to the state and allow the
government to cut some taxes
Well see that it is not that simple later in the class
Somehow, the political fuzz comes from a sense of UNFAIRNESS
associated with this rent
Cost savings get captured by a few and not really shared with majority of users

Introduction to the Economics of Public Services Regulation 18

 This is what drives the key questions of this course
1. WHAT-WHEN and HOW can government do to reduce
economic inefficiency associated with these sectors
(and often inequity and high fiscal costs associated with subsidies to
the sector)

2. WHAT-WHEN and HOW can government manage the social

and political risks associated with the fact that these industries
are common in public services
Well start with the efficiency concerns in this lecture
Ill deal with the social concerns more specifically later

Introduction to the Economics of Public Services Regulation 19

And as you think about what I have told you so far, you may
also want to think about the following
If the issues linking to costs and pricing are so well understood
conceptually.why is it still a problem in practice?
It turns out that:
One of the reasons why monopolies enjoy so much power in interactions with regulators
stems from the fact that these operators know more about their costs levels than their
regulator
=> they could decide to inflate their costs for instance by oversupplying quality or maintaining the assets
poorly or they could also minimize the efforts to operate efficiently since they know that the added costs
could be passed on to users or taxpayers
=> risk of cost inefficiency, in addition tor allocative and production efficiency problems!
=> WE WILL NEED TO THINK OF ISSUES LINKED TO INFORMATION ASYMMETRIES BETWEEN AN
OPERATOR AND A REGULATOR
=> Any operator can pretend to be high cost even if it is notsince this could allow a higher
price
Tempting since no competition!
And really quite easy to inflate profits by overestimating costs from an accounting viewpoint
Keep this importance of information asymmetries in mind because they will be
instrumental in a lot of what you will see later in the class, regulators need to do
to make sure the game is not systematically manipulated by operators in their
favor
Introduction to the Economics of Public Services Regulation 20
So what can governments do to minimize the efficiency loss
that would prevail under an unsupervised monopoly?
If for technical or political reasons, we are stuck with a monopoly
(e.g. natural or strategic legal monopolies)
to avoid losing the costs advantage,
what can government do to get the firm to produce as close as possible to
an economically efficient level and to charge as close as possible to a
competitive price?
Two conceivable options

1. OPTION 1 :
Keep the firm in the public sector (or nationalize if needed) to make sure
its managers do exactly as the voters and clients want (i.e. public
ownership and operation)

2. OPTION 2:
Regulate the firm to make sure it does not abuse its market power to
increase prices and not meet the demand it is supposed to address
Lets focus on this option
Introduction to the Economics of Public Services Regulation 21
If regulation is the way outuseful to get a first sense of what
regulation of a natural monopoly ultimately boils down to?
Regulation essentially requires a government agency to
dig deep into the operations of a business without
interfering abusively with the business
Regulators must be able to trace out firms marginal and average cost curves
as well as market demand curve
The regulated firms HATE IT.but unless this is done, the odds of users or
taxpayers being abused are not minor

but since information on costs and demand is imperfect,

regulating in the public interest boils down to using
imperfect information on firms to assess whether to accept
or reject their demands for prices and for returns on their
investments
sohow should a government do this?
Introduction to the Economics of Public Services Regulation 22
Keep in mind this graph as to why MC works for efficiency
but does work financially when we have a natural monopoly
( without a subsidy)

Euros Unregulated monopoly

under produces
and overcharges Efficient production is what
The slope od the would be achieved under
demand curve also perfect competition (D=MC)
mattersimagine BUT at that pointthe
different position of Pm A monopoly would lose
D and LRATC and moneywithout subsidy
think of what it
means for the size
C
of the efficiency Pe
LRATC
lossand the F
Pc MC
importance of B
MR D
regulation
Qm Qc Number of
Households
Qe Served

Introduction to the Economics of Public Services Regulation 23

 Some more intuition
If you really paid attention to the graphs earlier, you saw that
COSTs are central to everything,
How far a monopolist can go depends on how sensitive demand is
To achieve efficiency, governments need to subsidize from tax money and ensure that the producers break even with these
subsidies
But in general, governments are not keen on subsidizing as they want to be able to use the tax
money to support other activities such as education or health
Sohow can a regulator help ensure that costs are being recovered to ensure a maximum of
financial autonomy of these operators
WE KNOW FOR SURE THAT a monopolist charging at marginal cost (MC) will lose money
=> intuitively, you know that this means that you have to look for other solutions to allow the operator to
break even

KEY INTUITION I WILL GO THROUGH NEXT

=> the obvious solution for a regulator without an ability to subsidize?
come up with a regulated price that is somewhere in between the max price the
monopolist wants to charge and a price that allows the monopolist to break even
accounting for uncertainty with respect to costs and demand

=>THIS UNCERTAINTY ABOUT COSTS AND DEMAND IS SOMETHING ELSE YOU NEED TO KEEP IN
MIND AS IT WILL BE CENTRAL TO THE WAY GOVERNMENT CAN AND WILL REGULATE

Introduction to the Economics of Public Services Regulation 24

 Regulation of a Monopoly (1)
So what are the two most obvious regulatory options a regulator could consider
to allow a regulated operator to break even ?
1. Set prices = MC, .THEN SUBSIDIZE the monopoly from the general budget, to make up for
the loss
2. Set price = average costs (AC)
In practice, however, regulators in market economies around the world have
usually chosen a different solution
Regulators determine a price that gives owners a fair rate of return for funds theyve put
into the monopoly
This return is supposed to be linked to AC and allow for what economists call normal profit
Profit just high enough to cover all of the owners opportunity costs, including the foregone interest of their
own funds
What price will accomplish this?
A fair rate of return is already built into LRATC curve
So average cost pricing can be designed to lead to a faire return

Introduction to the Economics of Public Services Regulation 25

 Regulation of a Monopoly (2)
In the usual graph, with average cost pricing what happens is that
the regulators set price = cost per unit where LRATC curve crosses
demand curve
Average cost pricing is, however, not a perfect solution
It does not really make the market efficient
It provides little or no incentive for the natural monopoly to use capital
optimally
Tendency of regulated natural monopolies to overinvest in capital
This is known as the Averch-Johnson effect (after the 2 economists who explained it)
Averch-Johnson effect is a specific example of a more general idea
When a firm is not striving to maximize profit (in this case, because the government is
guaranteeing a specific rate of return)
Firm need not economize on costs

NOTE: all of this is about average pricebut price structure matters as well
See in a later lecture!
Introduction to the Economics of Public Services Regulation 26
 How should one think about the Regulation of a Monopoly (1)
So if we cannot set P=MC and then subsidize to compensate for the losswhat
can we do?
The most obvious regulatory options to allow a regulated operator to break even is to set
average price = average costs (AC)in theory

In practice, however, regulators in market economies around the world have

usually chosen what seems to be quite a different solution in practice but is
equivalent in practice
Regulators determine the average price that gives owners a fair rate of return for funds
theyve put into the monopoly
This return is supposed to be linked to AC and allow for what economists call normal profit
Profit just high enough to cover all of the owners opportunity costs, including the foregone interest of their
own funds
What price will accomplish this?
A fair rate of return is already built into LRATC curve
This strategycalled average cost pricingis the most common solution chosen by regulators of
natural monopolies
Introduction to the Economics of Public Services Regulation
27
A visual sense of the intuition on the regulation of a Monopoly:
Pe < Pr < Pm

Euros

Unregulated monopoly

"Fair rate of return" productionideal average

Pm A pricewhich is what regulation aims at

Efficient production
(requires subsidy)
C
Pr
F LRATC
Pe MC
B
MR D
Qm Qe Number of
Households
Qf Served

Introduction to the Economics of Public Services Regulation 28

How do economists think about the size of distortions?
First, lets look at the size of the efficiency that a monopolistic production could bring as
compared to a competitive one
This comes from a Measure the scope for scale economies
But this is quite technical and we will not do in this course

Second, we need to look at the size of the loss in production that will be associated with a
poorly regulated or unregulated monopoly (this is about an inefficiency in production)
This comes from the measure of by how much production should be lower than under a competitive
environment if there was no regulation and a measure of how much this would allow the monopolist
to increase prices above marginal and average costs

Third, measure by how much regulation would increase production and cut prices
Technically, when we do all this, we measure the welfare gains and losses of various policy options

So if you want to know the costs to society of not regulating or regulating poorly a monopoly
Compare the welfare gains from with and without regulation of the monopoly!
And this is something you should be able to do

Great
But how does one measure welfare again?
Introduction to the Economics of Public Services Regulation 29
 Do you remember the visuals of how economists
measure welfare in the case of competition?
In a competitive environment, the efficient
Euros/output unit output level ye satisfies p(y) = MC(y) (i.e.
price=marginal cost)
p(y)
At that point, total gains-to-trade between
CS producers and consumers is maximized.
MC(y)
p(ye)
(the price under a
PS
competitive equilibrium)
ye y
(the quantity
supplied at equilibrium)
The welfare gain from competition is the sum of consumer and producer surplus
(CS + PS)
Introduction to the Economics of Public Services Regulation 30
You really need to fully internalize the following:
The Welfare Loss from Monopolyand well coming back to this

1. A monopoly charges a higher price than a

competitive market . . .
MC(y)
Euros 3. The result is a welfare loss . . .

P(ym)
P(ye) E 4. from not producing
the efficient
quantity, at point E.

D
MR
2. and produces
a lower
quantity. ym Number of Kwh/Liters of water/Passengers
ye
Introduction to the Economics of Public Services Regulation 31
So what do we need to know to measure?
The price that would prevail under competition
Easyyou just need to know the marginal cost

The quantity that would prevail under competition

Easylets match demand and marginal cost and we get the
efficient quantity

The quantity and the price supplied by the monopolist

Thats a bit harder, because it is somewhat of a moving target
=> useful to try to figure out how monopolists pick their price and
their output level

And remember that underlying all of this is a knowledge of COSTS

Introduction to the Economics of Public Services Regulation 32
 How much does this DWL matter to society?
If small DWL (small triangle in the graph)
=>dont worry too much and let the monopolist set its prices and
quantity since it does not have a major impact

But if it is reasonably big or if it is perceived to be big (as in the case

of public services).
then you need to regulate

In practice, empirical estimates suggest that DWL in regulated

industries varies from 0.1% and 14% of GDP

This potentially strong size if what has motivated a lot of the research
on regulation
Lets review how it has evolved
Introduction to the Economics of Public Services Regulation 33
 To concludea quick review of the evolution of the main theories of regulation
PUBLIC interest theoriesthe oldest theories= TRADITIONAL THEORIES
The standard public interest or helping hand theory of regulation focus on market
failures which benevolent gvts can fix through regulation.
Ignores transaction costs, information gaps, complexity of public institutions,
incompetence of government and regulators, politics, corruption, cynicism of private
operators.

PRIVATE and SPECIAL interest theoriesthe critics of the old vision (mostly
from Chicago initially)
Focus on the non-benevolence of regulators and other government actors
Highlight multiple agenda in the demands for regulation from a diversity of actors
Concludes with the importance of limiting government opportunism and discretion

HYBRID theories (the current vision)

Built in non benevolence of public actors and their limited capacity into the design of
regulation that focuses on market failures and other concerns such as concerns for
safety, health, the environment, etc.
The modern version are quite anchored into the work that Laffont, Tirole, Baron, Meyerson and
their followers have developed to deal with uncertainty in the way the regulators can
supervise operators
Main message: incentives matterthe challenge is how to build them into the design of regulation
Introduction to the Economics of Public Services Regulation 34
 Main practical messages of more recent theories distrusting
government are:
regulation and competition policy actually generate rents operators
want to fight for and which regulators want to share with users and
taxpayers !!!
Problem 1: the rents and the associated fights distort outcomes and
users usually lose if decision makers are unaccountable
Problem 2: there are trade-offs between rents and efforts level by
the operators
=> if regulator takes too much of the rent away, operators cut efforts to
invest in long term gains for all
=> and short term losses by users may become long term losses if weak
regulators if the regulator does its job well
Problem 3: Various types of risks matter to effort and investment
incentives knowing which one matters is crucialbut not easy
Problem 4; Distributional consequences can be dramatic so politicians
have a strong view on this since it matters to reelection chances
Introduction to the Economics of Public Services Regulation 35