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Microeconomics and Corporate Analysis
Microeconomics and Corporate Analysis
State Intervention, Public choice and Economic Regulation
Lecture SlidesRui Baptista
The Economics of Government Intervention: Objectives
• Knowing what kinds of activities the public sector engages in, and how these are organised
• Understanding and predicting, insofar as possible, the reasons for intervention and the full consequences of intervention
• Evaluating alternative policies
Positive vs. Normative Economics
• Positive Analysis describes the operation
of markets and the consequences of
government intervention
• Normative analysis makes judgements on
the design and desirability of economic
policy
Welfare Economics
• Economics measures Welfare in terms of Efficiency, not of Equity
• Two Fundamental Theorems:– Markets with competitive conditions lead to
efficient resource allocations;– Any efficient allocation of resources can be
obtained by means of a decentralised market mechanism
Types of Market Failure
• Natural Monopoly
• Public Goods
• Externalities
• Incomplete Markets
• Information Failure
• Merit Goods
Reasons for Government Failure
• Consequences of intervention are hard to foresee
• Private incentives of legislators
• Action of special interests groups
• Bureaucracy
• Costs and decreasing returns associated with the tax system
Pure Public Goods
• It is not desirable (or efficient) to ration their use: the marginal cost of having one more consumer is irrelevant;
• It is difficult or impossible to ration their use: once a unit of the good is provided, it is impossible to exclude individuals from enjoying it and, therefore, impossible to charge a price
Impure Public Goods
• Exclusion is feasible, so it is possible to charge a price
• Social costs are different from private costs, so private provision might not be efficient
• Questions of regional and social equity associated with public provision
Publicly Provided Private Goods
• Exclusion is feasible and it is possible to charge a price equal to the marginal cost
• Social benefits are greater than private benefits, so private provision is not socially efficient
• Public and private provisions can co-exist
• Questions of regional and social equity
Externalities
• The economic activity of an individual/firm has an impact on the costs and/or benefits of other individuals/firms
• Private costs/returns are different from social costs/returns, leading to inefficient resource allocations
• Some externalities are associated with the use of scarce resources
Externality Associated with the Use of Scarce Resources
Cost of a Boat
Marginal Social Return
Average Return to a Boat
Output per Boat
Number of BoatsQmQe
Solutions to Externalities
• Internalisation by private forces
• Corrective taxes
• Subsidies
• Regulations
State Ownership vs. Regulation
Reasons for State Ownership
• Strategic social ownership
• Planning of key sectors
• Availability of services
• Income redistribution
Reasons for Privatisation
• Increases cost efficiency
• Better management
• Stock market pressure
• Entry threat
Regulation of Natural Monopoly
• “Public interest” regulation aims at achieving a second-best solution where price equals average cost
• A regulated firm has an incentive to modify its internal behaviour according to kind of regulation it faces
• There are asymmetries of information between the regulated firm and the regulatory agency
Rate of Return Regulation
• The firm is allowed to earn no more than a “fair” rate of return on its capital investment
• The regulated firm will choose a higher capital-labour ratio than it would without regulation, thus being internally inefficient
• It is not certain that output will increase, and it will never reach the second-best level
• If the regulator sets the maximum rate of return below the cost of capital, the firm will shut down
• Under any type of rate of return regulation, the regulated firm will always over-utilise the rate base
Internal Efficiency under Rate of Return Regulation
L
K
-w/r
(K/L)*
Q*1
Q*2
Q*3
C3
C2
C1
-w/r
A
B
C
L
K
(K/L)*
Q*1
Q*2
-w/rTRSR
A*
B*AR
BR
(K/L)R
Price Cap Regulation
• The regulator sets a maximum price for the market, called the price cap; the firm can set a price equal or below this one, and is able to retain all profits
• The regulator might specify that the price cap will be adjusted over time by a pre-announced adjustment factor that is exogenous to the firm - for instance some form of general price index (RPI-X)
• At long intervals, the price cap is reviewed by the regulator and possibly changed, considering the profits, cost and demand conditions
Price Cap vs. Rate of Return Regulation
MCU = MCPC
MCROR
ACU
ROR = PC
Q
P
QSBQROR = QP
PSB
PROR
(=P)
Multi-Product Natural Monopolies: Ramsey Prices
• The design of prices involves balancing the welfare losses across product markets as prices deviate from marginal cost
• The price structure will be dependent both on the cost structure of the firm and on the different demand functions faced in each market
• Cross-Subsidisation occurs when the profits made in some markets subsidise losses made in others
• The marginal loss to consumers resulting from a price increase from the welfare optimum point should be equal across all markets
Vertical Break-Ups, Competition and Market Efficiency
Arguments for Break-Up
• Economies of scale in generation are more limited than in distribution
• Unlike distributors, it is possible for generators to store energy and inputs
• Distribution has been broken up into regional networks, thus creating a market for generators
Arguments against Break-Up
• Uncertainty associated with equipment failures, fluctuations in input prices and demand
• Exhaustion of scale economies in generation might not be enough to guarantee a truly competitive market
• Incentives for large investments hindered by opportunistic behaviour
• A firm joining different stages in the vertical chain will have a wider
technological knowledge