EKN 310

Chapter 4 – Allocative E7iciency, Imperfect

Competition and Regulation

Introduction
This chapter will be focusing on imperfect competition and monopolies.

Imperfect competition:

• Is also called non-competitive markets

• It occurs when markets are dominated by monopolies or oligopolies
• We will be examining the economic e?ects of monopolies, using electricity
supply as a case study.

Monopolies:

• We must distinguish between 2 types of monopolies…

1. Statutory/ Artificial Monopoly

• Perfect competition in this market is technically possible but it is
restricted by legal or institutional barriers
• Barriers may include government regulations or incumbent firm
actions
• For example, controlling suppliers or temporarily lowering prices.

2. Natural Monopoly
• This is when technical factors prevent there from being competition.
• Due to the cost structure of the industry, it is only e?icient for there
to be ONE producer rather than multiple competition firms.
• In these industries, average costs decrease as output increases
(economies of scale) and
• These industries also have large capital outlays (they require huge
initial investments to set up infrastructure)
Social Costs of Statutory Monopolies
The figure below shows the distinction between perfect competition and
imperfect competition (monopoly) :

- Here we assume the demand function (D) and marginal cost (MC)
are the same for the 2 market forms.

Perfect Competition:

- MC represents the sum of marginal cost curves of individual firms

making up the market.
- Equilibrium occurs at point E where demand = supply.
- 0QC is produced at a price of 0PC.

Monopoly:

- MC represents the marginal cost of the monopoly only.

- Equilibrium occurs at point F where MR = MC
- The market produces a smaller quantity 0Qm , at a higher price 0Pm.

- The loss in consumer surplus under monopoly is given by the

rectangle PmGEPC.
- Of that PmGHPC is the straight transfer from consumers to
producers while the remaining triangle GEH is the deadweight loss.

- The value represented by HEQCQm represents the social cost of

monopoly because the resources contributing to this value (labour/
capital equipment) may remain unemployed for long periods of time
until they find alternative employment.
E"iciency Implications of a Monopoly:

• Remember from chapter 2 that for there to be pareto-e?iciency the

condition is:

• MRPT (how much Y must be sacrificed to produce on more X) must equal

marginal cost ratio and price ratio
• In perfect competition P=MC so this condition is satisfied
• And therefore the production mix is e?icient

Introducing monopoly…

• Assume that industry Y = monopoly and industry X = perfectly competitive

• This means Py > MCy
(because monopolies charge a higher price than marginal cost)
• And that PX = MCX
(because perf competitive firms charge price equal to their marginal cost).
• This means that for a monopoly

• So, when there is a monopoly, the e?iciency condition for pareto optimum
is broken
• And the economy produces the wrong combination of goods

Let’s see the economic consequence of this graphically…

 - R0T0 is the production possibility curve (shows maximum combos of
X and Y the economy an produce)

Perfect Competition :

- Competitive equilibrium is at point C where MRPTXY = MC = P

- Production at C is Xc and Yc
- The economy is pareto e?icient

Monopoly:

- M0 is the new equilibrium that occurs when good Y is monopolised

- MRPTXY > Px/Py
- At M0 production is at Ym and X2
- Less of Y and more X is produced
- The line PM (price line) represents the price ratio Px/Py
- At M0, the slope of the PPC does not equal the price line
- This shows the e?iciency condition is violated

Allocative ine?iciency:

- The distance between C and M0, allocative ine?iciency cause by the

monopoly
- Allocative e?iciency = the economy as whole produces too little of
good Y relative to good X at M0.
- To fix this, resources would have to be reallocated towards
producing more Y, to move the economy from M0 to C.

X-ine?iciency:

- Monopolies may also cause X-ine?iciency because they face less

competitive pressure which may give them incentive to…
Þ Use resources ine?iciently
Þ Have lower productivity
Þ Spend less e?ort reducing costs
- These actions can move production inside the PPC (like point M1)
Deregulation (removing barriers to enter):

- The government may try to increase competition by removing

barriers to enter the industry.
- Such barriers take various forms including licensing fees, property
taxes, restrictive labour laws and health standards.
- This encourages competition and moves the economy closer to C,
- Improving allocative and X-e?iciency (moving to M3 for example)

- However, deregulation may also entail a cost in terms of

competitive firms receiving decreased profits.
- Because comp firms are unable to carry out technical inventions
and innovations as fast as monopolies.
- So competitive firms may fall short of the M2 outcome.
- Whether deregulation will be beneficial or not depends on whether
the gains in allocative and X-ine?iciency are su?icient to o?set the
slower pace of technological advancement among competitive
firms.

Arguments regarding e"iciency of monopolies:

Against monopolies (Liebenstein):

• Monopolies lack incentives to maintain high labour productivity levels.

• Monopolies do not take su?icient time and e?ort necessary to acquire
correct information.
• Monopolies fail to achieve a pareto-optimal allocation of resources.

For monopolies(Schumpeter):

• Monopolistic firms are in a better position to achieve technological

advancement than competitive firms
• Some economists argue that monopolies may…
Þ invest more in research and innovation
Þ improve technology.
• These actions can shift the entire PPC outward from R0T0 to R1T1
• Where the economy will produce more of both goods (to M2 for example)
Natural Monopolies
Characteristics:

• An industry is a natural monopoly if it has large capital outlays that give

rise to economies of scale over the entire range of its output.
• The minimum average cost of production must be su?icient to supply the
entire market
• Aka only one firm can operate e?ectively in such market.
• Example of natural monopolies: public utilities that provide electricity,
water, rail etc

• Monopolies have increasing returns to scale

• Increasing returns to scale means that long-term average cost of the firm
decreases as output increases.
• Its MC curve will therefore lie below the AC curve over the entire output
range.

Perfet Competition:

- Firm will set MC = Market Price (MC = Pe)

- Equilibrium will this be at E where Qe is produced.

Monopoly (not controlled by govt):

- Profit will be maximized at M, where MC=MR

- At point M, the equilibrium price (Pm) exceeds the socially e?icient
price (Pe)
 - And the equilibrium output (Qm) is smaller than the pareto-optimal
level (Qe)
- So, profit-maximizing behaviour of a monopoly results in too little
output being produced at a high price which causes loss of welfare.
- The welfare loss is the di?erence in consumer surplus between the
2 equilibria
- Under monopoly, consumer surplus is the area AFPm which is
evidently smaller than the competitive consumer surplus, AEPe.

NOTE:

A natural monopoly exists due to the nature of the industry and its cost structure,
it has nothing to do with whether it is owned by the government/ private sector.
Ownership is irrelevant to welfare loss. Ownership only a?ects how the
monopoly’s allocative e?iciency and equity outcomes are managed.

Policy Options

• What are the policy options available aimed at improving the ine?iciency
or loss of welfare created by natural monopolies?
• There are several options available and they depend on…
Þ The type of externality created in the market
Þ Whether the monopoly provides a good/service that is an important
input (electricity/ water supply)

D = MSB
MC = MSC

Equilibrium at M implies
that MSB > MSC.
 • The only way to expand pecuniary externalities on other sectors is by
expanding production and lowering prices (to Qe & Pe)
• Lowering prices internalises the social benefit.

Options to achieve this:

1) Government takes ownership of natural monopoly (nationalised)

- Govt will then set the price = MC to achieve e?icient pricing.
- But at this price (at point E), the average cost is higher than the
price/revenue (AC > AR)
- This means the firm makes a loss (shown as ES)
- The government must cover this loss by subsidising it through taxes
- Higher taxes create distortions in the economy, causing an excess
burden (economic ine?iciency).

2) Government can borrow money to pay for the subsidy

- Instead of raising taxes
- Borrowing can increase interest rates (which makes borrowing
more expensive for businesses).
- This can crowd out private sector investment and spending.
- Ideal e?iciency outcome = combo of MC pricing and unit subsidies

Nationalised v Private Monopolies

• When a monopoly is nationalised, its output moves closer to the perfectly

competitive equilibrium (C) than a private monopoly (M0)
• However, because of taxes being used to subsidise losses and possible
crowing out of private investment create distortions, the economy still
operates inside the PPC at a point like MS.
• So, although nationalism can improve allocative e?iciency, it can distort
the rest of the economy.

• Nationalised monopolies are also often less X-e?icient because they have
less incentive to reduce costs or be innovative, as they can rely on state
funding rather than profits.

• In many developing countries (DCs), nationalised natural monopolies

failed to achieve e?icient outcomes because…
Þ Governments created unproductive jobs in state monopolies,
preventing MC pricing (so firms were forced to charge prices below
marginal cost).
Þ Subsidies drained government budgets but were often insu?icient
to cover losses.
Þ Customers often did not pay for services, increasing financial
losses.
Þ Revenue shortages prevented maintenance, upgrades and
expansion, worsening service delivery.
Þ Low labour productivity and poor service quality caused X-
ine?iciency.
Þ Governance problems occurred, such as political appointments of
unskilled managers and managers exploiting information
asymmetries to maximise budgets.

Because of these problems, many countries changed their approach/

model of governance by…

(1) Unbundling (restructuring) state monopolies

(2) Privatising parts where competition is possible
(3) Regulating the privatised components
1) Competitive Restructuring / Unbundling
Meaning:

• Competitive restructuring = ‘unbundling’ of industries that were previously

run as state-owned monopolies.
• It is at the heart of the new model for the governance of decreasing-cost
industries (natural monopolies).
• It separates natural monopoly activities from activities where competition
is possible.

Old Model: State-owned monopoly

• Governments believed that all activities in decreasing-cost industries had

falling average costs
• Because of this, it was assumed that only one firm could operate in the
industry e?iciently.
• As a result, only state-owned monopolies controlled the entire industry.

New understanding:

• Economists later realised that only some parts of these industries are true
monopolies.
• Other parts can operate competitively with multiple firms.
• So we must consider all production elements of a natural monopoly and
decide which parts are decreasing-cost industries and which are
competitive.

So what unbundling does: It separates the industry in 2 parts

1) Natural Monopoly components

- Usually remain government owned
- Regulated by authorities (price and service quality)
2) Competitive components
- Often privatised or opened to competition

Example: Electricity supply industry

Electricity has 4 main components..

 1. Generation
o The production of electricity in power plants
o Here competition is possible
2. Transmission
o The long-distance transportation of electricity at high voltage
through national grids
o This element is a natural monopoly because it requires very
expensive infrastructure
3. Distribution
o The short-distance transportation of electricity at a lower voltage to
customers
o This is also a natural monopoly because it requires capital
investment (construction of ‘grids’)
4. Supply
o The selling of electricity to end-users
o Here competition is possible

Purpose of competitive restructuring:

• To gain benefits of competitive markets such as lower prices, higher

outputs, better e?iciency (X-e?iciency) and better allocation of resources
(allocative e?iciency).

Limitations of competitive restructuring:

• Benefits are not guaranteed, especially in small developing economies.

• Problems may also occur if…
- Markers are too small for real competition
- Government cannot regulate firms e?ectively

2) Privatisation
Meaning:

• Privatisation = the transfer of the production of goods and services form

the public sector to the private sector.
• It can occur in di?erent degrees, from full transfer to shared responsibility.
• Types of privatisation include…
 - Full privatisation
- Partial privatisation (Quasi-privatisation)
- BOOT Model

Full Privatisation:

§ Government retains no control over any aspect of production

§ All aspects of an activity are transferred to the private sector.
§ The private firm handles planning, design, construction, financing,
maintenance etc.
§ Government has no operation role in the industry, except possibly
regulating standards.

§ Example: Road Project fully run by a private firm

Partial Privatisation (Quasi-privatisation):

§ Here, the public and private sectors share roles, risks and responsibilities.
§ This is often done through Public-Private Partnerships (PPPs).

§ Example: Education (govt builds schools and provides teaching while

private sector sets curriculum and standards).
§ Example: Healthcare (medical services may be private but government
can partially finance healthcare and ensure access for poorer people).

BOOT Model:

§ BOOT = Build, Own, Operate, Transfer

§ 1) Private firms build the infrastructure
§ 2) Private firms own and operate it for a specific period of time
§ 3) Private firms maintain it and recover costs
§ 4) After the contract period, ownership returns to government

§ Examples: Toll roads, infrastructure projects and prisons.

Reasons why governments privatise: Cost v E?iciency

• Financial reasons
v Many state-owned enterprises make losses
v Govts privatise to reduce financial burden and make revenue
from sales
• E?iciency reasons
v Firms must remain profitable to survive, this encourages higher
productivity, cost control, better management, X-e?iciency and
allocative e?iciency.
v However, allocative e?iciency only improves if competition
exists.
v So a private monopoly does not guarantee better outcomes.

Limitations of privatisation:

• Privatisation works best when certain conditions exist…

• Su?icient market size, open economy, strong competition, good
regulation, developed capital markets, e?ective legal system, qualified
managers.
• Without these, benefits may be limited.

Equity Considerations of privatisation:

• Privatisation raises fairness issues.

• Possible negative e?ects include job losses (firms cut excess workers) and
higher prices (removal of subsidies).
• The key question is whether users should pay the full cost of service, or if
taxpayers should subsidise them.

• There is a trade-o? between e?iciency and employment

- Employment: firms keen ine?icient workers but their costs stay high
so there are higher prices for consumers or government subsidies.
- E?iciency: firms cut ine?icient workers and become more e?icient
but this results in job losses and higher unemployment
• Policy-makers must choose between protecting jobs or reducing costs and
improving e?iciency.
Why privatisation is controversial:

Privatisation often causes immediate social costs such as…

Þ Job losses
Þ Price increases
Þ Political opposition

Even though long-term benefits include…

Þ Better service delivery

Þ Increased production
Þ Higher e?iciency
Þ Expanded infrastructure
Þ Increased investment

The solution to these mixed results, is to have targeted subsidies that can help
poor consumers from price increases.

3) Regulation
Meaning:

• Economic regulation = the rules made and enforced by government to

control prices and entry in certain industries.
• They are implemented by independent regulatory authorities created
through legislation.
• Examples in SA:
- ICASA, Independent Communications Authority of South Africa
(regulates telecommunications)
- NERSA, National Energy Regulator of south Africa (regulated the
energy sector)

Why regulation is needed:

• Regulation supports competitive restructuring and privatisation.

• Regulation ensures more e?icient outcomes in the absence of
competition.
• The main aim = limit privatised natural monopolies to a reasonable rather
than maximum (abnormal) profits.
 • AKA preventing privatised natural monopolies from charging excessively
high prices
• This is partly for e?iciency reasons but also to protect the consumers and
producers that use this product/service.

3 Models for regulating prices of privatised natural monopolies:

1. Rate of return regulation

2. Price-cap regulation
3. Sliding-scale regulation

1. Rate-of-return regulation (Profit regulation):

o Regulator sets prices so that the firm can cover operating and capital
costs & earn a fair/acceptable profit.
o Price = Operating costs + Capital costs + Allowed profit
o Allowed profit depends on the rate of return set by the regulator
o Price can fall between monopoly price and competitive price

- Given a regulated firm’s supply and demand curves, the regulator

determines the capital and operating costs as the area THQr
- and deems that a total profit of PrGHT is a satisfactory rate of
return. (profit per unit GH x 0Qr)
- If we add costs and profits we get the required revenue of the firm:
THQr + PrGHT = PrGQr
- This thus determines the price the monopoly can charge, which is
Pr (where Qr will be produced).
 - Note that the price will vary depending on the allowed profit set by
the regulator.
- We can assume that the price will be anywhere between Pm
(monopoly price) and Pe (competitive price).

o Problems with type of regulation includes…

Þ Cost padding (firms may inflate costs to justify higher profits)
Þ Capital-intensive production (firms invest in excessive capital
because profits depend on asset size)
Þ Information asymmetry (regulators often lack full knowledge of
firms’ true costs)

2. Price-Cap regulation:

o Regulator sets a maximum price that firms are allowed to charge (while
considering revenues and allowed rate-of return)
o Instead of calculating profits, the regulator simply limits the price.
o The formula used to set the price is…
P = RPI -X
- P is the allowed price increase
- RPI is the retail price index (inflation)
- X is the expected productivity growth
o The advantages of this regulation is that it encouraged firms to reduce
costs and improve e?iciency (this mimics competitive market incentives).
o The problems with this regulation are…
Þ Requires detailed economic information
Þ Firms may cut costs by reducing service quality
Þ Regulators must monitor firms closely, which is di?icult.

3. Sliding-Scale regulation:

o This combines elements of rate-of-return regulation and price-cap

regulation.
o Regulation is primarily based on capping prices (to maximize on inherent
advantaged of e?iciency)
o But it allows for the price cap to be reduced is the firms profits rise above a
predetermined level.
o The extra profits will be shared between firms and consumers.
 o The advantaged of this regulation are that it encouraged e?iciency
improvements but also prevents excessive profits.
o The problem with this regulation is that it requires large amounts of
information and monitoring, just like other models.

Regulation in developing countries:

• E?ective regulation can improve e?iciency and cause economic growth

(shift the PPC outward).
• Regulation has administrative costs, so outcomes lie inside the PPC, but
closer to e?iciency.

• A major challenge in developing countries is regulatory capture.

• Regulatory capture = when regulatory agencies do not promoted the
public interest as they should but rather commercial or political interests
of the regulated firms.
• This can be as a result from
- e?ective lobbying by firms
- firms rewarding o?icials of the regulatory agency with job
opportunities
- outright bribery.

Requirements for e?ective regulation:

• Clear policy frameworks

• Technical expertise
• Strong institutions
• Political support
• Good monitoring capacity

These can be di?icult for many developing countries to achieve.