Dr. Alejandro Díaz-Bautista, Professor of Economics and Industrial Organization

Industrial Organization Dr. Alejandro Díaz-Bautista Professor of Economics and Industrial Organization [email_address] Regulation and Averch Johnson Model 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 > p c  dwl > 0 may be excess capacity  firms not at min. AC price regulation   p c (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.

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.

A cost function C( y ) is strictly subadditive at y if, for any and all quantities of outputs y 1 ,…., y k , y j  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

IRS over all output levels Profit max pricing inefficient as firm sets p m > 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 . 2 nd 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

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?

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 profit R is the revenue function K is the quantity of capital L is the quantity of labor w is the wage rate r is the cost of capital s is the allowed rate of return The Averch Johnson model [1] 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: MP k is the marginal product of capital MP L 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,  > 0
The 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 Labor (units) Capital (units) 0 Isoquants    is a labor intensive technique  is a capital intensive technique

Labor (units) 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 = $1,000 w = $10 r = $50

The Averch Johnson Effect 0 Capital (units) Labor (units) M M ’ isoquant E A Slope = -r/w Slope = -(r -  )/w E is an efficient point A is the Averch Johnson point N N ’

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 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

First year under new regime Average Retail Electricity Prices in California (cents per kilowatt hour) Source: California Energy Commission 13.92 2003 13.41 2002 13.30 2001 10.42 2000 10.11 1999 10.09 1998 10.06 1997 9.98 1996 9.94 1995 10.23 1994

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

Economic foundations of the transition European Directive Member states A SUCCESSFULL OPENING in FOUR PRINCIPLES
Access to consumers
Progressive extension of eligibility, More fairness ….
Access to the transmission network
That is implement an efficient TPA: Transparent and non-discriminatory
Access to the power
More electricity, more services
Access to flexibility Spot markets development, short term contracts …
Market

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 monopolization
Dead-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 utility
Public utilities in 5 features
their consumption is divisible , unlike pure public goods
they are essential goods for which a minimal service is needed
they generate demand externalities ( club effect ), costumer’s satisfaction is generally increasing w.r.t. the number of costumers connected to the network
they 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
The old paradigm The integrated firm A new scheme : separate firms (sometimes with privatisation) P D T P D T P P D D F F F F F F Competition Competition (supply) Natural monopoly TPA 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’)

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 ).

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

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 wholesale electricity 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

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 2001 Re-introducing OTC ( NETA in UK ) can mitigate collusion but also create foreclosure conditions
Foreclosure by vertical integration or restraints e.g. downstream-integrated private generators could enter and manipulate intermediate price (RRC argument)

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

Prices are declining indeed
UK case (D. Newbery 2003)

Entries are observed ….
But are they all efficient ? (hit and run)

Liberalization impacts
Entrant market shares are increasing
Reference: CRE, France
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
Powernext
Injections (buys)
withdrawals (sales)

Liberalization and companies strategies:
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: Managing Strategically
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

Example: Pricing Strategies Willingness-To-Pay-based
Accurate 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

Liberalization
Relative price increase for non eligible (cross-subsidization)
Massive redundancy after privatisations (U.K.)
Concentration and apparition of new private monopolies with market power
High volatility in the values of privatised firm share (bankruptcy risk)
Vertical Integration and foreclosure
Price volatility and incertitude qui penalize capacity investment
Asymmetric information promote speculative strategies on spot markets
Market failure is costly for taxpayers
Price decline for eligible (in short run)
Productivity gains
Communication efforts from operators towards costumers
Industrial restructuring (M&A mainly) leading to more efficient firm
Fiscal returns for State budget through privatisations
Prices become good signals (internalising extern effects)
Regulation penalizes anticompetitive behaviours
Electricity becomes a commodity
VICES VERTUES

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

Industrial Organization Dr. Alejandro Díaz-Bautista Professor of Economics and Industrial Organization [email_address] Regulation and Averch Johnson Model 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.

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Dr. Alejandro Díaz-Bautista, Professor of Economics and Industrial Organization Presentation Transcript