The regulation of industry

24 November 2008

• Recall the problem of natural monopoly. When the technology of production

is subject to increasing returns to scale, for production efficiency, there should
be just one firm undertaking the entire production of the market. But an
unregulated monopoly would choose to produce at too low an output level
to meet allocative efficiency. For full efficiency to be attained, some sort of
regulation on the operation of the monopoly seems imperative.

• In figure 1, the unregulated monopoly chooses to sell Qm units at price P m

instead of Q∗ at price P ∗ − the efficient price—quantity pair. But regulating the
firm to sell Q∗ units at price P ∗ would bankrupt it sooner or later.

• A compromise is to make the firm sell at a price under which it just breakevens,
at where P = AC. Output is closer to the efficient level. Consumers pay a
lower price. Indeed Frank Ramsey in about one century ago showed that under
the constraint that the firm’s profit is non—negative, the efficient price is at
P = AC. This is often known as Ramsey pricing.

• Full-efficiency, at least in theory, is attainable. Previously we argued that if

the monopoly is allowed to collect a fixed fee from each consumer, the rev-
enue collected can be used to cover the loss from selling at P = MC. If each
consumer pays the same fixed fee but buys different quantities, each consumer
pays a different effective unit price. This “two—part” tariff is one possibility
the monopoly can choose from to price discriminate. The all knowing, fully—
informed monopoly may choose to altogether first-degree price discriminate and
also sell up to Q∗ units of output. In general, allowing the monopoly some kind
of price discrimination, output can expand from Qm and tends closer towards
Q∗ . There is just no need for any regulation to force the firm to expand out-
put above Qm . With the freedom to price in whatever manner it sees fit, the
monopoly is in its self—interest to do just that.

• It may not be desirable to allow the monopoly to price discriminate where the
price discrimination transfers real income from consumers to the monopoly,

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 Figure 1: A natural monopoly

however. Some variant of Ramsey pricing is probably both a viable and just
alternative. The actual implementation is far from trivial though. In reality, the
regulator is almost never well informed enough on demand and cost conditions
in the market to judge what the Ramsey price should be.

• At P = P r = AC, the firm’s economic profit is equal to zero. There could be

a positive accounting profit, equal to the normal returns on investment; i.e.,
the opportunity cost of employing the fixed assets in the given market. Thus
instead of directly regulating the firm to charge the Ramsey price, perhaps
an equivalent regulation is to allow the firm to earn an accounting profit that
corresponds to the zero economic profit. but not more.

1 Rental rate of capital equipment

• Before proceeding further, it is useful to first digress to a discussion on the
rental rate of capital.

• Suppose that, at time t, a firm buys a unit of capital equipment at a unit price
equal to pk (t) . Then it leases out the capital equipment at a unit rental of u (t)
for just one period and sells it immediately afterwards at price pk (t + 1). While
the unit of capital is in use during the given period, it depreciates at the rate

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 δ. If (capital) market is perfect,

1−δ
pk (t) = u (t) + pk (t + 1) ,
1+r
where r is the (risk—adjusted) interest rate. Rearranging,

1−δ
u (t) = pk (t) − pk (t + 1)
"
1+r #
1 − δ pk (t + 1)
= pk (t) 1 − .
1 + r pk (t)

If we write p (t + 1) /p (t) = 1 + θ (t), where θ (t) can be thought of as the rate

at which the price of capital equipment increases during period t,
" #
(1 − δ) (1 + θ (t))
u (t) = pk (t) 1 −
1+r
r + δ − θ (t) + δθ (t)
= pk (t) .
1+r
Since 1 + r ' 1 for small r and δθ (t) ' 0 for small δ and/or θ (t), we have

u (t) = pk (t) (r + δ − θ [t]) .

This is the equilibrium rental rate of capital equipment. At any other amount,
there will exist arbitrage opportunities.

• Now imagine that a firm owns a piece of capital equipment and chooses to keep
it for its own use for at least the current period of time. But the firm could
have leased out the piece of equipment in return for a rental income of u (t) .
Thus the (opportunity) cost of employing a unit of capital equipment for the
current period is simply the amount u (t) . Of course if the firm does not own
the piece of equipment in the first place but has to rent it from the market, it
pays exactly the amount u (t) as the rental.

2 The Averch—Johnson effect of rate of return reg-

ulation
• There are two inputs to production, capital K and labor L. The production
function is Q = f (K, L) . The monopoly’s profit is

π = P (Q) Q − wL − uK,

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 where P (Q) is the inverse demand curve, w the wage rate and u the rental rate
of capital equipment. To express the profit function in terms of just K and L,
we write
π = R (K, L) − wL − uK, (1)
where R (K, L) = P (f [K, L]) f (K, L) is the monopoly’s revenue as a function
of the two inputs. Imagine that the firm owns all the capital equipment that
it employs. The expenditure on capital input, the term −uK in (1), is not an
out—of—pocket expense. but rather an implicit (opportunity) cost. The firm’s
accounting profit is
πa = R − wL.
The returns on investment, as is commonly understood by accountants, regu-
lators, and just about everybody else, except students of economics, is given
by
πa R − wL
= .
pk K pk K
If economic profit shall be equal to zero,
R − wL uK u
= = = r + δ − θ.
pk K pk K pk

• To force Ramsey pricing then is to allow the monopoly a return on investment

(in the accounting sense) equal to the risk—adjusted interest rate, and further
augmented by physical depreciation and asset price appreciation, respectively.
In reality, there was almost never such a scientific approach to regulation in
figuring out the appropriate returns to investment to be allowed. Often, the
regulated rate of return was simply set equal to the returns on investment
in “similar” industries. Free of competition, real or potential, the regulated
monopoly faces quite a bit less risk than firms in the so—called “similar” indus-
tries. If the firm is allowed to earn up to the rate of returns on investment in
other industries, it is making a windfall, risk—adjusted.

• A further undesirable effect of ROR regulation is that it tends to encourage

the monopoly to overuse capital input. If the firm’s allowed profit is a fraction
of the value of its capital stock, investment in capital equipment relaxes the
constraint on the profit allowed, in addition to raising productivity. The firm’s
incentives to invest could be distorted upward as a result.

• Roughly speaking, the effective rental rate for capital input is brought down
with a ROR regulation. If one effect on the firm’s operation of adding a unit
of capital is that the firm’s profit rises by the amount spk , the firm’s effective
rental rate falls below u. At each output level, the lowering of the relative price
of capital input induces the firm to choose a higher K/L ratio. Further, the

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 lowering of the absolute level of the effective rental induces the firm to employ
a larger absolute amount of capital input.

• Suppose that it has been decided that a fair rate of return is equal to s. That
is, the monopoly’s accounting profit as a fraction of the value of its asset must
not exceed s,
R (K, L) − wL
≤ s. (2)
pk K
If s < u/pk , then π < 0. The monopoly would choose to exit. A s = u/pk
corresponds to the case of π = 0. There is still a positive (normal) return to
investment equal to u/pk = r + δ − θ. In the following we assume s > u/pk .

• The monopoly’s objective is to maximize profit (eq. [1]) subject to the rate of
return constraint (2) . The Lagrangian function is

L = R (K, L) − wL − uK − λ (R (K, L) − wL − pk Ks) . (3)

Taking foc and assuming an interior solution,

∂R
= w, (4)
∂L
∂R λ
=u− (spk − u) , (5)
∂K 1−λ
R − wL − spk K = 0. (6)
Further if the constraint (2) is binding, λ > 0. In any case, eqs. (4) − (5)
is a system of three equations in three unknowns: {K, L, λ} , the solution of
which represents the monopoly’s profit—maximizing input (and therefore) out-
put choices.

• Suppose there were no rate of return regulation. That is, there is no constraint
to the monopoly maximization. In this case, (5) simplifies to
∂R
= u. (7)
∂K
Divide (4) by (7),
∂f (K, L) /∂L w
= , (8)
∂f (K, L) /∂K u
where
∂R ∂P (Q) ∂f (K, L) ∂f (K, L)
= f (K, L) + P (Q)
∂L ∂Q ∂L ∂L
" #
∂f (K, L) ∂P (Q)
= f (K, L) + P (Q) ,
∂L ∂Q

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 ∂R ∂P (Q) ∂f (K, L) ∂f (K, L)
= f (K, L) + P (Q)
∂L ∂Q ∂K ∂K
" #
∂f (K, L) ∂P (Q)
= f (K, L) + P (Q) .
∂K ∂Q

Eq. (8) is the familiar “M RT S equal to the ratio of factor price” condition for
cost—minimization. In maximizing profit, the monopoly chooses to minimize the
cost to produce the given output. In so doing, production efficiency obtains.

• But where the constraint is binding, (8) – the condition for efficiency would
no longer be met. In particular, if λ < 1,
λ
u>u− (spk − u) ,
1−λ
and therefore
∂f (K, L) /∂L w w
= λ > .
∂f (K, L) /∂K u− 1−λ
(spk − u) u
Holding output constant then (along the given isoquant), the rate—of—return—
regulated monopoly would operate at a higher MRTS than an unregulated
monopoly would choose to operate at. If a higher MRTS shall be associated with
a higher K/L ratio, the regulated monopolist overuses capital input relative to
labor input.

• The conclusion just reached hinges on the presumption that λ < 1. Must this
restriction hold? But by (3) ,

∂L
= λK.
∂ (spk )

When the ROR constraint is binding, L = π, and therefore

∂π
= λK. (9)
∂ (spk )

The amount spk K is the accounting profit allowed under the ROR regulation.
If the ROR constraint is binding, for each unit increase in spk , accounting profit
would rise by
∂π a
= K.
∂ (spk )
But if accounting profit rises by K, economic profit must rise by a lesser amount
given that economic profit is accounting profit minus capital rentals (uK) .

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 Figure 2: Capital intensity and ROR regulation

• While the ROR regulation would lead to a heavier usage of capital input holding
output constant, output is not likely to remain unaffected in the interim. To
study the full effects on capital usage, we start with the unconstrained profit
maximization, whose solution is a pair {K0 , L0 } given by (4) and (7) . Write
R (L0 , K0 ) − wL0
= s0 .
pk K0
If the actual allowed s ≥ s0 , the constraint has no effect on the input (and
output) choices of the monopoly. On the other hand for s < s0 , the constraint
is binding; for each value of s, the constrained profit—maximizing input choices
is a list {Ks , Ls , λs } that solves (4) − (6). Differentiating (6) ,
à ! à !
∂R ∂Ls ∂R ∂Ks
−w + − spk = pk Ks .
∂L ∂s ∂K ∂s

Substituting from (4) and (5) ,

∂Ks pk Ks
= < 0,
∂s u − spk
for s > u/pk . Say we start with s = s0 . The constraint just binds. In this case
Ks = K0 and Ls = L0 . As s falls from s0 , the constraint begins to exert real

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 effects on the firm’s input choices. Where ∂Ks /∂s < 0, the decrease in s leads
to an increase in Ks . The ROR—regulated monopoly chooses to employ more
capital inputs than an otherwise identical unregulated monopoly would choose
to do so. This is known as the Averch—Johnson effect, which has received wide
empirical support.

3 The capture theory of regulation

• The existence of large economies of scale was used to justify the regulation in
traditional public utilities, such as electricity, gas, and telecommunications, in
addition to public transportation. But why did regulation spread to markets
in which economies of scale of any kind were not present at all? Why, for
example, did the government choose to set up legislation to restrict entry into
many professions (and output thereof), that includes for instance medicine,
accounting, law, and engineering? The usual argument of course is that these
are highly skilled professions and the general public need to be protected against
incompetent practitioners. But what about financial planning and analysis,
actuary, real estate brokerage, insurance sales, beauticians, night watchmen,
and taxi operators! In HK, among tens of thousands of building contractors,
large and small, only ten are licensed to handle materials containing asbestos.
While asbestos are definitely hazardous, the techniques to safely dismantle and
dispose such materials can be easily mastered by any semi—skilled workmen.

• George Stigler first suggested that regulation is supplied in response to interest

group lobbying pressure to protect the group from competition. Sam Peltzman
expanded on Stigler’s theory by suggesting that legislators select regulatory
policies that maximize the legislators’ political support. Interest groups provide
votes, fundings, and other resources to the legislators. In turn, the legislators
provide support in the form of wealth transfers to the interest groups that
provide the most votes and resources.

• To formalize Peltzman’s argument, suppose there are n firms in an industry

that benefit from regulation. Assume:

1. Regulation results in a wealth transfer of T from consumers to the n firms.

2. The cost of organizing firms to lobby is an increasing function C (n) of the
number of firms n. It is more difficult and costly to organize a large group
than a small group.
3. The incentive for consumers to lobby against regulation increases with the
number of consumers affected and in the intensity of consumers’ feelings.

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 Given these assumptions, the net benefit/firm is equal to

T − C (n)
B= .
n
Differentiating,
∂B −∂C/∂n × n − (T − C [n])
= < 0,
∂n n2
if T − C (n) ≥ 0. A major implication of the analysis is that regulation tends
to benefit small, well—organized groups with large gains from the regulation at
the expense of unorganized groups whose individual members are only mildly
affected by the regulation.

• Occupational licensing also nicely illustrates the Stigler/Peltzman theory. Pro-

fessional organizations of all sorts have been able to convince the government to
establish licensing regulations and to then allow the professional organizations
to set the licensing rules themselves. It should come as no surprise that these
self—imposed regulations often make entry difficult and result in high incomes
for those already licensed.