Problem Set Partial Done

8/10/2019 Problem Set Partial Done

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EC337 Industrial Economics 2 Department of Economics, University of Warwick

Market Economics, Competition and Regulation

PROBLEM SET 1

Answer all the questions in the space provided insert your answers electronically or by hand. Uponcompletion upload your document as a pdf file and submit it to the Undergraduate Office via the

MyEconomics Information ortal. !he ma"imum mar# for each question part is shown. Submission

deadline: before midnight on Wednesday 29 October 2014.

1 !"e followin# $uestion deals wit" elements of t"e %elt&man private interest t"eory of re#ulation

model discussed in 'ecture 2 (ssume a re#ulator ma)imi&es itswelfare* w"ere ceteris paribus

a lower price it re#ulates in t"e market results in "i#"er welfare and allowin# "i#"er profit for t"e

re#ulated firm also results "i#"er welfare (ssume t"at t"e re#ulated firm+s profit is a function of

t"e re#ulated pricepand its cost tec"nolo#y type $w"ic" is one of two values* $%or $&and $%

$&for any #iven output level

a -"ow in a dia#ram t"e nature of t"e optimal solution for .ot" re#ulated firm cost

types 1 mark

Answer

!"e optimal solution for a re#ulation occurs w"en t"e profit function ' f(p)c* is tan#ential to t"e

iso/political support function In ot"er words, t"e politician will lower t"e price to #ain consumer votes

until t"e mar#inal vote #ain e$uals t"e mar#inal power loss from dissatisfyin# consumers 0ot" of

t"ese functions are as follows


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M2 M1

P1 P2

Profit

Price

2

1 (low cost)

2 (high cost)

P1

Profit

Price

1


Iso/political function*

p,fp,c

i ( set of, or com.inations of price and profit t"at yields e$ual political supportii !"e politicians preference is for a "i#"er iso/political support ie towards top left of t"e #rap"iii 4or a #iven level of profit, t"e politician or re#ulator is .etter off wit" a lower price and vice

versa as s"own .elow 2 implies a "i#"er iso political function compared to 1

%rofit 4unction*

5 fp,c

i ( function t"at s"ows t"e relations"ip .etween price and profit for a #iven costii 4irms yield t"e ma)imum profit w"en t"e price is set at t"e ma)imum point of t"e function

iii 4or a #iven level of price, a firm yields lower profit if it "as a "i#"er cost as s"own .elow !"e

profit function s"ifts away from t"e ori#in to t"e .ottom ri#"t of t"e #rap" t"e "i#"er cost it

.ear


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M2

1 (low cost)

M1

2 (high cost)

P1 P2

Profit,

Price

1


6ence, t"e optimal solution for a private interest re#ulation occurs w"en t"e profit function '

f(p)c* is tan#ential to t"e iso/political support function p,fp,c !"e tan#ential value is calculated

.y ma)imisin# p,fp,c wit" respect to price !"is is illustrated as follows*

4rom t"e a.ove dia#ram, we can conclude t"at t"e optimal solution for a "i#" cost firm type*

i 6as a "i#"er price p2 instead of p1

ii 6as a lower profit 2 instead of 1)

elative to t"e low cost type, vice versa

. Is it possi.le at an optimal solution for t"e re#ulated price to .e lower for t"e "i#"

cost firm compared a#ainst t"e low cost firm8 If yes, .riefly e)plain w"at mi#"t

cause t"is 2 marks

(nswer*

9es !"is could .e due to t"e influence t"at a particular firm "as t"at ena.les t"em to pressure t"e

politician into #ivin# t"em a favour and reduces t"eir cost 4or e)ample, say, a "i#" cost firm "as a

lar#e influence in t"e #overnment Due to its influence, it mi#"t .e a.le to #et support from t"e

#overnment suc" as su.sidy in order to keep down its cost %rovided t"at t"e firm was provided wit" a

su.stantial support, it may .e a.le to s"ift its profit function to t"e left, and ac"ieve a lower cost

function compared to an e)istin# low cost firm !"e optimal solution for t"e re#ulated price for t"is

particular firm would t"en also .e lower


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M1

P

Profit,

Price

Pm

A


c Is t"ere a difference in predictions a.out re#ulation and market structures .etween

t"e private and pu.lic interest t"eories of re#ulation8 %rovide a .rief reason for

your answer 2 marks

%u.lic Interest !"eory of e#ulation can .e defined as re#ulatory intervention t"at occurs in t"e interestof t"e pu.lic at lar#e It is mainly done to correct market failures .y internalisin# e)ternalities t"at arepresent %u.lic interest re#ulation normally occurs in a monopoly market, and t"e re#ulation impliest"at a su.stantial market imperfection is occurrin# and it needs to .e corrected .y "avin# a re#ulationwit"out compromise (s a result, we would more likely to o.serve t"at most pu.lic interest re#ulationare e)ecuted in a monopoly or in a "i#"ly concentrated market

%rivate Interest !"eory of e#ulation on t"e ot"er "and, can .e defined as t"e re#ulatoryintervention as a result of powerful interest #roups e)ertin# pressure on politicians and re#ulators tocapture rents at t"e e)pense of more dispersed #roups In t"is t"eory, re#ulation is supplied .y utility/ma)imisin# politicians and re#ulators in response to demand for re#ulation .y interest #roups In ot"erwords, politicians face a trade/off .etween #ainin# votes from t"e consumers w"ic" advocates for a

lower % and #ainin# votes from t"e producers w"ic" advocates for a "i#"er ). The optimal solution

would hence, e some point etween !first"est# welfare ma$imising point (Point B) and Monopol%

pricing (Point A).

-ince t"e optimal solution is .etween t"ese two points, we would e)pect t"at t"e market would .eeit"er relatively competitive suc" as a#riculture, and ta)i industry or relatively monopolistic in naturesuc" as network industries, dependin# upon t"e s"ape of t"e profit and iso political function


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2 !"e followin# $uestion deals wit" elements of t"e 'affont : !irole optimal static mechanism

discussed in 'ecture ; ( #overnment principal is seekin# to re#ulate a firm a#ent .y offerin#

a menu of contracts made contin#ent on an announcement .y t"e a#ent !"e firm supplies a

procurement contract for e)ample, defence services and can .e one of two types


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(nswer*

!"e cost t"at would arise w"en an ' firm mimics an 6 firm is a situation called rent e)traction !"is

occurs w"en a low cost firm was #iven a lar#e reim.ursement .y t"e #overnment as it claims t"at it is a

"i#" cost firm !"is could .e t"e case as for firms wit" >low , t"ey will .e #iven cost reim.ursementrepresented .y t"e term [email protected]@1 !"is cost/reducin# incentives contract specify t"at t"e #overnment

pays a fraction of t"e realised cost 6owever, since it is Aust a fraction wit" value of .Ca .etween ?

and 1, firms know t"at t"e cost overruns are not fully reim.ursed (s a result, all firm types, e)cept for

t"e most inefficient ones will earn information rent of U? as lon# as t"eir B@B"i#"

!o address t"is pro.lem, 'affront and !irole 1 s"ows t"at t"e optimal contract is linear and "avin#

a lump sum transfer and a cost/s"arin# term as follows,

Wherea(Ca is t"e lump sum transfer, and.Ca is t"e s"are or fraction t"at t"e re#ulator pays for any cost overrun

!"rou#" t"is mec"anism,i -elf/selection re$uires t"e mana#er to trut"fully announce "is e)pected cost, Caso t"at "e

receives t"e contract w"ic" is appropriate for "is type and "ence indirectly reveals "is true B

incentive compati.ilityii Fe)t, t"is formula also disincentivise a firm to overstate "is announced cost !"is is

.ecause, if t"e value of Ca C, t"e cost s"arin# term would t"en .e ne#ative (s a result,t"e total t would t"en .e lower

iii !"e least efficient firm receives utility e$ual to t"e outside option .ut all ot"er a#ent typesenAoy information rent in t"e form of "i#"er e)pected utility t"an availa.le outside

c Usin# words andGor notation .riefly descri.e t"e constraints appearin# in t"e #overnment+s

optimi&ation pro#ramme 2 marks

>enerally, a #overnment would like to ma)imise welfare as s"own .elow


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W"ere - is Consumer -urplus, B is firm type, e is cost reducin# effort,

Is effort function, and

Is t"e transfer made to t"e firms!"e welfare is t"en ma)imised wit" respect to t su.Aect to*

i UH? !"is is a participation constraint w"ere t"e utility of t"e firm "as to .e positive in orderfor it to supply suc" #oodsGservices to t"e #overnment or to t"e pu.lic

ii !"e mar#inal cost of effort "as to .e e$ual to mar#inal .enefit of effort w"ic" in t"is case,e$uals to 1 due to linearity, and eac" e)tra unit of effort lowerin# cost C .y one unit !"is isalso known as individual rationality/moral "a&ard constraint

iii w"ere t"e e)pectedutility of a firm t"at announced its true type is #reater t"an its e)pected utility if it announceda different type of firm t"at it actually is Incentive compati.ility constraint

E!"

Dr C"ris Doyleodule 'eader EC3371 cto.er 2?1J


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Problem Set Partial Done