EC337 Industrial Economics 2

Department of Economics, University of Warwick

Market Economics, Competition and Regulation

PROBLEM SET 1
Answer all the questions in the space provided insert your answers electronically or by hand. Upon
completion upload your document as a pdf file and submit it to the Undergraduate Office via the
MyEconomics Information Portal. The maximum mark for each question part is shown. Submission
deadline: before midnight on Wednesday 29 October 2014.

1. The following question deals with elements of the Peltzman private interest theory of regulation
model discussed in Lecture 2. Assume a regulator maximizes its welfare: where ceteris paribus
a lower price it regulates in the market results in higher welfare and allowing higher profit for the
regulated firm also results higher welfare. Assume that the regulated firms profit is a function of
the regulated price p and its cost technology type C which is one of two values: CH or CL and CH
> CL for any given output level.
a. Show in a diagram the nature of the optimal solution for both regulated firm cost
types. 1 mark

Answer:
The optimal solution for a regulation occurs when the profit function

= f(p,c) is tangential to the

iso-political support function. In other words, the politician will lower the price to gain consumer votes
until the marginal vote gain equals the marginal power loss from dissatisfying consumers. Both of
these functions are as follows.

EC337 Industrial Economics 2

Department of Economics, University of Warwick

Iso-political function:
M (p,f(p,c))
i)
ii)
iii)

A set of, or combinations of price and profit that yields equal political support.
The politicians preference is for a higher iso-political support i.e towards top left of the graph
For a given level of profit, the politician or regulator is better off with a lower price and vice
versa as shown below. M2 implies a higher iso political function compared to M1

Profit

M2 M1

1 P1

P2
Profit

Price

Profit Function:

= f(p,c)
i)
ii)
iii)

Price

2 (high cost)
1 (low cost)

A function that shows the relationship between price and profit for a given cost.
Firms yield the maximum profit when the price is set at the maximum point of the function
For a given level of price, a firm yields lower profit if it has a higher cost as shown below. The
P1

profit function shifts away from the origin to the bottom right of the graph the higher cost it
bear.

1
Profit,
EC337 Industrial Economics 2

Department of Economics, University of Warwick

Hence, the optimal solution for a private interest regulation occurs when the profit function

Price function M (p,f(p,c)). The tangential value is calculated

f(p,c) is tangential to the iso-political support
2 (high cost)

by maximising M(p,f(p,c) with respect to price. This is illustrated as follows:

M1

P1 P2

1 (low cost)

M2

From the above diagram, we can conclude that the optimal solution for a high cost firm type:
i)
ii)

Has a higher price (p2 instead of p1)

Has a lower profit (2 instead of 1)

Relative to the low cost type, vice versa.

b. Is it possible at an optimal solution for the regulated price to be lower for the high
cost firm compared against the low cost firm? If yes, briefly explain what might
cause this. 2 marks
Answer:
Yes. This could be due to the influence that a particular firm has that enables them to pressure the
politician into giving them a favour and reduces their cost. For example, say, a high cost firm has a
large influence in the government. Due to its influence, it might be able to get support from the
government such as subsidy in order to keep down its cost. Provided that the firm was provided with a
substantial support, it may be able to shift its profit function to the left, and achieve a lower cost
function compared to an existing low cost firm. The optimal solution for the regulated price for this
particular firm would then also be lower.

EC337 Industrial Economics 2

A

Profit,

Department of Economics, University of Warwick

c. Is there a difference in predictions about regulation and market structures between

the private and public interest theories of regulation? Provide a brief reason for
your answer. 2 marks

Pc

Pm

Public Interest Theory of Regulation Price

can be defined as regulatory intervention that occurs in the interest
of the public at large. It is mainly done to correct market failures
by internalising externalities that are
present. Public interest regulation normally occurs in a monopoly market, and the regulation implies
that a substantial market imperfection is occurring and
it needs to be corrected by having a regulation
M1
without compromise. As a result, we would more likely to observe that most public interest regulation
are executed in a monopoly or in a highly concentrated market.
P

Private Interest Theory of Regulation on the other hand, can be defined as the regulatory
intervention as a result of powerful interest groups exerting pressure on politicians and regulators to
capture rents at the expense of more dispersed groups. In this theory, regulation is supplied by utilitymaximising politicians and regulators in response to demand for regulation by interest groups. In other
words, politicians face a trade-off between gaining votes from the consumers (which advocates for a
lower P) and gaining votes from the producers (which advocates for a higher ). The optimal solution

would hence, be some point between first-best welfare maximising point (Point B) and Monopoly
pricing (Point A).

Since the optimal solution is between these two points, we would expect that the market would be
either relatively competitive such as agriculture, and taxi industry or relatively monopolistic in nature
such as network industries, depending upon the shape of the profit and iso political function.

EC337 Industrial Economics 2

Department of Economics, University of Warwick

2. The following question deals with elements of the Laffont & Tirole optimal static mechanism
discussed in Lecture 5. A government (principal) is seeking to regulate a firm (agent) by offering
a menu of contracts made contingent on an announcement by the agent. The firm supplies a
procurement contract (for example, defence services) and can be one of two types High Cost
H or Low Cost L. The government is not able to observe the firm cost type and assumes that
there is an equal probability it is dealing with an H or L type. Each firm type chooses costly
effort and given its type, higher effort implies a lower cost of service. Effort is not observable to
government. The model is static.
a. Given the information structure, what two behavioural effects might occur? 1 mark
Answer:
The two behaviourial effects that might occur are:
i)

Adverse selection
Is a situation where an agent possesses information that the other dealing agent doesnt
have and uses that information asymmetry to gain money or profit at the expense of that
other dealing agent. In this case, government may not know the firm type (e.g Low cost).
The firm could then notify the government that it is a high cost firm so that it receives higher
reimbursement for its cost.

ii)

Moral hazard.
Is a situation where an agent gets involved in a risky event knowing that it is protected
against the risk and the other party will incur the cost. In this context, moral hazard can be
observed when a firm doesnt try to reduce its cost in providing goods and services knowing
that the cost would be reimbursed by the government.

b. What cost arises as a result of the possibility an L type firm might mimic an H type firm? Explain
in brief how this cost is addressed in the optimal static mechanism. 2 marks

EC337 Industrial Economics 2

Department of Economics, University of Warwick

Answer:
The cost that would arise when an L firm mimics an H firm is a situation called rent extraction. This
occurs when a low cost firm was given a large reimbursement by the government as it claims that it is a
high cost firm. This could be the case as for firms with >low , they will be given cost reimbursement
represented by the term 0<b(Ca)<1. This cost-reducing incentives contract specify that the government
pays a fraction of the realised cost. However, since it is just a fraction (with value of b(Ca) between 0
and 1), firms know that the cost overruns are not fully reimbursed. As a result, all firm types, except for
the most inefficient ones will earn information rent of U>0 as long as their <high.
To address this problem, Laffront and Tirole (1986) shows that the optimal contract is linear and having
a lump sum transfer and a cost-sharing term as follows,

Where
a(Ca) is the lump sum transfer, and
b(Ca) is the share or fraction that the regulator pays for any cost overrun
Through this mechanism,
i)
Self-selection requires the manager to truthfully announce his expected cost, Ca so that he
receives the contract which is appropriate for his type and hence indirectly reveals his true
(incentive compatibility)
ii)
Next, this formula also disincentivise a firm to overstate his announced cost. This is
because, if the value of Ca > C, the cost sharing term would then be negative. As a result,
the total t would then be lower.
iii)
The least efficient firm receives utility equal to the outside option but all other agent types
enjoy information rent in the form of higher expected utility than available outside.

c. Using words and/or notation briefly describe the constraints appearing in the governments
optimization programme. 2 marks
Generally, a government would like to maximise welfare as shown below

EC337 Industrial Economics 2

Department of Economics, University of Warwick

Where S is Consumer Surplus, is firm type, e is cost reducing effort,

Is effort function, and
Is the transfer made to the firms.
The welfare is then maximised with respect to t subject to:
i)

U0. This is a participation constraint where the utility of the firm has to be positive in order
for it to supply such goods/services to the government or to the public.

ii)

The marginal cost of effort has to be equal to marginal benefit of effort (which in this case,
equals to 1 due to linearity, and each extra unit of effort lowering cost C by one unit). This is
also known as individual rationality-moral hazard constraint

iii)

where the expected

utility of a firm that announced its true type is greater than its expected utility if it announced
a different type of firm that it actually is (Incentive compatibility constraint)

END
Dr. Chris Doyle
Module Leader EC337
16 October 2014

EC337 Industrial Economics 2

Department of Economics, University of Warwick