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A regulatory bargain for diversified enterprises
International
Journal
of Industrial
Organization
11 ( 1993) I-20. North-Iiolland
regulatory enterprises Ronald R. Braeutigam*
Final version received April 1992
This paper examines an alternatice to traditional rate of return regulation and price cap regulation for public utilities which serve both non-competitive and competitive markets. The alternative is ;i regulatory bargain in which the allowed economic profit for the firm is tied to the level of net economic benefits (consumer surplus) accruing to the customers in noncompetitive markets. Among other things. this form of regulation is shown to lead to cost minimizing production. efficient pricing in competitive and wn-competitive markets, diversification into competitive markets if and only if there are economies of scope. and protection of customers in non-competitive markets from economic harm (reduced consumer surplus) if the tirm does diversify.
1. Introduction
The increasingly frequent diversification of public utilities into competitive markets has created a number of difficulties for regulators employing traditional rate of return regulaiion. Where regulators have attempted to establish revenue requirements by imposing a rate of return constraint on the non-competitive markets served by the firm, rate of return regulation has necessitated the allocation of common costs of production, typically accomplished through fully distributed cost pricing practices. Such cost allocation mechanisms have been criticized widely in the literature for a number of reasons, including their arbitrary nature, the circularity of a process that sets rates based on allocations which in turn ultimately depend on rates, and a general lack of foundation in economic principles [see, for example, Friedlaender ( 1969); Zajac ( 1978); Berg and Tschirhart ( 1989) and Braeutigam (1989)]. The problems with cost allocation mechanisms exist even where utilities have monopolies in all markets served. However, the problems are exacerbated in the presence of competition in some of the markets served by a utility, since cost allocation rules not only affect the revenue requirenents Department Corr’L~.~pc)ritit’rl(‘C’ to: R.R. Braeutigam. Evanston, IL 60208-2400, USA. *The author wishes to thank Norman Ireland comments on this research. The author is Kapnick western University. 0167-7187 ‘93 $06.00 (
1993
01’ Economics,
Northwestern
l_!niversity.
and William Rogerson for their Professor of Business Institutions.
Elscvier Science Publishers
B.V. All rights reserved
helpful North-
2
R.R. Bmeutigam,
Regulatory bargain for &cersij?ed enterprises
in individual markets, but also affect the Economic viability of rivals in competitive markets. Recently Braeutigam and Panzar (1989) identified a number of problems with the incentive structures created by return regulation for public utilities serving both non-competitive and competitive markets, including incentives for a firm to choose economically ineflicient levels of production in its markets and to misreport costs as attributable to non-competitive services whenever possible. They also showed that if a competitive market served b:T the firm is mistakenly placed inside the rate of return constraint along with non-competitive services, the firm will have an incentive to price below marginal cost in that market. In addition, their ana,lysis demonstrated that cost allocation rules may make economically efficient diversification unprofitable for the firm, may induce a firm to choose an inefficient technology, and may create cost reduction incentives stroirger in competitive markets than in non-competitive markets. Concerns such as these have led to a number of regulatory bodies (most notably in the telephone industry) to move toward the adoption of ‘price cap’ regulation.’ Much of the original excitement over price caps stemmed from the hope that this form or regulation would induce the firm to produce in a cost minimizing fashion by breaking the linkage between the firm’s costs and the process by which regulators determine rates. This approach contrasts sharply with rate of return regulation, which ties the allowed revenues to the costs incurred by the firm. In applying the purest form of price cap regulation to diversified firms, a regulator might first classify non-competitive markets (i.e. those markets with relatively inelastic demands) as ‘core’ markets, and competitive markets (i.e. those markets with highly elastic demands) as ‘non-core’ markets.2 The regulator might then set a ceiling on the individual rates, or an index of rates, to be charged in core markets, the level of the ceiling being affected ‘Many of the proposals for price cap regulation in the United States have found their roots in the model provided by British Telecommunications plc (‘British Telecom’). In 1984 the British Government chose to regulate the firm’s prices directly through a formula relating price increases for telephone services to the annual change in the British Retail Price index minus a specified percent (initi,tlly 3”“) productivity factor. See ‘License granted by The Secretary of State for Trade and Industry to British Telecommunication under Section 7 of the Telecommunications Act of 1984, as amended in 31 July, 1987 (HMSO, London. 1987). In the United States price level regulation has been pursued at both state and federal levels in the telecommunications industry. For example, at the federal level, see Further Notice of Proposed Rulemaking, CC Docket No. 87-313, FCC Docket No. 88-172, 2.7 May, 1988 (‘Further Notice’). See also Title 30, Vermont Stats, Ann.. # 226a and 227a for the sta:Lte allowing negotiated contract prices for basic exchange telecommunications service in Vermont. ‘The classification of markets may not be a trivial matter, since, for example, demand elasticities may not always be known with great accuracy. Furthermore, a market which is inelastic today may become elastic after some time as substitute services emerge; thus classificatton as core or non-core may not only involve uncertainties, but may have to be reassessed as market conditions change.
R.R. Brmutiganz, Regulatory
bargain .for drxwijied
enterprises
3
only by exogenous cost factors, such as prices paid for factors of production. The firm would be allowed to enter CO and produce whatever output levels it desires in non-core markets. Many of the incentives that would arise with pure price caps are similar to the incentives present in competitive markets.” Among other thingi pure price cap regulation would induce the firm to produce in a cost minimizing fashion, ta undertake ,*ost reducing innovation as an unregulated firm, to produce in each comp:*rrtive non-core market up to the point at which marginal cost equals price,4 and to diversify into a competitive non-core market if and only if diversification is economically efficient. In practice it may not always be easy to break the linkage between rates and costs. It will no doubt depend on the nature of the industry among other things. For example, in a study of the possible use of price caps to the oil pipeline industry, Hillman ( i990) has suggested how the exogeneity of price caps might be preserved. Price caps in core markets might be based on the rates charged by other pipelines operating under similar conditions of production; such ‘yardstick’ price determinations would presumably be most useful where the markets used as a basis for setting price caps are competitive? In other industries the exogeneity of price caps may be more difficult to achieve. There may be no obvious yardsticks in some cases. In other cases, even if candidates for yardsticks exist, concern over whether the price caps are too low or too high may tempt regulators to assess the appropriateness of the caps using some definition of the profit generated by the firm in its core markets. Such a possibility is more than hypothetical. For example, price cap schemes such as those adopted by the FCC and by the state of Vermont both announce an intent to review the performance of the regulatory process after some period of time, including an assessment of the rate of return achieved. The use of rate of return as a criterion as a part of price cap system endogenizes the price caps, and thus reintroduces the incentives for adverse performance identified by Braeutigam and Panzar. What, then, can be done to regulate diversified industries when for some reason the linkage between rates and cc’ :s cannot be broken? Since neither 3F~r a more de!ai!ed discussion of these incentives see Hillman and Braeutigam ( 1989, pp. 3738 and 63-66). 4To the extent that the firm can influence the price in a non-tort market, then price will diverge from marginal cost, and some economic inefficiency will be mtroduced as a result. However, if the firm’s ability to inlluence price is minimal. then the size of the resulting inefficiency should be small. 51n addition the implementation of price cap regulation will require the resolution of a number of operation4 issues discussed in the literature, including the way in which the caps are set a;ld adjusted over timr: PC fac+cr prices and conditions of demand change. For more on this point Li:e Voge!sang (:QP’?. Ki’imarl and Braeutigam (1989, pp. 59-62, and 1990), and Sibley and Sappington (1990) ior 9\,proac’.zs !;? determining the weights of the mdex in a formulation of price caps that ir dynamic GUI ~~:ict’cap for muia that adjusts over time.
4
R.R. Braeutigam, Reghtory
bargain for dicersjfied enterprises
rate of return regulation nor price cap regulation succeeds here, alternative regulatory bargains need to be explored. In this paper we analyze the rudiments of one such bargain, which we call the Net Benefit Sharing (NBS) bargain. This form of regulation would tie the firm’s total profits to the consumer benefits (i.e. consumer surplus) generated in non-competitive markets, thereby allowing the firm to keep a limited portion of the net economic benefits from production. This bargain induces the profit maximizing firm to behave as a cost minimizer and produce outputs according to the inverse elasticity rules characteristic of a Ramsey optimum. Furthermore, diversification into competitive markets will increase profits if and only if there are economies of scope. In addition to these properties of economically efficient operation, the constraint also induces the firm to satisfy one of the equity-based concerns of many regulators who want to ensure that diversification into competitive markets does not harm (reduce the aggregate consumer surplus of) the customers in monopoly markets. 2. A model of the diversified firm Consider a regulated firm potentially serving two types of markets, non-competitive (monopoly) markets and competitive markets. The noncompetitive markets might be viewed as the traditional center of the productive activity of the regulated enterprise. They are sometimes referred to as the ‘core’ markets served by the firm. Examples of such markets might be the local exchange and access services provided by a local telephone company, or the provision of electric and natural gas services to residential and business customers who have no other ways to obtain these services other than from the pub% utilities who are local distributors of gas and electricity. Demands for these types of services are usually characterized as being relatively inelastic. Let p =(pl, p2,. . . , p,) be the vector of prices of the nz non-competitive products. The demand for the non-competitive output is denoted by Y&I), for i= 1, . . . ,m, so that there may exist cross elasticities cf demand among the set of non-competitive products. The vector of noncompetitive outputs is y@) = (yr @I),y2@), . . . , y,(p)). The demand schedule for each service satisfies the usual property that demand is downward sloping (i/li/c?pi < 0, Vi). At the same time the firm may diversify into competitive markets. Let 4,) be the vector of prices of the n competitive products, and =+,,42:..., -G.- (Z42,...,Z, ) be the corresponding vector of output produced by the firm. We assume that if the regulated firm diversifies into a competitive market, it provides a product which is a perfect substitute for the products of its rivals; furthermore, we assume that the market will remain competitive. Thus the firm may cl~Lithe- its level of output in each of these markets, but since the markets are competitive, the firm takes 4 as given in the market.
5
We assume that the firm knows its own cost function, C(y@),z), that would be associated with the cost minimizing production of y and z.~ However, the firm may not act as a cost minimizer, and may in fact produce any observed y and z with total expenditures E in excess of C(y@),t). Let u 20 denote the difference between E and C(y(p),z), where u can include expenditures arising from either technically or allocatively inefficient production. One of the primary benefits that might be achieved under diversification is the realization of economies of scope.’ If a firm diversifies into competitive markets with economies of scope, the total cost of producing y and z will be lower than the total cost of two separate entities, one producing only the non-competitive services y, and thz other producing only the competitive services z. In other words, if C(y, Z)< C(y.0) + C(0, .:). then there are economies of scope, and it would be less costly to produce both competitive and non-competitive outputs with one firm than with two or more firms. If C(y, Z)> C(y, 0) + C(0, :), there are diseconomies of scope. and it would be more costly to produce both competitive and non-competitive outputs with one firm than with two or more firms. Finally, if C(y, z)= C(y,O)+ C(O,z), then it costs the same to produce competitive and non-competitive outputs with one firm as it would with two or more firms. Both the regulated firm and the regulator are assumed to have symmetric information about demand schedules. For the competitive markets both know the market prices in any competitive markets served by the firm as well as the quantities produced by the regulated firm in those markets. Fcr non-competitive markets both the regulator and the firm can observe the demand schedules facing the regulated firm. In both non-competitive and competitive markets both the regulator and the firm can observe the regulated firm’s prices, levels of outputs, and thus the revenues collected. To retain the flavor of regulatory reality, we assume information IS asymmetric with respect to costs. The firm knows its total expenditures E and it knows whether it is producing its outputs in a cost minimizing manner. While the regulator can also verify the total expenditures E through audits of the company’s books, it cannot observe whether the firm is producing outputs at the minimum possible total cost. In other words, we allow for the possibility that the firm might employ wasteful expenditures, whose level is denoted by M. While the regulator can observe the total expenditures made by a firm, E = C(y@), Z)+ u, it cannot tell whether u =O, in which case production is cost minimizing, or whether u > 9, in which case the firm is producing inefficiently. ‘The prices of factors of production will be assumed constant in this analysis. an< Ibr simplicity of notation are therefore suppressed from references to cost functions throughout the presentation. ‘For a further discussion of economies of scope. see Baumol et al. ( 1982, pp. 71-72).
R. R. Braeutigam, Regulatnrq’ bargain for dicers~fied ante .;.+.c::,
6
While the firm knows whether there are economies of scope assoc&ed with the production of both the monopoly and competitive products, the regulator does not. If there are economies of scope, a blanket prohibition on diversification might unnecessarily deprive society of the opportunity to gain from the cost savings that diversification would yield. The profit earned by the firm, 71,is the difference between the revenues earned in all of its markets less the total expenditures incurred by the f”trm. Given ~1,Z, and tl, the profit of the regulated firm can be written as ~(p,z,~)=p’y(p)+q’z-cGv(I4),z)-u.
(1)
Since both the regulator and the firm can observe revenues and expenditures, both can also observe the level of profit earned by the firm. We assume that the firm will choose the prices in non-competitive markets, the level of output in competitive markets, and the level of waste expenditures u to maximize its profit, subject to any regulatory constraint that it might be required to satisfy. The total welfare associated with the values (p, Z,U) can be represented as follows: (2) where, in addition to the terms already defined, Sm~(p)) denotes the consumer surplus generated in the non-competitive markets and S’(q) denotes the consumer surplus generated in the competitive markets. One of the properties of this structure is that, in the normative analysis to follow, the amount of consumer surplus generated in competitive makcts will be constant, since the price q does not change as z varies. Furthermore, since each competitive firm earns zero profit, the total producer surplus for these rivals (not including the profit of the regulated firm) remains constant and zero. Eq. (2) can be viewed as the sum of consumer and producer surplus in the regulated and competitive markets. Since the last term in (2) is a constant, maximizing rV in (2) is equivalent to maximizing W in (3): W@, t, u) = Srn(_V(p)) +p *ycp)+ q ’ z -
a_Y@)i z) - 24.
(3)
We ;zssume that W and 71 are strictly concave in their arguments.*
We also assume that, given Z, the firm is unable to break even when prices (2!c set at marginal cost in the non-competitive markets, i.e. 71~0 when pi = [YS ., /F\’ZTi-T j , . . . ,f~ This a‘< .,~:t:r;tlon Y. :s to c+ture a feature of the -. ~~lnc::-/it\ “FT._ ..__1 l
aS.ibmptifr.1 tfi;li . e-t EL.7.’ _ ..
>f 71’ 11: * rec:,;r,-* 7%’ ‘(-‘ -_ ‘, _ il wlv.- , - * -ic,tent with the tile rgf~gl;l:ed jlrn, I: ’ -;:,;I _’=’._. .*_ ‘= I &I__’ :.,_ ITI .y,- ;.c!‘;.1. : . YS such a
7
regulated utility problem, since the firm cannot break even when prices are set at first best.”
3. Possible regulatory objectives We now turn to the identification of a number of possible objectives that might be pursued by regulators, for reasons apparent as the set is presented. This set of objectives is surely not exhaustive, or even necessarily pursued by any particular regulatory agency. These possible objectives have been used by Braeutigam and Panzar ( 1989) to eval::ate the performance of rate of l-&u-n regulation, and by Hillman and Braeutigam (1989) to assess the performance of variations of price cap regulation. In this paper we use the set to assess the performance of the NBS bargain. The first four objectives arise if the policy-maker is interested in achieving economic efficiency (maximizing u/v), subject to a constraint that the firm earns some minimum level of profit x0, where x0 20: max IV@, z, U)subject to r@. Z,24)2 no. (p.I.u)
(4)
At a solution to (4), the envelope theorem indicates that dkV/dn’
Objectire
1 (Cost
Minimizing
Regulatory
Ohjectire
2 (&/ficierlt
Production).
The regulatory constraint should induce the firm to produce in a cost minimizing fashion, i.e. without waste (u = 0). Productiorz
irz Competitive
Markets).
If
“In other words, without this assumption, marginal cost pricing in non-competitive markets would enable the firm to break even and maximize economic efficiency at the same time. While this would lx a desirable state of the world, it is not characteristic of most regulated utilities.
8
diversification occurs, the regulated firm should produce in the competiti=le market so that price equals marginal cost (vi = ?C/?Zi, i = 1,. . . , n). Markets). At a solution to (4), [?Ilj/,‘?pi] J[?nj?pi] = [?lV/c’p~]/[2~/3p~], i = 1,. . . , m; k = 1, . . . , m. With independent demands (and demand elasticities for services i and k denoted respectively by ei and Q), this condition can be expressed in Regulatory
Qbjectioe 3 (Eff lcient Production
in Non-competitive
terms of the more familiar inverse elasticity rules characteristic of a Ramsey optimum: [pi - ?C/?yi] . ei/pi = [pk - (~C/(?J’L]*e,lpk, i = 1,. . . , m; k = I,. . . , m. lo In addition, the economic viability of the firm is important to the regulator, since the basic non-competitive services may not be produced otherwise. Regulatory
even,
so
Objective 4 (Economic
that
the
Yiability). The firm should at least break
non-competitive
services
continue
to
be provided
(Np* z, u) 2 no).
Ihis viability is imposed as a part of the solution to the partially regulated second-best problem (4) through the constraint ~c(p,z, U)>=rr” 2 0. The first four objectives are derived from welfare considerations that lead to a variation of second-best pricing. Among other things, a regulator may have two additional concerns about the effects of diversification of the regulated enterprise into competitive markets. First, it is possible for diversification to improve profits for the firm, lut to reduce the sum of consumer and producer surplus. A regulator may object to such economically inefficient diversification. Thus a possible regulatory objective is the following: Regulatory
Objectiue
5 ( Welfclre
lrweasing
Diversification).
constraint should be structured so that if diversification increases welfare IN Since the regulator
The regulatory is profitable, then it
may not be able to observe whether
there are
“‘Let W” be the surplus achieved at a maximum of (4) when the constraint is nz~‘>O. Of course, an alternative regulatory regime that constrains the firm to a level of profit below no (e.g. n* j, so that TI= z* < no might lead to a level of PY> W”, even though prices under the regime do not satisfy Ramsey rules; however. in that case IV could be even larger if the Ramsey rules were satisfied.
economies of scope, it may be desirable for the regulatory system to induce the firm to use its own information Gout economies of scope in an economically efficient manner so that the firm will find diversification profitable when there are economies of scope and unprofitable when there are diseconomies of scope. In addition, a regulator may be concerned about the economic we%being of customers in regulated markets as a result of diversification. The regulator may therefore wish to require that customers in non-competitive markets will not be made worse off (incurring a loss in consumer surplus) as a result of diversification. Thus we state an additional possible regulatory objective based on this concern for equity: Regulatory Ohjectire 6 ( Protectim o/’ Nowcompetitive Cmtonzers U de) Dicers~fication). Customers in regulated markets should realize a consumer
surp!us under diversification no less than they would achieve if the firm were prohibiied from entering the competitive market. Finally, a regulator will undoubtedly be interested in the practicality of imyllementing any regulatory constraint, particularly with respect to the observabihty of the data needed by the regulator. Regulatory Objectire 7 (Implen2e~ztahilit~).The regulatory
constraint should be structured so that it depends only on data observable by the regulator. AI example of a need to satisfy implementability would occur if the firm knows its cost structure, but the regulator does not. An implementable regulatory constraint may depend on total expenditures made by the firm (which the regulator can observe), but it should not be structured to require the regulator to know the actual cost structure of the firm C, including whether there are economies of scope, or whether there is inefficient production (U> O).’’ 4. Net benefit sharing: An alternative regulatory bargain
In this section we consider the NBS bargain. This form of regulation recognizes that the net economic benefits accruing to the firm are represented by the economic profit of the firm and that the net economic benefits flowing to customers of the core (presumably non-competitive) services can be measured by the consumer surplus in those markets. The outcome of the “A number of possible regulatory mechanisms dealing with asymmetric information have been explored in the literature. Many of these mechanisms explore the possibility of using taxes or subsidies (both being outside the scope of the investigation here) to induce the firm to perform more efficiently [see, for example, Baron (1989)].
10
R.R. Braetrtigant,
Regulatory
bargain jbr dirers$ed
enterprises
bargain between the firm and core market customers allows the firm to earn positive economic profits, denoted as before by rc, but the bargain specifies that the amount of those profits must be less than or equal to some designated fraction, 2, of the consumer surplus, denoted by Sm. In other words the bargain splits the total surplus according to the fraction represented by CC The consumer surplus generated in the non-core markets is excluded from the regulatory constraint for two reasons. First, in competitive markets there are a number of firms responsible for generating consumer surplus. The inclusion of consumer surplus from the markets in the regulatory constraint would lead to the obvious question as to why the regulated firm’s profits should be based on consumer surplus that would be generated even if the regulated firm did not enter the competitive market at all.’ 2 Second, and more importantly, the inclusion of only the surplus generated in the core markets will generate economic incentives that lead to the achievement of the possible regulatory objectives identified in section 3,’ 3 The fraction of surplus retained as profit, 2, might be a constant, but more generally might be structured to depend on the level of total consumer surplus. For analytical purposes, suppose 2~: 2 dti!cs depend on S” as well as on a shift parameter /3, so that @Sm.,!2). An increase in B would be associated with a bargain in which r is higher for any given level of Sm. If 3~ depends on the level of consumer surplus in core markets, the economic incentives discussed below will hold as long as allowed profit increases as S” increases. * 4 Thus while the bargaming outcome allows the firm to increase its total profit as consumer surplus increases, the constraint may be designed so that the fraction of total surplus kept as profit falls as total surlYus grows. What is important is that the firm takes the form of r(S”‘.$) as exogenous, that is, that the firm does not believe it can manipulate the function z(S~,~) by its own actions. Formally, the regulatory constraint can be written as follows: ~c(p,z, u) 5 a(S”, /Wm.
(5)
The firm then chooses p, z and u to maximize profit (1) subject to the constraint (5). Let E, be the Lagrange multiplier associated with the constraint and form the Lagrangian for the problem (6). The first-order conditions for an optimum (7)-(9) are as follows, where the substitution “In addition, reglllatoi\ may not have information about the demand schedules in these markets, and the gat hxing of such information would be ..n unnecessary burden on the regulatory process. ’ 3To see the division of surplus another way, let ; be the fraction of total surplus kept by the firm as profit rr. Then rr = ;1(rr+S”), which implies that x = [;I/( 1 --?)I. Thus the regulatory constraint can be equtvalently represented by TC~G;l(n+ Sm) or by TI2 xS”. “Thus, in addition to r(S”,/I)>O, we shall require that [x(S”,~I)+.F”x,(S”,/~)] ~0.
_l’i= -- ?S”/r?pi has been made and the arguments of 71and Sm, yi and ci:have been omitted for notational simplicity:
H=
7-c+
2&S” -
n] = ( 1 -
E,)7r+ i,cxS”,
(6)
c’H/c?,-i= ( 1 - i.)?lT/c?Zi= ( 1 - i)( qi - ?C/f?Zi)5 0;
-li ~
0;
3i
c’Hlc’ri = 0, Vi,
?H/?u = ( 1 - i.)c?n/ik = - ( 1 - i) 5 0; u 2 0;
(8) uSH/?u = 0.
(9
Let us now turn to some of the properties that make this form of regulatory bargain worth consideration. The first shows that the firm will be induced to act as a cost minimizer, even though the regulator cannot directly observe whether production is efficient. This satisfies Regulatory Objective 1. Property 1 (Cost Minimizing Production). The_firm will ?ehat:e to minimize the costs i?f’producing any observed y and z (i.e. u = 0). Prooj: Assume the constraint is binding (2 > 0). Then, by (9) cH/?u 5 O=G, 5 1. But by (7) i_= 1*?H/?pi = [%,Sm+ ~]~i > 0, which violates optimality. Thus
i. < 1 and u = 0, and the firm produces efficiently. Now we examine the prices that would be set by the firm. Property 2 shows that the firm will produce its output in the competitive non-core markets so that price and marginal costs are equated, satisfying Regulatory Objective 2. Propert!. 2 (Efficient Production in Competitille Markets). The firm non-core markets so that price produce its output in the competitiw marginal costs are equated. Proqf: This follows directly from the first-order
condition
will and
(8). Since iti< 1,
R. R. Brauctigatn,
12
Regu!atory
bargain jbr dicersfted
?7t/?Zi =0,
which implies that price and marginal non-core markets.
etlterpriws
cost are equal in the
With respect to pricing in the core markets, Property 3 shows that the firm will follow the efficient inverse elasticity pricing rules of a Ramsey optimum, as characterized by Partially Regulated Second Best. Pro/I?srt4’ 3 (Eff lcient Production produce in its non-competitive Ramsey optima/Q are satisfied.
in Non-competitive Markets). The firm will markets so that the inverse elasticity ru/es of
Proqf. By (7), Sn/?pi = [i.[ar,S” + Z(S”)]i( 1 -,Q]J.~. Vi. As noted in the discus-
Regulated Second Best, [c’W/Spi]/[~~/~pi] = [S W/?pn]/[?~/?p,], i = 1,. . . , I~Z; k = 1,. . . , m. But since IV = 71+ Srny(I:!V;‘?/Ii= ?n/?pi -yiY Vi, and thus the Partially Regulated Second Best pricing rule can also be writ’ien as c?Tt,‘?pi = [i.[r,S” + r]/( 1 - i,)]yi, Vi.
sion
of Regulatory
Objective
3, at
Partially
Regulatory Objective 4 requires that the firm earn at least a normal return on investment so that it remains financially viable. Under price cap regulation tinancinE viability is not guaranteed since it is possible that a regulator might set caps so low that profit is negative. However, under the net becefit bargain discussed here, the firm will remain viable whenever it is possible for a totally unconstrained firm to earn positive profits. This is true since the constraint ties profit to consumer surplus in the core markets, and that surplus is always positive. Before considering the other regulatory objectives, two other properties of ib.2 nel: ITen& bargain are presented for completeness. They boih address the P;‘LY :t r.t c’l ‘ougher regulatory bargain (a lower level of fi) on the firm, cc):,;umers and total welfare. -i ( F,j$~ts of a Tighter Bargain on Profits and Consumer Surplus). Wh~*n rht~bargairA?.y wnstraifqt w? ,the firm is binding, a tighter bargain (i.e. a Jowe!. icce! Ly- /j) will dwre’rbTI’ I;& G-m’s profit and increase the consumer sui ,-JUL% ww markei; )-
“_
,ys
!+oqf:
i
_$‘
ealvel+e theorem, dn/dfl= i.r,J”. Since rB > 0, then dn/dp > 0, qIcvw a tightei’ bargain lowers the profit of the firm. Next, since Z= zS”, .v . (2::
Since :I tighter regulatory bargain (i.e. a lower /I) decreases profit but increases wxGrner surplus, the effect of tightened regulation on total surplus
is not immediately obvious. In general a tighter bargain need not increase total welfare. If it is possible for the firm to break even when all prices are jet equal to marginal cost in the core markets, then at that set of prices there remains the question as to whether the firm earns profits that exceed ~6”. If so, then the regulatory constraint might actually reduce total welfare by forcing the firm to price below marginal cost. While this may not be viewed as typical in the case of natural monopoly, it should be noted that a natural monopoly could exist in such a case.’ 5 However, if the firm cannot break even when prices equal marginal costs in the core markets, a tighter regulatory bargain will increase total welfare. This is shown in Property 5. Property 5 ( EJects of u Tighter Bargain on Total Welfare). If the fkn cannot break even (i.e. emi x 2 0) wheri ull prices are set at marginal cost, then a tighter hurgain will increase totul welfare W Proof
Since W=;rr+S”. d W/dfl= dn/dg + dSm/dfl = Lcx,S”(El- 1)/r = r,S,(i.z + i, - 1)/r. The first-order condition (7) can be rewritten as ?H/Spi = ( 1 - i) (?W/c?pi- iX,\7Jm -( kt + i, - 1 )yi = 0, Vi, when pi > 0. If the firm cannot break even when all prices are set at marginal cost, then ?W,@+ 4 which implies that the first two terms of the right-hand side of the first-order ?W/@= condition that (i.r+i,-- 1)cO. Then are negative and ~,Srn(2.~+ i_- 1)/r ~0. Thus a tighter bargain increases total welfare W The next property relates the incentive to diversify to the existence of economies of scope. It points out that under the net benefit sharing bargain economics of scope are the primary factor in determining whether the firm diversifies. Property 6 (Economies of Scope and Diversification). lf there are economies of scope, the profit maxinli~ing_firm will dioers(fy under the regulatory mechanism 71-I: YS”. ij’ there are diseconomies of scope, the firm will not diversify. lf there are ncnther economies uor diseconomies of scope, the firm will be indifferent to dirers@ution. Proof Let the superscript d refer to the profit maximizing choice of the diversified firm, i e. @, z) =@“, zd) solves max 7t=py@) +qz - C(y, z) subject to 715 rS”. Albo let the superscript o refer to the point maximizing choice of the undiversified firm, so that !p, Z)=(@‘, 0) solves max ;TC =PJ@) - C(J, 0) subject to 7cQS”. Also recognize that if the non-core services are provided by a separate firm using the stand alone technology of the other suppliers in the ‘“As is well known from the discussion of Baumol et al. ( 1982, pp. 18-22), a natural monopoly (i.e. a lirm operating with a subadditive cost structure) could exist for levels of output that would allow for the firm to break even when price equals marginal cost.
R.R. &wwti,gaf?z, Rcydatory
14 market,
then
competition
hargairtjbr direr.$ed
enterprises
leads to zero economic profits in the competitive
enterprise, i.e. q, z = C(0, z).” If there are neither economies nor diseconomies of scope, then pdyd + qzd - Cdvd, zd) =pdyd
+ qzd - CQd,
0) - C(0, zd)
=pdy”
+ qzd - C(yd, 0) - qzd =pdyd
Sp”y”
- C&O.
- C(yd,
0)
0).
and p”_Vo- C(y”, 0) = pOy’ +
qzd - C(y”,
0) - C( 0, zd) =p”y”
+ qzd - C(y”,
zd)
spdyd+q?-C(yd.Zd).
Hence p”yo -- C(J”, 0) =pdyd + qzd - C(J~. ~~1. Thus, if there are neither economies nor diseconomies of scope, the firm is indifferent to diversification. If there are economies of scope, then p”y” - C@“, 0) =p”y”
+ qzd - C(y”.
0) - C( 0, Zd ) < p”y” + qzd - C(y”,
spdyd
+ qzd - C(yd,
Zd).
Zd)
Thus diversification will be profitable. If there are diseconomies of scope, then pdyd + qzd - C(yd,
zd)
+ qtd - C(yd.
0) - C( 0, td) =pdyd sp”yo
- Qyd.
0)
- CLjYO, 0).
Thus diversification will be unprofitable. As Property 6 shows, the firm will find it profitable to diversify when there are cost saving benefits to be achieved through economies of scope. The next property shows that those benefits will be shared; not only will the firm’s profit increase, but customers in non-competitive core markets will also benefit from diversification. Stated another way, regulators can be assured that, taken as a group, customers in core markets will not be harmed by diversification of the regulated firm into competitive makets. This satisfies Regulatory Objective 6. lhThis assumes that indivisibilities 91“ = C(0, zd) and 9:” = C(0, :“I.
are not a problem
in the competitive
markets,
so that
Property 7 (Protection qf Non-cortrpetitire Customers Under Dicers$cation). If dirersfjication is prqfitahle under the regulatory nzechanism IT2 zS”, it will increase the we&we 91’the customers qf’ the monopoly sewices. Proof.
The proof is trivial, since 3 is constructed so that d[gS”]/dS” = r,S” + cx~0. As S” increases, so will xS” and thus so will the maximum allowed profit E. A firm that increases its profit through diversification will therefore only be able to do so if S” increases at the same time. The linal property considered here relates to Regulatory Objective 5, which states that the regulatory constraint should be structured so that if diversilication is profitable, then it increases welfare W Property 8 indicates that this goal is satisfied. Property 8 ( We!$we increases welfiwe.
Increasing
Diversification).
Prqfitahie
dirers&ation
ProoJ The proof follows directly from Property 7. If diversification is profitable, then not only are the prolits of the regulated firm higher, but consumer surplus in regulated markets is higher. Since consumer surplus in competitive markets is unaffected by diversification, total surplus increases with diversification.
5. An example
We now provide an example to illustrate the comparative performance properties of simpie price cap and net benefit sharing forms of regulation. To keep the example simple, we shall focus on a firm producing only a single product in a monopoly market. Diversification is not an issue here. Rather the example focuses on the way in which output price, profit, consumer surplus, and welfare (the sum of consumer and producer surplus) vary as the firm experiences changes in factors affecting demand and cost. Let the demand structure be represented by _v=20k -p, where k is a demand shift parameter to be used in comparative statics below. As k rises, demand shifts outward (upward). Assume the cost structure is C =(60+;,7)~, where w is a cost shift parameter also used in comparative statics. C is linear homogeneous in 1%‘; thus w may be used to capture the effects of factor price changes. The variable MTmay also be used to represent changes in cost due to technological change, such as changes in productivrty. T".i.lS, a fxtor price increase of l%, coupled with a productivity increase of 3yA(i.e. costs would fall by 37; in hanmec\ wr;=.Wlead to a change in w of --2y0. the absence of factor price L___~_~, To begin, let k = NT=1. It can easily be shown that the lowest price at
16
R.R. Braeutigam, Regulatory bargain for diversified enterprises
which the firm just breaks even is p = 5. If a regulator had full information and desired to achieve second best, it could do so by directing the firm to set p= 3.
However, in the absence of full information, suppose the regulator allows the firm to set a price that allows the firm to earn some positive profit in order to induce the firm to minimize costs. Suppose the price cap and net benefit sharing rules are constructed so that p= 6 will result under each regime. For price caps, the regulator observes w and sets the price cap so Under the NBS system, suppose the bargain between the that ps6w.” regulator and the regulated firm results in a regulatory constraint @rxSm, where a=( 10/98). It is easy to verify that a price of 6 will result from NBS and price caps under these particular regulatory constraints.
5.1. Vuriakms
irt 1~
Suppose k = 1, but w varies. The effects of variations in w on output price [fig. l(a)], profit [fig. l(bj], consumer surplus [fig. l(c)], and the sum of consumer and producer surplus [fig. l(d)] are shown for three types of firms: (1) unregulated profit maximizer (dotted curve); (2) the firm under price cap regulation (dashed curve); and (3) the firm under NBS regulation (the solid curve). The profit maximizing unregulated firm can break even as long as 06 w 5 1.43. Several comparative properties of the regulatory regimes can be observed in the example. fi) As w rises above 1, the firm will reach negative profits under price caps before it does under NBS. Under price cap regulation, the firm can break even only as long as 0 s w 5 1.36. Under NBS regulation the firm can break even as long as 05 w 5 1.43, although the NBS constraint will not be binding for 1.375 s w 5 1.43. Thus, if w increases to the range 1.36 5 w 5 1.43, the NBS firm can continue to produce, even though the firm under price cap regulation will fail to break even unless the price cap formula is somehow renegotiated. (ii) As w rises above ! (in the range 1-c w5 1.36), price and profit for the firm under NBS will be higher than under price caps. Correspondingly, consumer surplus and welfare will be higher for the firm under price caps. (iii) As w falls from 1, price and profit for the firm under MS will be lower than under price caps for values of w such that 0.6 5 WC 1.O. Correspondingly, consumer surplus and welfare will be higher for the firm under NBS. For values of w such that 0 < ~‘5 0.6, these results are reversed. “Note that while the maximum allowed price varies with M’,including changes in factor prices and productivity, it does not depend on k; this is ci)llslstent with :he way in which price caps are typically implemented.
R.R. Braeutigam, Regulatory
(a)
D .
bargain for diversijied enterprises
17
12 10 8 6 d L
(b)
(cl
0.2
0.1
0.6
0.8
1
1.2
1.4
W
0.2
0.4
0.6
0.8
1
1.2
i.4
W
Profit
S
...... . . . . . . 1
W
.. . . I
i.. . ... I
. . . . ... . . . I
1 I
...J&&_ I I
I
I
I
I
I
0.2
0.4
0.6
0.8
1
1.2
1.4
,
w
0.2
0.4
0.6
0.8
1
1.2
1.4
w
W
Fig. 1 (a) Price of output vs. w: (b) profit vs. MY(c) consumer surplus vs. W; (d) welfare (consumer net plus producer surplus) vs. W. Key: - - -- unregulated firm; -- -- price cap regulation; ~ benefit sharing. *5
.h.
3 Variations in k
Suppose W= 1, but k varies. The effects of variations in k on output price [fig. 2(a)], profit [fig. 2(b)l, consumer surplus [fig. 2(c)], and the sum of consumer and producer surplus [fig. 2(d)] are shown for the same three types of firms. The profit maximizing unregulated firm can break even as long as k k0.8246. In other words, for values of k less than approximately 0.8246, the average cost schedule lies entirely above the demand schedule for all prices, and even the unregulated profit maximizer will fail to break even for any
R.R. Braeutigam, Regulatory bargain for diversified enterprises
18
09
Profit
200 150 100 50
1
1.5
2
2.5
1
1.5
2
2.5
(4
k
Fig. 2 (a) Price of output vs. k; (b) profit vs. 1:; (c) consumer surplus vs. k; (d) welfare (consumer plus producer surplus) vs. k. Key .**. unregulated firm; -- - - price cap regulation; ~ net benefit sharing
choice of output. Several further comparative properties of the regulatory regimes can be observed in the example. (i) As k falls below 1, the firm will encounter negative profits under price caps before it does under NBS. Under price cap regulation the firm can break even only as long as k 20.9. Under NBS regulation the firm can break even as long as k ~0.8246, although the NBS constraint will be not binding for k zO.85. Th us, if k falls ?o the range 0.8246 5 k 50.9, the NBS firm can
contintie to produce. while the firm under price cap regulation will fail to break even unless the price cap formula is somehow renegotiated. (ii) For values of k such that 0.9 5 k < I, price and profit for the firm under NBS will be higher than under price caps. Correspondingly, consumer surplus and welfare will be higher for the firm under price caps. If k > 1, these findings are re;-;rersed.so that consumer surplus and welfare will be higher for the firm under NBS.‘* The example points out that the NBS firm will be able to survive without renegotiation of the constraint for all values of k and M’ for which an unregulated profit maximizer can also survive. By contrast, for some values of k and \t’ the price cap regulated firm will fail to survive without renegotiation of the price cap formula, including values for which the NBS firm remains financially viable. This occurs because the NBS constraint allows the firm to take into account $1 L i\: changes rn M’and k observed by the firm, even though (consistent with an environment of asymmetric information) the NBS regulator does not observe the cost shift parameter. The typical price cap constraint (i) does not incorporate values of k at all, and (ii) does not take into account whether the aliowed price cap would require the fir ~1to incur negative p-4%.
6. Conclusion
The diversification of public utilities into competitive markets has created a number of substantial problems for regulators employing rate of return regulation. This has led policy-m:!kers to consider other forms of regulatory bargain. W’lile pure price cap regulation provides the firm with incentives to produce efficiency and to diversib ?r;l~~ :hcrc ~-2 Y~.~nomies of scope, it is most likely to do so in industrial settings in which the price caps are exogenous to the firm. In practice, however, price caps may not be exogenous. Under price cap regulation in several jurisdictions, price cap regulation may well be augmented by a form of rate of return regulation, leading to the reintroduction of many of the adverse incentives long associated with the rate of return constraint. While such problems as these and others discussed in the text may not be insurmountable, they are at rhe least formidable, and suggest reason to diversify the quest for better kinds of regulatory bargain. The central purpose of this paper has been to explore the rudiments of an alternative form of regulatory bargain as a way of dealing with diversified firms, one that allows the firm to earn a level of profit which is positive but no larger than a designated share of the net econunnic benef? i&s me;lstired - COLGI_I be further enhanced by implementing an ‘“The welfare perfGxP,;tnce of :he NBS scherr._ x that depends on Sm. as suggc’s:A ii1 thv Imnulation of t’q. (5).
20
R.R. Braeutigam, Regulatory bargain for dirersiJied enterprises
by consumer surplus) accruing to customers in core markets. This form of regulation has several desirable characteristics. It will depend only on variables observable to the regulator, and specifically does not require the regulator to know whether the firm is producing efficiently (although at an optimum for the firm, production is efficient). It does not require any allocation of common costs over the products of the firm, as would be the case with rate of return regulation. Furthermore, it would retain many of the basic features and benefits of pure price cap regulation. However, because it would tie the firm’s total profits to the level of consumer benefits, it would not require that the link between prices set and the firm’s cost factors (both exogenous and endogenous) be broken. It would also reduce the need for regulators to propose indices to adjust price caps as exogenous cost and demand factors change since all cost and demand factors would be included in the regulatory constraint imposed on the firm. The net benefit sharing bargain leads to an outcome that satisfies all of the regulatory objectives identified in the paper. References Baron, D-P., 1989, Design of regulatory mechanisms and institutions, in: R. Schmalensee and R,D. Willig, eds., Handbook of industrial organization, vol. 2 (North-Holland, New York) Chap. 24, 1347- 1447. Baumol, W.J., J.C. Panzar and R.D. Willig, 1982, Contestable markets and the theory of industry structure (Harcourt, Brace. Jovanovich, New York). Berg, S.V. and J. Tschirhart, 1989, Natural monopoly regulation: Principles and practice (Cambridge University Press). Braeutigam, R.R., 1939, Optimal policies for natural monopolies, in: R.Schmalensee and R.D. Willig, eds., Handbook of industrial organization. vol. 2 (North-Holland, New York) Chap. 23, 1289-l 346. Braeutigam, R.R. and J.C. Panzar, 1989, Diversification incentives under ‘price-based’ and ‘costbased’ regulation, RAND Journal of Economics 20, 373-391. Friedlander, A.F.. 1969, The dilemma of freight transport regu!ation, 1963 (T!x Brookings Institution, Washington, DC). Hillman, J-J., 1990, Oil pipeline rates: A case for yardstick r~gul~tfxr, in* M.A. Crew, ed., Competition and the regulation of utilities (Kluwer, Boston, MA!. Hillman, .!.I. and R.R. Braeutigam, 1989, Price level regulation for diversified public utilities (Kluwer, Boston, MA). Hillman, J.J. and R.R. Braeutigam, 19Gi). The potential benefits and problems of price level regulation: A more hopeful perspective, Northwestern University Law Review 84, no. 2, 695-710. Sibley, D. and D. Sappington, 1990, Strategic nonlinear pricing under price cap regulation, Bell Communications Research Corporation, manuscript. Vogelszng, I., 1988, Price cap regulation of telecommunications services: A long run approach, RAND Publication Series N-2704-MF. Zajac, E.E.. 1978, Fairness or efficiency: An introduction to public utility pricing (Ballinger, New York).
Journal
of Industrial
Organization
11 ( 1993) I-20. North-Iiolland
regulatory enterprises Ronald R. Braeutigam*
Final version received April 1992
This paper examines an alternatice to traditional rate of return regulation and price cap regulation for public utilities which serve both non-competitive and competitive markets. The alternative is ;i regulatory bargain in which the allowed economic profit for the firm is tied to the level of net economic benefits (consumer surplus) accruing to the customers in noncompetitive markets. Among other things. this form of regulation is shown to lead to cost minimizing production. efficient pricing in competitive and wn-competitive markets, diversification into competitive markets if and only if there are economies of scope. and protection of customers in non-competitive markets from economic harm (reduced consumer surplus) if the tirm does diversify.
1. Introduction
The increasingly frequent diversification of public utilities into competitive markets has created a number of difficulties for regulators employing traditional rate of return regulaiion. Where regulators have attempted to establish revenue requirements by imposing a rate of return constraint on the non-competitive markets served by the firm, rate of return regulation has necessitated the allocation of common costs of production, typically accomplished through fully distributed cost pricing practices. Such cost allocation mechanisms have been criticized widely in the literature for a number of reasons, including their arbitrary nature, the circularity of a process that sets rates based on allocations which in turn ultimately depend on rates, and a general lack of foundation in economic principles [see, for example, Friedlaender ( 1969); Zajac ( 1978); Berg and Tschirhart ( 1989) and Braeutigam (1989)]. The problems with cost allocation mechanisms exist even where utilities have monopolies in all markets served. However, the problems are exacerbated in the presence of competition in some of the markets served by a utility, since cost allocation rules not only affect the revenue requirenents Department Corr’L~.~pc)ritit’rl(‘C’ to: R.R. Braeutigam. Evanston, IL 60208-2400, USA. *The author wishes to thank Norman Ireland comments on this research. The author is Kapnick western University. 0167-7187 ‘93 $06.00 (
1993
01’ Economics,
Northwestern
l_!niversity.
and William Rogerson for their Professor of Business Institutions.
Elscvier Science Publishers
B.V. All rights reserved
helpful North-
2
R.R. Bmeutigam,
Regulatory bargain for &cersij?ed enterprises
in individual markets, but also affect the Economic viability of rivals in competitive markets. Recently Braeutigam and Panzar (1989) identified a number of problems with the incentive structures created by return regulation for public utilities serving both non-competitive and competitive markets, including incentives for a firm to choose economically ineflicient levels of production in its markets and to misreport costs as attributable to non-competitive services whenever possible. They also showed that if a competitive market served b:T the firm is mistakenly placed inside the rate of return constraint along with non-competitive services, the firm will have an incentive to price below marginal cost in that market. In addition, their ana,lysis demonstrated that cost allocation rules may make economically efficient diversification unprofitable for the firm, may induce a firm to choose an inefficient technology, and may create cost reduction incentives stroirger in competitive markets than in non-competitive markets. Concerns such as these have led to a number of regulatory bodies (most notably in the telephone industry) to move toward the adoption of ‘price cap’ regulation.’ Much of the original excitement over price caps stemmed from the hope that this form or regulation would induce the firm to produce in a cost minimizing fashion by breaking the linkage between the firm’s costs and the process by which regulators determine rates. This approach contrasts sharply with rate of return regulation, which ties the allowed revenues to the costs incurred by the firm. In applying the purest form of price cap regulation to diversified firms, a regulator might first classify non-competitive markets (i.e. those markets with relatively inelastic demands) as ‘core’ markets, and competitive markets (i.e. those markets with highly elastic demands) as ‘non-core’ markets.2 The regulator might then set a ceiling on the individual rates, or an index of rates, to be charged in core markets, the level of the ceiling being affected ‘Many of the proposals for price cap regulation in the United States have found their roots in the model provided by British Telecommunications plc (‘British Telecom’). In 1984 the British Government chose to regulate the firm’s prices directly through a formula relating price increases for telephone services to the annual change in the British Retail Price index minus a specified percent (initi,tlly 3”“) productivity factor. See ‘License granted by The Secretary of State for Trade and Industry to British Telecommunication under Section 7 of the Telecommunications Act of 1984, as amended in 31 July, 1987 (HMSO, London. 1987). In the United States price level regulation has been pursued at both state and federal levels in the telecommunications industry. For example, at the federal level, see Further Notice of Proposed Rulemaking, CC Docket No. 87-313, FCC Docket No. 88-172, 2.7 May, 1988 (‘Further Notice’). See also Title 30, Vermont Stats, Ann.. # 226a and 227a for the sta:Lte allowing negotiated contract prices for basic exchange telecommunications service in Vermont. ‘The classification of markets may not be a trivial matter, since, for example, demand elasticities may not always be known with great accuracy. Furthermore, a market which is inelastic today may become elastic after some time as substitute services emerge; thus classificatton as core or non-core may not only involve uncertainties, but may have to be reassessed as market conditions change.
R.R. Brmutiganz, Regulatory
bargain .for drxwijied
enterprises
3
only by exogenous cost factors, such as prices paid for factors of production. The firm would be allowed to enter CO and produce whatever output levels it desires in non-core markets. Many of the incentives that would arise with pure price caps are similar to the incentives present in competitive markets.” Among other thingi pure price cap regulation would induce the firm to produce in a cost minimizing fashion, ta undertake ,*ost reducing innovation as an unregulated firm, to produce in each comp:*rrtive non-core market up to the point at which marginal cost equals price,4 and to diversify into a competitive non-core market if and only if diversification is economically efficient. In practice it may not always be easy to break the linkage between rates and costs. It will no doubt depend on the nature of the industry among other things. For example, in a study of the possible use of price caps to the oil pipeline industry, Hillman ( i990) has suggested how the exogeneity of price caps might be preserved. Price caps in core markets might be based on the rates charged by other pipelines operating under similar conditions of production; such ‘yardstick’ price determinations would presumably be most useful where the markets used as a basis for setting price caps are competitive? In other industries the exogeneity of price caps may be more difficult to achieve. There may be no obvious yardsticks in some cases. In other cases, even if candidates for yardsticks exist, concern over whether the price caps are too low or too high may tempt regulators to assess the appropriateness of the caps using some definition of the profit generated by the firm in its core markets. Such a possibility is more than hypothetical. For example, price cap schemes such as those adopted by the FCC and by the state of Vermont both announce an intent to review the performance of the regulatory process after some period of time, including an assessment of the rate of return achieved. The use of rate of return as a criterion as a part of price cap system endogenizes the price caps, and thus reintroduces the incentives for adverse performance identified by Braeutigam and Panzar. What, then, can be done to regulate diversified industries when for some reason the linkage between rates and cc’ :s cannot be broken? Since neither 3F~r a more de!ai!ed discussion of these incentives see Hillman and Braeutigam ( 1989, pp. 3738 and 63-66). 4To the extent that the firm can influence the price in a non-tort market, then price will diverge from marginal cost, and some economic inefficiency will be mtroduced as a result. However, if the firm’s ability to inlluence price is minimal. then the size of the resulting inefficiency should be small. 51n addition the implementation of price cap regulation will require the resolution of a number of operation4 issues discussed in the literature, including the way in which the caps are set a;ld adjusted over timr: PC fac+cr prices and conditions of demand change. For more on this point Li:e Voge!sang (:QP’?. Ki’imarl and Braeutigam (1989, pp. 59-62, and 1990), and Sibley and Sappington (1990) ior 9\,proac’.zs !;? determining the weights of the mdex in a formulation of price caps that ir dynamic GUI ~~:ict’cap for muia that adjusts over time.
4
R.R. Braeutigam, Reghtory
bargain for dicersjfied enterprises
rate of return regulation nor price cap regulation succeeds here, alternative regulatory bargains need to be explored. In this paper we analyze the rudiments of one such bargain, which we call the Net Benefit Sharing (NBS) bargain. This form of regulation would tie the firm’s total profits to the consumer benefits (i.e. consumer surplus) generated in non-competitive markets, thereby allowing the firm to keep a limited portion of the net economic benefits from production. This bargain induces the profit maximizing firm to behave as a cost minimizer and produce outputs according to the inverse elasticity rules characteristic of a Ramsey optimum. Furthermore, diversification into competitive markets will increase profits if and only if there are economies of scope. In addition to these properties of economically efficient operation, the constraint also induces the firm to satisfy one of the equity-based concerns of many regulators who want to ensure that diversification into competitive markets does not harm (reduce the aggregate consumer surplus of) the customers in monopoly markets. 2. A model of the diversified firm Consider a regulated firm potentially serving two types of markets, non-competitive (monopoly) markets and competitive markets. The noncompetitive markets might be viewed as the traditional center of the productive activity of the regulated enterprise. They are sometimes referred to as the ‘core’ markets served by the firm. Examples of such markets might be the local exchange and access services provided by a local telephone company, or the provision of electric and natural gas services to residential and business customers who have no other ways to obtain these services other than from the pub% utilities who are local distributors of gas and electricity. Demands for these types of services are usually characterized as being relatively inelastic. Let p =(pl, p2,. . . , p,) be the vector of prices of the nz non-competitive products. The demand for the non-competitive output is denoted by Y&I), for i= 1, . . . ,m, so that there may exist cross elasticities cf demand among the set of non-competitive products. The vector of noncompetitive outputs is y@) = (yr @I),y2@), . . . , y,(p)). The demand schedule for each service satisfies the usual property that demand is downward sloping (i/li/c?pi < 0, Vi). At the same time the firm may diversify into competitive markets. Let 4,) be the vector of prices of the n competitive products, and =+,,42:..., -G.- (Z42,...,Z, ) be the corresponding vector of output produced by the firm. We assume that if the regulated firm diversifies into a competitive market, it provides a product which is a perfect substitute for the products of its rivals; furthermore, we assume that the market will remain competitive. Thus the firm may cl~Lithe- its level of output in each of these markets, but since the markets are competitive, the firm takes 4 as given in the market.
5
We assume that the firm knows its own cost function, C(y@),z), that would be associated with the cost minimizing production of y and z.~ However, the firm may not act as a cost minimizer, and may in fact produce any observed y and z with total expenditures E in excess of C(y@),t). Let u 20 denote the difference between E and C(y(p),z), where u can include expenditures arising from either technically or allocatively inefficient production. One of the primary benefits that might be achieved under diversification is the realization of economies of scope.’ If a firm diversifies into competitive markets with economies of scope, the total cost of producing y and z will be lower than the total cost of two separate entities, one producing only the non-competitive services y, and thz other producing only the competitive services z. In other words, if C(y, Z)< C(y.0) + C(0, .:). then there are economies of scope, and it would be less costly to produce both competitive and non-competitive outputs with one firm than with two or more firms. If C(y, Z)> C(y, 0) + C(0, :), there are diseconomies of scope. and it would be more costly to produce both competitive and non-competitive outputs with one firm than with two or more firms. Finally, if C(y, z)= C(y,O)+ C(O,z), then it costs the same to produce competitive and non-competitive outputs with one firm as it would with two or more firms. Both the regulated firm and the regulator are assumed to have symmetric information about demand schedules. For the competitive markets both know the market prices in any competitive markets served by the firm as well as the quantities produced by the regulated firm in those markets. Fcr non-competitive markets both the regulator and the firm can observe the demand schedules facing the regulated firm. In both non-competitive and competitive markets both the regulator and the firm can observe the regulated firm’s prices, levels of outputs, and thus the revenues collected. To retain the flavor of regulatory reality, we assume information IS asymmetric with respect to costs. The firm knows its total expenditures E and it knows whether it is producing its outputs in a cost minimizing manner. While the regulator can also verify the total expenditures E through audits of the company’s books, it cannot observe whether the firm is producing outputs at the minimum possible total cost. In other words, we allow for the possibility that the firm might employ wasteful expenditures, whose level is denoted by M. While the regulator can observe the total expenditures made by a firm, E = C(y@), Z)+ u, it cannot tell whether u =O, in which case production is cost minimizing, or whether u > 9, in which case the firm is producing inefficiently. ‘The prices of factors of production will be assumed constant in this analysis. an< Ibr simplicity of notation are therefore suppressed from references to cost functions throughout the presentation. ‘For a further discussion of economies of scope. see Baumol et al. ( 1982, pp. 71-72).
R. R. Braeutigam, Regulatnrq’ bargain for dicers~fied ante .;.+.c::,
6
While the firm knows whether there are economies of scope assoc&ed with the production of both the monopoly and competitive products, the regulator does not. If there are economies of scope, a blanket prohibition on diversification might unnecessarily deprive society of the opportunity to gain from the cost savings that diversification would yield. The profit earned by the firm, 71,is the difference between the revenues earned in all of its markets less the total expenditures incurred by the f”trm. Given ~1,Z, and tl, the profit of the regulated firm can be written as ~(p,z,~)=p’y(p)+q’z-cGv(I4),z)-u.
(1)
Since both the regulator and the firm can observe revenues and expenditures, both can also observe the level of profit earned by the firm. We assume that the firm will choose the prices in non-competitive markets, the level of output in competitive markets, and the level of waste expenditures u to maximize its profit, subject to any regulatory constraint that it might be required to satisfy. The total welfare associated with the values (p, Z,U) can be represented as follows: (2) where, in addition to the terms already defined, Sm~(p)) denotes the consumer surplus generated in the non-competitive markets and S’(q) denotes the consumer surplus generated in the competitive markets. One of the properties of this structure is that, in the normative analysis to follow, the amount of consumer surplus generated in competitive makcts will be constant, since the price q does not change as z varies. Furthermore, since each competitive firm earns zero profit, the total producer surplus for these rivals (not including the profit of the regulated firm) remains constant and zero. Eq. (2) can be viewed as the sum of consumer and producer surplus in the regulated and competitive markets. Since the last term in (2) is a constant, maximizing rV in (2) is equivalent to maximizing W in (3): W@, t, u) = Srn(_V(p)) +p *ycp)+ q ’ z -
a_Y@)i z) - 24.
(3)
We ;zssume that W and 71 are strictly concave in their arguments.*
We also assume that, given Z, the firm is unable to break even when prices (2!c set at marginal cost in the non-competitive markets, i.e. 71~0 when pi = [YS ., /F\’ZTi-T j , . . . ,f~ This a‘< .,~:t:r;tlon Y. :s to c+ture a feature of the -. ~~lnc::-/it\ “FT._ ..__1 l
aS.ibmptifr.1 tfi;li . e-t EL.7.’ _ ..
>f 71’ 11: * rec:,;r,-* 7%’ ‘(-‘ -_ ‘, _ il wlv.- , - * -ic,tent with the tile rgf~gl;l:ed jlrn, I: ’ -;:,;I _’=’._. .*_ ‘= I &I__’ :.,_ ITI .y,- ;.c!‘;.1. : . YS such a
7
regulated utility problem, since the firm cannot break even when prices are set at first best.”
3. Possible regulatory objectives We now turn to the identification of a number of possible objectives that might be pursued by regulators, for reasons apparent as the set is presented. This set of objectives is surely not exhaustive, or even necessarily pursued by any particular regulatory agency. These possible objectives have been used by Braeutigam and Panzar ( 1989) to eval::ate the performance of rate of l-&u-n regulation, and by Hillman and Braeutigam (1989) to assess the performance of variations of price cap regulation. In this paper we use the set to assess the performance of the NBS bargain. The first four objectives arise if the policy-maker is interested in achieving economic efficiency (maximizing u/v), subject to a constraint that the firm earns some minimum level of profit x0, where x0 20: max IV@, z, U)subject to r@. Z,24)2 no. (p.I.u)
(4)
At a solution to (4), the envelope theorem indicates that dkV/dn’
Objectire
1 (Cost
Minimizing
Regulatory
Ohjectire
2 (&/ficierlt
Production).
The regulatory constraint should induce the firm to produce in a cost minimizing fashion, i.e. without waste (u = 0). Productiorz
irz Competitive
Markets).
If
“In other words, without this assumption, marginal cost pricing in non-competitive markets would enable the firm to break even and maximize economic efficiency at the same time. While this would lx a desirable state of the world, it is not characteristic of most regulated utilities.
8
diversification occurs, the regulated firm should produce in the competiti=le market so that price equals marginal cost (vi = ?C/?Zi, i = 1,. . . , n). Markets). At a solution to (4), [?Ilj/,‘?pi] J[?nj?pi] = [?lV/c’p~]/[2~/3p~], i = 1,. . . , m; k = 1, . . . , m. With independent demands (and demand elasticities for services i and k denoted respectively by ei and Q), this condition can be expressed in Regulatory
Qbjectioe 3 (Eff lcient Production
in Non-competitive
terms of the more familiar inverse elasticity rules characteristic of a Ramsey optimum: [pi - ?C/?yi] . ei/pi = [pk - (~C/(?J’L]*e,lpk, i = 1,. . . , m; k = I,. . . , m. lo In addition, the economic viability of the firm is important to the regulator, since the basic non-competitive services may not be produced otherwise. Regulatory
even,
so
Objective 4 (Economic
that
the
Yiability). The firm should at least break
non-competitive
services
continue
to
be provided
(Np* z, u) 2 no).
Ihis viability is imposed as a part of the solution to the partially regulated second-best problem (4) through the constraint ~c(p,z, U)>=rr” 2 0. The first four objectives are derived from welfare considerations that lead to a variation of second-best pricing. Among other things, a regulator may have two additional concerns about the effects of diversification of the regulated enterprise into competitive markets. First, it is possible for diversification to improve profits for the firm, lut to reduce the sum of consumer and producer surplus. A regulator may object to such economically inefficient diversification. Thus a possible regulatory objective is the following: Regulatory
Objectiue
5 ( Welfclre
lrweasing
Diversification).
constraint should be structured so that if diversification increases welfare IN Since the regulator
The regulatory is profitable, then it
may not be able to observe whether
there are
“‘Let W” be the surplus achieved at a maximum of (4) when the constraint is nz~‘>O. Of course, an alternative regulatory regime that constrains the firm to a level of profit below no (e.g. n* j, so that TI= z* < no might lead to a level of PY> W”, even though prices under the regime do not satisfy Ramsey rules; however. in that case IV could be even larger if the Ramsey rules were satisfied.
economies of scope, it may be desirable for the regulatory system to induce the firm to use its own information Gout economies of scope in an economically efficient manner so that the firm will find diversification profitable when there are economies of scope and unprofitable when there are diseconomies of scope. In addition, a regulator may be concerned about the economic we%being of customers in regulated markets as a result of diversification. The regulator may therefore wish to require that customers in non-competitive markets will not be made worse off (incurring a loss in consumer surplus) as a result of diversification. Thus we state an additional possible regulatory objective based on this concern for equity: Regulatory Ohjectire 6 ( Protectim o/’ Nowcompetitive Cmtonzers U de) Dicers~fication). Customers in regulated markets should realize a consumer
surp!us under diversification no less than they would achieve if the firm were prohibiied from entering the competitive market. Finally, a regulator will undoubtedly be interested in the practicality of imyllementing any regulatory constraint, particularly with respect to the observabihty of the data needed by the regulator. Regulatory Objectire 7 (Implen2e~ztahilit~).The regulatory
constraint should be structured so that it depends only on data observable by the regulator. AI example of a need to satisfy implementability would occur if the firm knows its cost structure, but the regulator does not. An implementable regulatory constraint may depend on total expenditures made by the firm (which the regulator can observe), but it should not be structured to require the regulator to know the actual cost structure of the firm C, including whether there are economies of scope, or whether there is inefficient production (U> O).’’ 4. Net benefit sharing: An alternative regulatory bargain
In this section we consider the NBS bargain. This form of regulation recognizes that the net economic benefits accruing to the firm are represented by the economic profit of the firm and that the net economic benefits flowing to customers of the core (presumably non-competitive) services can be measured by the consumer surplus in those markets. The outcome of the “A number of possible regulatory mechanisms dealing with asymmetric information have been explored in the literature. Many of these mechanisms explore the possibility of using taxes or subsidies (both being outside the scope of the investigation here) to induce the firm to perform more efficiently [see, for example, Baron (1989)].
10
R.R. Braetrtigant,
Regulatory
bargain jbr dirers$ed
enterprises
bargain between the firm and core market customers allows the firm to earn positive economic profits, denoted as before by rc, but the bargain specifies that the amount of those profits must be less than or equal to some designated fraction, 2, of the consumer surplus, denoted by Sm. In other words the bargain splits the total surplus according to the fraction represented by CC The consumer surplus generated in the non-core markets is excluded from the regulatory constraint for two reasons. First, in competitive markets there are a number of firms responsible for generating consumer surplus. The inclusion of consumer surplus from the markets in the regulatory constraint would lead to the obvious question as to why the regulated firm’s profits should be based on consumer surplus that would be generated even if the regulated firm did not enter the competitive market at all.’ 2 Second, and more importantly, the inclusion of only the surplus generated in the core markets will generate economic incentives that lead to the achievement of the possible regulatory objectives identified in section 3,’ 3 The fraction of surplus retained as profit, 2, might be a constant, but more generally might be structured to depend on the level of total consumer surplus. For analytical purposes, suppose 2~: 2 dti!cs depend on S” as well as on a shift parameter /3, so that @Sm.,!2). An increase in B would be associated with a bargain in which r is higher for any given level of Sm. If 3~ depends on the level of consumer surplus in core markets, the economic incentives discussed below will hold as long as allowed profit increases as S” increases. * 4 Thus while the bargaming outcome allows the firm to increase its total profit as consumer surplus increases, the constraint may be designed so that the fraction of total surplus kept as profit falls as total surlYus grows. What is important is that the firm takes the form of r(S”‘.$) as exogenous, that is, that the firm does not believe it can manipulate the function z(S~,~) by its own actions. Formally, the regulatory constraint can be written as follows: ~c(p,z, u) 5 a(S”, /Wm.
(5)
The firm then chooses p, z and u to maximize profit (1) subject to the constraint (5). Let E, be the Lagrange multiplier associated with the constraint and form the Lagrangian for the problem (6). The first-order conditions for an optimum (7)-(9) are as follows, where the substitution “In addition, reglllatoi\ may not have information about the demand schedules in these markets, and the gat hxing of such information would be ..n unnecessary burden on the regulatory process. ’ 3To see the division of surplus another way, let ; be the fraction of total surplus kept by the firm as profit rr. Then rr = ;1(rr+S”), which implies that x = [;I/( 1 --?)I. Thus the regulatory constraint can be equtvalently represented by TC~G;l(n+ Sm) or by TI2 xS”. “Thus, in addition to r(S”,/I)>O, we shall require that [x(S”,~I)+.F”x,(S”,/~)] ~0.
_l’i= -- ?S”/r?pi has been made and the arguments of 71and Sm, yi and ci:have been omitted for notational simplicity:
H=
7-c+
2&S” -
n] = ( 1 -
E,)7r+ i,cxS”,
(6)
c’H/c?,-i= ( 1 - i.)?lT/c?Zi= ( 1 - i)( qi - ?C/f?Zi)5 0;
-li ~
0;
3i
c’Hlc’ri = 0, Vi,
?H/?u = ( 1 - i.)c?n/ik = - ( 1 - i) 5 0; u 2 0;
(8) uSH/?u = 0.
(9
Let us now turn to some of the properties that make this form of regulatory bargain worth consideration. The first shows that the firm will be induced to act as a cost minimizer, even though the regulator cannot directly observe whether production is efficient. This satisfies Regulatory Objective 1. Property 1 (Cost Minimizing Production). The_firm will ?ehat:e to minimize the costs i?f’producing any observed y and z (i.e. u = 0). Prooj: Assume the constraint is binding (2 > 0). Then, by (9) cH/?u 5 O=G, 5 1. But by (7) i_= 1*?H/?pi = [%,Sm+ ~]~i > 0, which violates optimality. Thus
i. < 1 and u = 0, and the firm produces efficiently. Now we examine the prices that would be set by the firm. Property 2 shows that the firm will produce its output in the competitive non-core markets so that price and marginal costs are equated, satisfying Regulatory Objective 2. Propert!. 2 (Efficient Production in Competitille Markets). The firm non-core markets so that price produce its output in the competitiw marginal costs are equated. Proqf: This follows directly from the first-order
condition
will and
(8). Since iti< 1,
R. R. Brauctigatn,
12
Regu!atory
bargain jbr dicersfted
?7t/?Zi =0,
which implies that price and marginal non-core markets.
etlterpriws
cost are equal in the
With respect to pricing in the core markets, Property 3 shows that the firm will follow the efficient inverse elasticity pricing rules of a Ramsey optimum, as characterized by Partially Regulated Second Best. Pro/I?srt4’ 3 (Eff lcient Production produce in its non-competitive Ramsey optima/Q are satisfied.
in Non-competitive Markets). The firm will markets so that the inverse elasticity ru/es of
Proqf. By (7), Sn/?pi = [i.[ar,S” + Z(S”)]i( 1 -,Q]J.~. Vi. As noted in the discus-
Regulated Second Best, [c’W/Spi]/[~~/~pi] = [S W/?pn]/[?~/?p,], i = 1,. . . , I~Z; k = 1,. . . , m. But since IV = 71+ Srny(I:!V;‘?/Ii= ?n/?pi -yiY Vi, and thus the Partially Regulated Second Best pricing rule can also be writ’ien as c?Tt,‘?pi = [i.[r,S” + r]/( 1 - i,)]yi, Vi.
sion
of Regulatory
Objective
3, at
Partially
Regulatory Objective 4 requires that the firm earn at least a normal return on investment so that it remains financially viable. Under price cap regulation tinancinE viability is not guaranteed since it is possible that a regulator might set caps so low that profit is negative. However, under the net becefit bargain discussed here, the firm will remain viable whenever it is possible for a totally unconstrained firm to earn positive profits. This is true since the constraint ties profit to consumer surplus in the core markets, and that surplus is always positive. Before considering the other regulatory objectives, two other properties of ib.2 nel: ITen& bargain are presented for completeness. They boih address the P;‘LY :t r.t c’l ‘ougher regulatory bargain (a lower level of fi) on the firm, cc):,;umers and total welfare. -i ( F,j$~ts of a Tighter Bargain on Profits and Consumer Surplus). Wh~*n rht~bargairA?.y wnstraifqt w? ,the firm is binding, a tighter bargain (i.e. a Jowe!. icce! Ly- /j) will dwre’rbTI’ I;& G-m’s profit and increase the consumer sui ,-JUL% ww markei; )-
“_
,ys
!+oqf:
i
_$‘
ealvel+e theorem, dn/dfl= i.r,J”. Since rB > 0, then dn/dp > 0, qIcvw a tightei’ bargain lowers the profit of the firm. Next, since Z= zS”, .
Since :I tighter regulatory bargain (i.e. a lower /I) decreases profit but increases wxGrner surplus, the effect of tightened regulation on total surplus
is not immediately obvious. In general a tighter bargain need not increase total welfare. If it is possible for the firm to break even when all prices are jet equal to marginal cost in the core markets, then at that set of prices there remains the question as to whether the firm earns profits that exceed ~6”. If so, then the regulatory constraint might actually reduce total welfare by forcing the firm to price below marginal cost. While this may not be viewed as typical in the case of natural monopoly, it should be noted that a natural monopoly could exist in such a case.’ 5 However, if the firm cannot break even when prices equal marginal costs in the core markets, a tighter regulatory bargain will increase total welfare. This is shown in Property 5. Property 5 ( EJects of u Tighter Bargain on Total Welfare). If the fkn cannot break even (i.e. emi x 2 0) wheri ull prices are set at marginal cost, then a tighter hurgain will increase totul welfare W Proof
Since W=;rr+S”. d W/dfl= dn/dg + dSm/dfl = Lcx,S”(El- 1)/r = r,S,(i.z + i, - 1)/r. The first-order condition (7) can be rewritten as ?H/Spi = ( 1 - i) (?W/c?pi- iX,\7Jm -( kt + i, - 1 )yi = 0, Vi, when pi > 0. If the firm cannot break even when all prices are set at marginal cost, then ?W,@+ 4 which implies that the first two terms of the right-hand side of the first-order ?W/@= condition that (i.r+i,-- 1)cO. Then are negative and ~,Srn(2.~+ i_- 1)/r ~0. Thus a tighter bargain increases total welfare W The next property relates the incentive to diversify to the existence of economies of scope. It points out that under the net benefit sharing bargain economics of scope are the primary factor in determining whether the firm diversifies. Property 6 (Economies of Scope and Diversification). lf there are economies of scope, the profit maxinli~ing_firm will dioers(fy under the regulatory mechanism 71-I: YS”. ij’ there are diseconomies of scope, the firm will not diversify. lf there are ncnther economies uor diseconomies of scope, the firm will be indifferent to dirers@ution. Proof Let the superscript d refer to the profit maximizing choice of the diversified firm, i e. @, z) =@“, zd) solves max 7t=py@) +qz - C(y, z) subject to 715 rS”. Albo let the superscript o refer to the point maximizing choice of the undiversified firm, so that !p, Z)=(@‘, 0) solves max ;TC =PJ@) - C(J, 0) subject to 7cQS”. Also recognize that if the non-core services are provided by a separate firm using the stand alone technology of the other suppliers in the ‘“As is well known from the discussion of Baumol et al. ( 1982, pp. 18-22), a natural monopoly (i.e. a lirm operating with a subadditive cost structure) could exist for levels of output that would allow for the firm to break even when price equals marginal cost.
R.R. &wwti,gaf?z, Rcydatory
14 market,
then
competition
hargairtjbr direr.$ed
enterprises
leads to zero economic profits in the competitive
enterprise, i.e. q, z = C(0, z).” If there are neither economies nor diseconomies of scope, then pdyd + qzd - Cdvd, zd) =pdyd
+ qzd - CQd,
0) - C(0, zd)
=pdy”
+ qzd - C(yd, 0) - qzd =pdyd
Sp”y”
- C&O.
- C(yd,
0)
0).
and p”_Vo- C(y”, 0) = pOy’ +
qzd - C(y”,
0) - C( 0, zd) =p”y”
+ qzd - C(y”,
zd)
spdyd+q?-C(yd.Zd).
Hence p”yo -- C(J”, 0) =pdyd + qzd - C(J~. ~~1. Thus, if there are neither economies nor diseconomies of scope, the firm is indifferent to diversification. If there are economies of scope, then p”y” - C@“, 0) =p”y”
+ qzd - C(y”.
0) - C( 0, Zd ) < p”y” + qzd - C(y”,
spdyd
+ qzd - C(yd,
Zd).
Zd)
Thus diversification will be profitable. If there are diseconomies of scope, then pdyd + qzd - C(yd,
zd)
+ qtd - C(yd.
0) - C( 0, td) =pdyd sp”yo
- Qyd.
0)
- CLjYO, 0).
Thus diversification will be unprofitable. As Property 6 shows, the firm will find it profitable to diversify when there are cost saving benefits to be achieved through economies of scope. The next property shows that those benefits will be shared; not only will the firm’s profit increase, but customers in non-competitive core markets will also benefit from diversification. Stated another way, regulators can be assured that, taken as a group, customers in core markets will not be harmed by diversification of the regulated firm into competitive makets. This satisfies Regulatory Objective 6. lhThis assumes that indivisibilities 91“ = C(0, zd) and 9:” = C(0, :“I.
are not a problem
in the competitive
markets,
so that
Property 7 (Protection qf Non-cortrpetitire Customers Under Dicers$cation). If dirersfjication is prqfitahle under the regulatory nzechanism IT2 zS”, it will increase the we&we 91’the customers qf’ the monopoly sewices. Proof.
The proof is trivial, since 3 is constructed so that d[gS”]/dS” = r,S” + cx~0. As S” increases, so will xS” and thus so will the maximum allowed profit E. A firm that increases its profit through diversification will therefore only be able to do so if S” increases at the same time. The linal property considered here relates to Regulatory Objective 5, which states that the regulatory constraint should be structured so that if diversilication is profitable, then it increases welfare W Property 8 indicates that this goal is satisfied. Property 8 ( We!$we increases welfiwe.
Increasing
Diversification).
Prqfitahie
dirers&ation
ProoJ The proof follows directly from Property 7. If diversification is profitable, then not only are the prolits of the regulated firm higher, but consumer surplus in regulated markets is higher. Since consumer surplus in competitive markets is unaffected by diversification, total surplus increases with diversification.
5. An example
We now provide an example to illustrate the comparative performance properties of simpie price cap and net benefit sharing forms of regulation. To keep the example simple, we shall focus on a firm producing only a single product in a monopoly market. Diversification is not an issue here. Rather the example focuses on the way in which output price, profit, consumer surplus, and welfare (the sum of consumer and producer surplus) vary as the firm experiences changes in factors affecting demand and cost. Let the demand structure be represented by _v=20k -p, where k is a demand shift parameter to be used in comparative statics below. As k rises, demand shifts outward (upward). Assume the cost structure is C =(60+;,7)~, where w is a cost shift parameter also used in comparative statics. C is linear homogeneous in 1%‘; thus w may be used to capture the effects of factor price changes. The variable MTmay also be used to represent changes in cost due to technological change, such as changes in productivrty. T".i.lS, a fxtor price increase of l%, coupled with a productivity increase of 3yA(i.e. costs would fall by 37; in hanmec\ wr;=.Wlead to a change in w of --2y0. the absence of factor price L___~_~, To begin, let k = NT=1. It can easily be shown that the lowest price at
16
R.R. Braeutigam, Regulatory bargain for diversified enterprises
which the firm just breaks even is p = 5. If a regulator had full information and desired to achieve second best, it could do so by directing the firm to set p= 3.
However, in the absence of full information, suppose the regulator allows the firm to set a price that allows the firm to earn some positive profit in order to induce the firm to minimize costs. Suppose the price cap and net benefit sharing rules are constructed so that p= 6 will result under each regime. For price caps, the regulator observes w and sets the price cap so Under the NBS system, suppose the bargain between the that ps6w.” regulator and the regulated firm results in a regulatory constraint @rxSm, where a=( 10/98). It is easy to verify that a price of 6 will result from NBS and price caps under these particular regulatory constraints.
5.1. Vuriakms
irt 1~
Suppose k = 1, but w varies. The effects of variations in w on output price [fig. l(a)], profit [fig. l(bj], consumer surplus [fig. l(c)], and the sum of consumer and producer surplus [fig. l(d)] are shown for three types of firms: (1) unregulated profit maximizer (dotted curve); (2) the firm under price cap regulation (dashed curve); and (3) the firm under NBS regulation (the solid curve). The profit maximizing unregulated firm can break even as long as 06 w 5 1.43. Several comparative properties of the regulatory regimes can be observed in the example. fi) As w rises above 1, the firm will reach negative profits under price caps before it does under NBS. Under price cap regulation, the firm can break even only as long as 0 s w 5 1.36. Under NBS regulation the firm can break even as long as 05 w 5 1.43, although the NBS constraint will not be binding for 1.375 s w 5 1.43. Thus, if w increases to the range 1.36 5 w 5 1.43, the NBS firm can continue to produce, even though the firm under price cap regulation will fail to break even unless the price cap formula is somehow renegotiated. (ii) As w rises above ! (in the range 1-c w5 1.36), price and profit for the firm under NBS will be higher than under price caps. Correspondingly, consumer surplus and welfare will be higher for the firm under price caps. (iii) As w falls from 1, price and profit for the firm under MS will be lower than under price caps for values of w such that 0.6 5 WC 1.O. Correspondingly, consumer surplus and welfare will be higher for the firm under NBS. For values of w such that 0 < ~‘5 0.6, these results are reversed. “Note that while the maximum allowed price varies with M’,including changes in factor prices and productivity, it does not depend on k; this is ci)llslstent with :he way in which price caps are typically implemented.
R.R. Braeutigam, Regulatory
(a)
D .
bargain for diversijied enterprises
17
12 10 8 6 d L
(b)
(cl
0.2
0.1
0.6
0.8
1
1.2
1.4
W
0.2
0.4
0.6
0.8
1
1.2
i.4
W
Profit
S
...... . . . . . . 1
W
.. . . I
i.. . ... I
. . . . ... . . . I
1 I
...J&&_ I I
I
I
I
I
I
0.2
0.4
0.6
0.8
1
1.2
1.4
,
w
0.2
0.4
0.6
0.8
1
1.2
1.4
w
W
Fig. 1 (a) Price of output vs. w: (b) profit vs. MY(c) consumer surplus vs. W; (d) welfare (consumer net plus producer surplus) vs. W. Key: - - -- unregulated firm; -- -- price cap regulation; ~ benefit sharing. *5
.h.
3 Variations in k
Suppose W= 1, but k varies. The effects of variations in k on output price [fig. 2(a)], profit [fig. 2(b)l, consumer surplus [fig. 2(c)], and the sum of consumer and producer surplus [fig. 2(d)] are shown for the same three types of firms. The profit maximizing unregulated firm can break even as long as k k0.8246. In other words, for values of k less than approximately 0.8246, the average cost schedule lies entirely above the demand schedule for all prices, and even the unregulated profit maximizer will fail to break even for any
R.R. Braeutigam, Regulatory bargain for diversified enterprises
18
09
Profit
200 150 100 50
1
1.5
2
2.5
1
1.5
2
2.5
(4
k
Fig. 2 (a) Price of output vs. k; (b) profit vs. 1:; (c) consumer surplus vs. k; (d) welfare (consumer plus producer surplus) vs. k. Key .**. unregulated firm; -- - - price cap regulation; ~ net benefit sharing
choice of output. Several further comparative properties of the regulatory regimes can be observed in the example. (i) As k falls below 1, the firm will encounter negative profits under price caps before it does under NBS. Under price cap regulation the firm can break even only as long as k 20.9. Under NBS regulation the firm can break even as long as k ~0.8246, although the NBS constraint will be not binding for k zO.85. Th us, if k falls ?o the range 0.8246 5 k 50.9, the NBS firm can
contintie to produce. while the firm under price cap regulation will fail to break even unless the price cap formula is somehow renegotiated. (ii) For values of k such that 0.9 5 k < I, price and profit for the firm under NBS will be higher than under price caps. Correspondingly, consumer surplus and welfare will be higher for the firm under price caps. If k > 1, these findings are re;-;rersed.so that consumer surplus and welfare will be higher for the firm under NBS.‘* The example points out that the NBS firm will be able to survive without renegotiation of the constraint for all values of k and M’ for which an unregulated profit maximizer can also survive. By contrast, for some values of k and \t’ the price cap regulated firm will fail to survive without renegotiation of the price cap formula, including values for which the NBS firm remains financially viable. This occurs because the NBS constraint allows the firm to take into account $1 L i\: changes rn M’and k observed by the firm, even though (consistent with an environment of asymmetric information) the NBS regulator does not observe the cost shift parameter. The typical price cap constraint (i) does not incorporate values of k at all, and (ii) does not take into account whether the aliowed price cap would require the fir ~1to incur negative p-4%.
6. Conclusion
The diversification of public utilities into competitive markets has created a number of substantial problems for regulators employing rate of return regulation. This has led policy-m:!kers to consider other forms of regulatory bargain. W’lile pure price cap regulation provides the firm with incentives to produce efficiency and to diversib ?r;l~~ :hcrc ~-2 Y~.~nomies of scope, it is most likely to do so in industrial settings in which the price caps are exogenous to the firm. In practice, however, price caps may not be exogenous. Under price cap regulation in several jurisdictions, price cap regulation may well be augmented by a form of rate of return regulation, leading to the reintroduction of many of the adverse incentives long associated with the rate of return constraint. While such problems as these and others discussed in the text may not be insurmountable, they are at rhe least formidable, and suggest reason to diversify the quest for better kinds of regulatory bargain. The central purpose of this paper has been to explore the rudiments of an alternative form of regulatory bargain as a way of dealing with diversified firms, one that allows the firm to earn a level of profit which is positive but no larger than a designated share of the net econunnic benef? i&s me;lstired - COLGI_I be further enhanced by implementing an ‘“The welfare perfGxP,;tnce of :he NBS scherr._ x that depends on Sm. as suggc’s:A ii1 thv Imnulation of t’q. (5).
20
R.R. Braeutigam, Regulatory bargain for dirersiJied enterprises
by consumer surplus) accruing to customers in core markets. This form of regulation has several desirable characteristics. It will depend only on variables observable to the regulator, and specifically does not require the regulator to know whether the firm is producing efficiently (although at an optimum for the firm, production is efficient). It does not require any allocation of common costs over the products of the firm, as would be the case with rate of return regulation. Furthermore, it would retain many of the basic features and benefits of pure price cap regulation. However, because it would tie the firm’s total profits to the level of consumer benefits, it would not require that the link between prices set and the firm’s cost factors (both exogenous and endogenous) be broken. It would also reduce the need for regulators to propose indices to adjust price caps as exogenous cost and demand factors change since all cost and demand factors would be included in the regulatory constraint imposed on the firm. The net benefit sharing bargain leads to an outcome that satisfies all of the regulatory objectives identified in the paper. References Baron, D-P., 1989, Design of regulatory mechanisms and institutions, in: R. Schmalensee and R,D. Willig, eds., Handbook of industrial organization, vol. 2 (North-Holland, New York) Chap. 24, 1347- 1447. Baumol, W.J., J.C. Panzar and R.D. Willig, 1982, Contestable markets and the theory of industry structure (Harcourt, Brace. Jovanovich, New York). Berg, S.V. and J. Tschirhart, 1989, Natural monopoly regulation: Principles and practice (Cambridge University Press). Braeutigam, R.R., 1939, Optimal policies for natural monopolies, in: R.Schmalensee and R.D. Willig, eds., Handbook of industrial organization. vol. 2 (North-Holland, New York) Chap. 23, 1289-l 346. Braeutigam, R.R. and J.C. Panzar, 1989, Diversification incentives under ‘price-based’ and ‘costbased’ regulation, RAND Journal of Economics 20, 373-391. Friedlander, A.F.. 1969, The dilemma of freight transport regu!ation, 1963 (T!x Brookings Institution, Washington, DC). Hillman, J-J., 1990, Oil pipeline rates: A case for yardstick r~gul~tfxr, in* M.A. Crew, ed., Competition and the regulation of utilities (Kluwer, Boston, MA!. Hillman, .!.I. and R.R. Braeutigam, 1989, Price level regulation for diversified public utilities (Kluwer, Boston, MA). Hillman, J.J. and R.R. Braeutigam, 19Gi). The potential benefits and problems of price level regulation: A more hopeful perspective, Northwestern University Law Review 84, no. 2, 695-710. Sibley, D. and D. Sappington, 1990, Strategic nonlinear pricing under price cap regulation, Bell Communications Research Corporation, manuscript. Vogelszng, I., 1988, Price cap regulation of telecommunications services: A long run approach, RAND Publication Series N-2704-MF. Zajac, E.E.. 1978, Fairness or efficiency: An introduction to public utility pricing (Ballinger, New York).