<< Chapter < Page Chapter >> Page >

Perhaps the most plausible option for the regulator is point F; that is, to set the price where AC crosses the demand curve at an output of 6 and a price of 6.5. This plan makes some sense at an intuitive level: let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit, so that it can continue operating, but prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Of course, determining this level of output and price with the political pressures, time constraints, and limited information of the real world is much harder than identifying the point on a graph. For more on the problems that can arise from a centrally determined price, see the discussion of price floors and price ceilings in Demand and Supply .

Cost-plus versus price cap regulation

Indeed, regulators of public utilities for many decades followed the general approach of attempting to choose a point like F in [link] . They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation    .

Cost-plus regulation raises difficulties of its own. If producers are reimbursed for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing lots of staff, because what they can charge is linked to the costs they incur.

Thus, in the 1980s and 1990s, some regulators of public utilities began to use price cap regulation    , where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.

Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. But if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices being charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.

With natural monopoly, market competition is unlikely to take root, so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task.

Key concepts and summary

In the case of a natural monopoly, market competition will not work well and so, rather than allowing an unregulated monopoly to raise price and reduce output, the government may wish to regulate price and/or output. Common examples of regulation are public utilities, the regulated firms that often provide electricity and water service.

Cost-plus regulation refers to government regulation of a firm which sets the price that a firm can charge over a period of time by looking at the firm’s accounting costs and then adding a normal rate of profit. Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.

Problems

Use [link] to answer the following questions.

If the transit system was allowed to operate as an unregulated monopoly, what output would it supply and what price would it charge?

Got questions? Get instant answers now!

If the transit system was regulated to operate with no subsidy (i.e., at zero economic profit), what approximate output would it supply and what approximate price would it charge?

Got questions? Get instant answers now!

If the transit system was regulated to provide the most allocatively efficient quantity of output, what output would it supply and what price would it charge? What subsidy would be necessary to insure this efficient provision of transit services?

Got questions? Get instant answers now!

Questions & Answers

explain the nature of economics
Matilda Reply
interpret micro economic issues
Matilda
ito ang dami ng producto na nais handa at kanyang ibenta ng isang prodyuser
Jomar Reply
i dont understand
Gaabshe
even I also don't understand ..this language.. vn I converse everybody say farzana ur language is not understood by all user? now no one there is question about it?
shaikh
What is diminishing returns?
Shadrach Reply
explain competitive demand
ADENIJI Reply
the demand that are compiting for sale. the buyer can substitute one for another good
Iftikhar
yg
Margarette
the demand where commodities fight for the market. in this type of demand, commodities can be substituted for the most suitable one subject to ( price, consumers choice, consumers income etc)
WILSON
Demand is said to be competitive when a commodity that is needed to satisfy wants in place of another similar goods. increase in price of a commodity X will result in increase in demand of the substitute (commmodity Y).
yusuf
examples of giffen goods are garri (cassava), maize
yusuf Reply
what is Public Finance?
kweku Reply
it's basically the field of economics that deals with the government's involvement in the economy; from spending to maybe interest rate manipulation, etc.
Matthew
examples of giffen goods
Getrude
i want to get the solutions of problems how i get kindly give guidance
Syeda Reply
please give some suggestions about getting solutions of all chapters...
Syeda
hard work
Iftikhar
and the grace of God
The
knowledge skills
MUSA
Syeda Economics is difficult. No all fields are difficult
The
what is Keynesian
AKINOLA
Keynesian economics is the theory proposed by Keynes( an economist). He proposed to manipulate demand side factors to bring economy out of depression in 1930s.
Champro
whose totaly oppossid the government intervention and give importance to agreegad demand
Iftikhar
Good afternoon my fellow forum brothers and sisters
Abdullahi Reply
no just want to know true God
Suprim
Good afternoon!!
Martha
hey is there somebody single n young like me bcoz I'm looking for
Suprim
what is facing trade offs
Nancy Reply
It is giving up a commodity to purchase another commodity
The
for example, when we have two commodities like chicken and turkey you can trade off of give up chicken to purchase turkey
The
that can also be called foregone goods
AKINOLA
it like opportunity cost
AKINOLA
it's like trade by batter
Abdullahi
Do you transform into thesecourses, in french people?
Ramadan
I can just speak french andI can just speak french and no english
Ramadan
what is elastic
Tida Reply
elastic is the change in to price and change in demand
ehtesham
Is the percentage change in quantity demand and quantity supply.
Robert
Or percentage change in price of demand and supply
Robert
Right
ehtesham
Robert Mensah you are explaining elasticity of demand
The
robert i think he talk about elastic releated to elasticity of price a proportionate change in price over qd
Iftikhar
can anyone explain what happrn her i don't understand anything
Brahim
is the percentage change in demand as price change
MUSA
sometimes price is elastic,inelastic
The
price elasticity is different from price being elastic
The
elasticity is not always the percentage change in demand as a result of changes in price. there's income elasticity and cross elasticity so it's not necessarily always price
The
elastic is when a change in price of a commodity results in a relatively a larger proportion change in the quantity demand of the commodity
Nancy
what is inelastic
Tida Reply
price is said to be inelastic when it is less than 1
The
what is national income accounting
Aisha Reply
National income is the income earned by all factors of production..
Majid
So this benefits the workers or the businesses?
Neil
Like whose income are we talking about here
Neil
what is multiplier
Khalid
Good & services manufactured in a country with in one year is calld national income
Fani
incom earned by using of sources of production is national income while i dont know the accounting insuch
Iftikhar
neil and aisha can u explain the turm accounting in such question
Iftikhar
I think when we include accounting national income accounting is the measurement of total goods and services produced in an economy in a given period of time
The
what is mutual funds
Khalid Reply
it is a combination of financial securities such as treasury bills , bonds etc in one managed by an institution that individuals and firms invest in for profit. it is usually a long term investment and is seen as a low risk investment because the financial instruments invested in, are diversified.
Ekeanyanwu
A mutual fund is a professional managed investment that pools money from many investors to invest.
Malik
could you please recommend me any book to understand game theory
Prtj Reply
Please keep all the conversations in English language to be understandable for all users.
QuizOver Reply
hi..prtj yad..the game theory is different type ..which one you want...the cartles game theory u can read the Johnson mascrehanson book
shaikh
any one can hicson approach
Iftikhar
what is the game theory about
The
hi..iftikhar alam..it's not hicson..it's Hickson theory of labour..
shaikh
oh. the game theory is about Hickson theory of labour
The
I think Game Theory has to do something with companies in Macro-Econ
Neil
Wot
Neil
ok
The
I mean like I don't learn about if until Later, but if you're interested here's a YouTube link: ***youtu.be/PCcVODWm-oY
Neil
Mr.joker ..game theory is not about labour ..it's about who will fix the price of product first in a market ..like a pepsi and cocola compny..but the pepsi producer will wait to fix the price unless the cocola has fixed its price ..aftr that they will fix the price and make discount n all to grab th
shaikh
wats dis ?Neil which link?
shaikh
Oh nvm it censored it -_-
Neil
Go to YouTube and search Crash Course Game Theory. They explain it in less than 20 min
Neil
Sorry Shaikh-ji :P
Neil
sorry for what?
shaikh
ok thank you for explaining
The
my pleasure..joker ji
shaikh
ok thank you for explaining
The
and Neil it's good if you are sharing some new information related to theories ..no need to say sorry..I will also learn
shaikh
its oky shaikh whats it is.,... explain hickson approach while f u till something about marshellion demond
Iftikhar
But it's like. I don't know anything. Check the video out tho
Neil
u guys call me ...vth my name also ..it's my surname shaikh..and k iftikhar u need to know the Hickson theory
shaikh
k..Neil..I understood
shaikh
Then your first name is Farzana?
Neil
Dang I'm so sorry
Neil
mr joker what about the art of advertisement vr to advertise r not like such wd can understand game theory
Iftikhar
That's a cook name :)
Neil
again sorry..what happend dear?
shaikh
Iftikhar ask questions after you've seen the video I'm talking about bro
Neil
*cool name
Neil
I said sorry bc I assumed that your first name was Shaikh
Neil
iftikahr ji..hicksion and marshelion deamnd theory said that the consumer should benefited in minimum cost..like maximum benefit and minimize cost
shaikh
iftikhar..Moreover the hicksion theory on normal goods said that consumer had subtitue goods ..so if commodity is more cheaper than y thn they will go for that..means if coffee bcm expensive so consumer will prefer tea..so maximum benefit and minimize cost
shaikh
But how can that be true tho? Np me benefits by spending less. You know like Normative and Inferior goods? Is this why it's a Theory? And I think it's spelled Marshelion Demand Theory.
Neil
That theory just don't make no sense
Neil
Oh I see. Wait so Hicksion Theory = Marshelion Theory?
Neil
but dear if the cheaper good has a utility for the consumer then he will buy na
shaikh
*no one benefits by spending less
Neil
Oh Ok
Neil
Wow this is interesting
Neil
Neil .. I thought u reaaly dnt wnt that I will stay here..
shaikh
I've been saying the exact opposite of that Farzana. You've just misunderstood. I think your knowledge of Econ is amazing and its beneficial for you to stay.
Neil
Wait should we call you Ms. Shaikh or Farzana is fine?
Neil
oh thnx Neil ..sry I hv misunderstood to you? and I hope now I'm texting in English..that everybody can understand
shaikh
and whatever u want to Cal..u can..
shaikh
Thnx Farzana 😁
Neil
yeah..my pleasure dear
shaikh
who said hickson = marshelion theory
Iftikhar
yes farzana you have now began talking just be confined in English
Francis
hope you don't have any issue to if I say dear..coz im used to say to my students dear
shaikh
oh ..thanx..francis
shaikh
Hey np
Neil
oh..thnx neil
shaikh
what are the releation beyond them
Iftikhar
ifitikahr u need to know the relation between Hickson and marshellion
shaikh
yah shaikh and whats the second name of hickson and marshelion
Iftikhar
neil whats the second name of hickson and marshellion theory
Iftikhar
2nd name?
Neil
Their both Theories? Is that watchu asking?
Neil
ok..iftikhar Il mak simple this for u...wait ..and my name is farzana
shaikh
iftikhar. its other name is ..hicksion demand function or marshelion its added coz the marshelion has developed this theroy more
shaikh
So, it is called Marshelion Demand Theory AS WELL AS Hicksion Demand Theory
Neil

Get the best Principles of economics course in your pocket!





Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Principles of economics' conversation and receive update notifications?

Ask