Theory of Regulation, Natural Monopoly, Average Cost Pricing, Liability

Chapter Summary:

The marginal benefit of an item might diverge from the marginal cost for three fundamental reasons: market power, asymmetric information and externalities of public goods. These divergence outcomes in economic efficiency. Government regulation might help where private action fails to solve the economic inefficiency.

Usually, the govt. can regulate the conduct, information and structure of an industry.  Particularly, the conduct of a franchised monopoly might be regulated directly via price or indirectly via the rate of return. Competition law regulates the conduct and structure of businesses in common. In conditions of asymmetric information, mandatory disclosure is one of the forms of regulation.

Externalities might be regulated via fees or standards. The proficient degree of an externality based on time and location. The government can assist to solve inefficiency in accidents and public goods by giving a suitable legal framework.
The laws concerning copyrights and patents should balance the incentive for new research against incompetent use of existing knowledge.
Key Concepts:


General Chapter Objectives:

A) Examine how government regulation can solve the economic inadequacy occurring from monospony and monopoly.

B) Differentiate a natural monopoly from the potentially competitive market.

C) Examine how government regulation can solve the economic inefficiency occurring from asymmetric information.

D) Examine how government regulation can solve the economic inadequacy occurring from externalities.

E) Examine the legal framework for the resolution of economic inefficiency in the provision of public goods.


1) Economic inadequacy and government regulation:

a) Divergence of marginal cost and marginal benefit.

  • Asymmetric information.
  • Market power.
  • Externalities and public goods.

b) Government regulation:

  • Conduct.
  • Information.
  • Structure.

2) Natural monopoly:

A) Natural monopoly is a market where:

i) The average cost is reduced with a single supplier, example: distribution of water and electricity.

ii) A market is a natural monopoly whenever economies of scope or scale are big relative to market demand.

B) Two philosophies for the management of natural monopoly.

i) Government ownership or provision. A government-owned enterprise tends to be relatively ineffective.

  • More prone to be beholden to employees, high salaries and over staffing, resultant in higher costs.
  • Dependence on the govt. for the investment funds.

ii) Privatization: It is the transfer of ownership from the government to private sector. A private exclusive franchise awarded to a commercial enterprise, subject to govt. regulation.  The government enterprise might be privatized and remain a monopoly, and hence there is no competition on the seller side.

a) Price regulation: the regulated price is fixed.

  • Marginal cost pricing is a policy where the provider is needed to set price equivalent to marginal supply and cost the quantity demanded.
  • Production at economic proficient level: marginal benefit equivalents marginal cost.
  • Government subsidy might be needed.

b) Average cost pricing is a policy where the provider is needed to set price equivalent to average supply and cost the quantity demanded.

  • With the economies of scale, average cost curve is greater than marginal cost curve.
  • Lower level of provision than the marginal cost pricing. Economically incompetent level: marginal benefit equivalents price equivalents average cost.

c) The provider subject to price regulation will overstate its reported costs to try to set a higher price.

d) Rate of return regulation: The franchise holder can set prices freely, provided it doesn’t surpass the maximum permitted rate of return (or profit) on the value of the rate case.

  • Rate base is the assets to which, the rate of return regulation applies.
  • The franchise holder’s prices are needed to be decreased if its rate of return surpasses the specified maximum.
  • Three difficulties: Disputes over suitable rate of return: few comparable investments; Disputes over assets comprising the rate base needed to give the service; a provider subject to rate of return regulation will invest beyond the economically proficient level, receive a bigger rate base and profit.

3) Potentially competitive market:

a) With modifications in technology or market demand, a market might shift from being a natural monopoly to the potentially competitive market, and vice-versa.

b) A potentially competitive market is one, where economies of scope or scale are small as compare to the market demand.

i) Govt. protection such as exclusive franchises or limitations against imports is anti-competitive.
ii) Such markets must be open to competition.
4) Competition laws:

a) When perfect competition triumphs over a potentially competitive market, the invisible hand makes sure economic efficiency.

b) Regulated industries are subject to the laws specific to industry.

c) Un-regulated industries are subject to the general competition law.

i) Competition laws or antitrust law aim to prohibit collusion, limit mergers, and discourage other anti-competitive business practices (example: control over re-sale prices and exclusive agreements).
ii) Enforcement includes prosecution by the competition agency.
iii) Enforcement as well includes review of merger and acquisition proposals.
5) A natural monopoly with the upstream or downstream markets which are potentially competitive.

a) Monopoly and potentially competitive market engage successive phases of production and monopoly franchise holder as well participates in the potentially competitive market (example: franchiser over distribution of water is vertically integrated up-stream into the production of water).

b) Structural regulation is a manner to separate a natural monopoly from up-stream or down-stream markets which are potentially competitive, example: compulsory divestment of one of the businesses.
6) Information asymmetry:

a) Information asymmetry might be solved via government regulations:

i) Regulations on conduct (that is, of the better informed party), example: limitations against high pressure sales tactics, waiting periods, agreements in writing, recommending second opinions are obtained.

ii) Better-informed party being needed by the govt. to disclose the information.

Note: Information must be objectively confirmable.

iii) Structural regulations (that is, on the better informed party). Govt. mandatory specialization in medical advice in respect of service, mandatory separate demonstration in real estate transactions.

b) Self-regulation: It is the regulation of practitioners by a professional organization.

i) Rules of conduct and regulations of business structures.
ii) Limited right to license practitioners might be a cover to limit competition.
7) Externalities. 

A) Private action might fail to solve wide-spread externalities including big numbers of parties.

B) The economically proficient quantity of emissions is the level which balances the social marginal benefit with the social marginal cost (that is, sum of marginal costs to individual victims), taking into account both private and the external benefits and costs.

i) Major benefit: Evading costs of technologies which generate fewer emissions.
ii) Major cost: Harm to crops and health.
iii) The proficient degree of an externality differs with position and time.

C) Two approaches to control emissions:

i) User fee: permit all sources to emit as much as they like given that they pay a user fee.

  • The user fee is set for all the sources of pollution at social marginal cost of emissions.  
  • This balances social marginal benefit of emissions with the social marginal cost, and attains the economically proficient level of emissions.

ii) Regulate directly via standard:

a) A standard is a set at economically adequate level of pollution.

b) The standard may be implemented via:

  • When the cost of monitoring is low, a licensing scheme: Sale of fixed no. of user licenses via public auction to all sources. At equilibrium price, the price of each and every license equivalents the social marginal cost of the emissions, similar as a user fee determined by the competitive market.
  • The demand of each and every source of pollution for the licenses will be similar as its marginal benefit from the emissions.
  • The market demand equivalents the horizontal sum of the individual demand; the market demand curve is the social marginal benefit curve.

All sources and the total emissions will be economically adequate.

c) When the cost of monitoring is high for some sources, cost-efficient to directly state the standard.

D) Random externalities (or accidents):

i) The economically adequate level of care balances the social marginal benefit of care (that is, in terms of decreased damage from accidents) with the marginal cost of care to driver.

ii) The law of torts governs interaction among parties which have no contractual relationship, states the liability of parties to an accident (that is, set of conditions beneath which one party should pay damages to the other) and the damages, and guides potential injurers to select the economically efficient height of care.
8) Public goods:

a) A public good gives non-rival consumption or use. It might be given: on a commercial basis (or privately), by charity or the government.

b) Economic efficient level of provision: The marginal benefit equivalents marginal cost (zero).

c) Private provision:

i) The public good can be given commercially only when it is excludable. Excludability depends on legal frame-work and technology.

ii) Regulators must balance the trade-off in between excludability (example: the length of a patent or copyright as the financial incentive to inventor or creator) and economically efficient utilization of the public good.

iii) Throughout the life of a patent or copyright, the owner has a limited right. The user’s marginal benefit equivalents the price however is higher than the marginal cost, and society bears the cost of less than efficient utilization.

iv) On expiration of the copyright or patent, usage expands to the point where marginal benefit equivalents zero, that is economically efficient.

d) Public provision of public goods and provision of the public goods through charities.

i) Provision of public goods which are not excludable or are hard to exclude.
ii) When no price is charged, the good will be employed up to the quantity where marginal benefit equivalents zero, and is economically efficient.

e) Public provision of the private goods:

i) Like food, housing, education and medical services.
ii) To equalize wealth distribution and give equivalent opportunity.

f) Public provision of the congestible facilities (example: roads, tunnels, subways).

i) User fees for the congestible facilities (example: tolls) must be set equivalent to the marginal cost of use, where the cost comprises the negative externalities enforced on other users.  
ii) User fees must be set according to demand for the facility: as marginal cost differs throughout the day, therefore should the fees.


The main public-health accomplishment in developed countries has been almost complete eradication of infectious diseases like measles and polio. Whereas measles only causes discomfort among children, it is much more injurious to adults. By contrary, polio is very dangerous to both adults and children. A person can gain immunity by either becoming infected or being immunized. Even when they are provided free of charge, immunizations oblige private costs. In specific, there is always the risk of contracting the disease from inoculation.

a) Compare the private in relation to social benefit(s) from one person's inoculation against a communicable disease.

b) Absent govt. intervention, will too many or too few people receive inoculations? Is this under or over-inoculation problem probable to be better or worse for polio as compared with the measles?

c) Must the Govt. subsidize inoculations and, if so, to what level?

d) In numerous developed countries, the law needs all children to be inoculated. Is it socially efficient to need 100 percent inoculation?

a) The private advantage of inoculation is that once a person is inoculated, he or she will not be infected. The social advantage is the private advantage plus the decrease in the probability which other people will be infected (as the person being inoculated is less probable to infect others). Thus, one person's inoculation produces a positive externality to the society.

b) Absent govt. intervention, each person will be inoculated when the private advantage surpasses the private cost of inoculation. Now the private advantage of inoculation is less than the social advantage. Supposing that the marginal private cost of inoculation is similar as the marginal social cost, there will be few people obtaining inoculations. As polio is a more severe disease than measles, the marginal private advantage of inoculation is greater. The marginal private cost (comprising risk of infection from inoculation), though, is also higher in particular, the marginal private cost of inoculation against the measles is much low whenever the inoculation is taken as child. On balance, the under-inoculation trouble is possibly more serious for polio.

c) As one individual's inoculation produces positive externalities, the govt. must subsidize inoculations till the marginal social advantage equivalents the marginal social cost.

d) In common it is not socially efficient to need 100 percent inoculation. For illustration, assume all however one person are inoculated. In this situation it is almost not possible for the last person to acquire that disease. Thus, the benefit (both private and social) of inoculation is much small. It is very possible that this benefit is less than the cost (that is, the cost of inoculation, and the risk of acquiring the disease from inoculation). Thus, 100 percent inoculation necessity is not efficient. In practice, 100 percent inoculation is hard to enforce.

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