Regulation of Monopolies and

Competition
CONTENT

1. Markets
1. Perfect Competition
2. Imperfect Competition
3. Monopoly

2. Regulation: Regulation schemes

Market: Perfect Competition

As we explain before

We have a market in perfect competition when exists a lot of firms, that provide
a good or service.

Perfect conditions of competition are difficult to achieve in practice:

Many small companies (price takers)
There are no producers so large that they can have an influence on
the price
All companies has the same information from the market

Normally those conditions, are not available on the initial point of a power
sector.
Market: Perfect Competition

In order to maximize their profits. The seller will have an objective function,
related to the price and costs of production.

" = " "

The price is related to the level production: = " "

If have the assumption that the production dont have influence on the price:
,-
=0
,./

The optimal conditions occurs when:

= " (" )
Market: Perfect Competition

Each company will have a production as much as the marginal cost of

production match the price.
If the price (equal to marginal cost) is higher than average cost, the company
have profits
If the price (equal to marginal cost) is lower than average cost, the company
have losses
Market: Perfect Competition

Market Equilibrium

In short term: companies will

not has the same level of
profits, because of their
different costs structure.

In long term: if there is no

barriers for new parties, and
has the same technologies,
the companies could have the
same profits.
Market: Imperfect Competition

An imperfect market exists when only few firms (big players) can benefits and
modify the market price of a good or service.

An Oligopoly is market with imperfect conditions. Power sector (generation)

normally have condition of oligopoly.

The companies deal with the relationship of their own decisions and competitors
decisions.

Companies use model to make their decision based on the variation of quantity
(Cournot), or price (Bertrand), or a mix of both.

The Nash-Cournot Equilibrium: A market is in equilibrium when no competitor

improves its profit by unilaterally modifying its output
Market: Imperfect Competition

Sectors regulators bodies or antitrust commission, can use son measure that can
define the imperfection of the market.

The common indicators are:

Hirschman Herfindahl Index. Estimate the level of market concentration.

The expect result is below 2,500
= 6 8"
"

Lerner Index. Estimate the difference between the price versus the price of a
perfect market. Need to know the real previous information of the market.
"
" =

Market: Monopoly

The monopoly is that market in which there is a single offeror who has full
capacity to determine the price.

It is not often that perfect competition occurs because there are strong
incentives to try to break it, because if the company has control over prices,
you can use the ability to influence them to improve their individual position.

Causes of a Monopoly:
The exclusive control of a productive factor by the company or the
domination of the most important sources of the raw materials
indispensable for the production of a certain good.
The granting of a patent also generates a monopolistic and temporary
situation.
State control of the provision of the original state monopoly services.
These services are often provided through concession operators.
Market: Monopoly

The existence of a market size and an industry cost structure can lead to a
natural monopoly.

A natural monopoly is that company whose average cost per unit of

production decreases with the increase of demand, so that a single company
can offer the production of the industry more efficiently than many
companies.

When there are economies of scale, the company with greater production
capacity can increase it at a lower cost by discouraging its potential
competitors natural monopoly.

When the monopoly company stays alone raises prices above the cost of
production (market power) need for regulation.
Market: Monopoly

Some of the reasons of why the transmission and distribution of electricity

constitute a natural monopoly is that:

Has Economics of Scale, achieving large decrease in average cost by

expanding production.
Low rate of return.
Low risk.
Entry barriers (concessions, regulations, patents).
High costs (in the phase of installation or creation of National networks)
Market: Market Equilibrium: Competition - Monopoly
Regulation concepts

Regulation is simply a system that allows a government to formalize and

institutionalize its commitments to protect consumers and investors.
[Tenenbaum 1995].

The regulation seeks to protect consumers from the power of monopolies and
oligopolies that can use their market dominance to fix with any excuses, high
prices or reduce the quality of their services.
The regulation acts by establishing a limit to the prices that can be set by
companies, instituting obligations regarding the quality and continuity of
their services and norms on the coverage of these and participating in the
process of planning the investments.
This participation can take several forms. For example, the state may plan
investments directly or may condition business plans to administrative
authorization.
Regulation concepts

The regulation also seeks to protect investors against the state that could act
opportunistically setting rates and supply obligations that do not allow
investors to recover their investments.

For its part, the state may have an interest in acting opportunistically, for
example, to benefit consumers or reduce inflation. Regulation prevents such
behavior by establishing rules for prices to reflect costs (social surplus) and
often transferring the power to set those prices to independent regulatory
agencies.
Regulation Conceptes

Regulation pursues several substantive objectives, which conflict with each other

Productive Allocative
Sustainability Equity
Efficiency Efficiency
Regulation Conceptes

Regulation pursues several substantive objectives, which conflict with each other

Efficiency
Price discrimination is efficient, but may not be fair

Equity
Allocative
Efficiency

"The equalization of tariffs and costs can reduce

incentives to minimize costs" Productive
Efficiency

Allocative
Efficiency
Sustainability Bajo monopolio natural, los costos marginales
estn por debajo de los costos medios
Regulation Conceptes

Regulator use four (4) main variables, to has expected result of regulation

Regulated
Revenue
Price Control (regulated
revenue).
Control of the quality of the
Service.
Entry/exit
Regulatory Quality of
Territorial franchise (entry
and exit of agents)
Variables service

Control of New Investments.

Investments
Regulation Concepts

And the regulatory instruments used to achieve the regulatory objectives

Sustainability
Rate Level

Allocation Efficiency

Rate
Equity Structure

Productive Efficiency
Rate regime
Regulation: Regulatory approaches

Regulatory
approaches

Cost of
Incentives
Service

Rate of Slading Cap Yardstick

return Scale regulation Competition

Profit Revenue Revenue

Sharing Price Cap
Sharing Cap
Regulation: Regulatory approaches

Cost of Service Regulation

The determination of permitted income (rate level). Which is based on the

declaration of information by the company. In this sense, under this scheme the
regulator may have a disadvantage in front of the company, due to information
asymmetry.
Cost acknowledgments incurred and investments made by the company.
At this stage, the addition and removal of assets to the company's capital
base are also considered.
The recognized rate of return that the investor can recover on the
invested capital.
Determination of the tariff structure. Where they define how the recognized
rate level will be collected, based on the user's portfolio of the company. Here
the different types of tariffs are defined for each type of user, and the different
charges that contemplate those tariffs.
Regulation: Regulatory approaches

Cost of Service Regulation

A process of rate revision under the regulation for cost of service, contemplates
by the regular, the following process:
Rate revision Rate level definition Rate structure

The regulator or The company Prices and rate

the Company supplies the options are
requests the financial and costs defined
revision of the information It is verified that
rate level, either The level of return under the
by being high on investment is proposed price
(regulator) or not set structure the
recovering costs Recognizes a operating and
(company) level of operating capital costs of the
costs previous period
Recognizes and the following
investments made period are
and amortizations recovered
Regulation: Regulatory approaches

Cost of Service Regulation

The regulator seeks an economic equilibrium, using an equation:

C

6 : : = = +
:DE

"Under this type of regulation, part of the negotiation focuses on the value of the
rate of return ... which is allowed to be recovered, and on which investments are
introduced in the calculation of the value of the capital base. Reality, what
matters ..., ... is the product of both quantities. Moreover, it should be noted that
the above formula includes permitted expenditures that do not necessarily
coincide with those actually incurred. Incentive to the company to improve its
efficiency or on the contrary may be an economic penalty if the company is
inefficient in its management. Toms Gmez San Romn (self traduction)
Regulation: Regulatory approaches

Cost of Service Regulation

Pros Cons
Allows the company to recover its It does not provide incentives to
costs by giving it financial stability. efficiency and in some cases has
The cost of capital is maintained as a evolved into an intrusive and legalistic
control parameter of the regulator and form of regulation.
it must be sufficiently low. It has a tendency towards
It can lead to a good balance between overinvestment justified on the basis
optimal levels of investment and of technical engineering criteria and
quality of service, being careful not to that companies increase their costs
over-invest if the allowed rate of resulting in higher prices for
return is set too high (A-J effect). consumers
Regulation: Regulatory approaches

Incentive Regulation

It seeks to promote that the company has benefits on the savings that it
obtains against the criteria of efficiency introduced through the recognized
tariffs.
Review processes are established in the regulatory framework, and are
usually performed every 4 or 5 years. In each tariff review process, the
company's recognized revenue levels are determined, establishing limitation
criteria, quality requirements and progressive efficiency criteria in the
provision of the service during the future tariff period.
Regulation: Regulatory approaches

Incentive Regulation: Common schemes

Price Cap. A maximum price is set, either average or

by type of service. Adjustments within the tariff
G
period are made considering inflation, an index of F = FHE 1 +
productivity increase (factor x) and a factor to
correct externalities.

Revenue Cap. A maximum allowable income

associated with the activity is set. The adjustments
are made just as in the price limitation, adding the
increment of costs associated to the integration of
new users.
F = FHE 1 +
Regulation: Regulatory approaches

Incentive Regulation

Incentive regulation requires attention to some aspects for its application of a

regulatory plan under this scheme.

Regulatory period. How often will the revisions be made?

Determination starting point. The definitions of the basis on which
income will be determined, which will be recognized at the level of costs
and which will be recognized as the regulated capital base.
Specifying settings parameters. Which variables will be considered in the
adjustments of prices, inflation, demand growth, productivity factor, etc.
Definition of complementary objectives. Quality of service,
environmental impact, etc.
Regulation: Regulatory approaches
Incentive Regulation
Pros
It promotes productive efficiency, as
companies increase their profits over
savings achieved versus recognized
costs
Efficiency gains can be transferred to
users in subsequent periods, through
factor X
Normally, service price reductions are
achieved, compared to the cost of
service regulation
Cons
It can degrade the quality of service,
due to the emphasis on reducing costs
by companies
In the case of the yardstick, companies
do not always operate under the same
conditions and in different markets
Risk of transfer of costs from non-
regulated to regulated activities
Excessive concern about the benefits
that companies may be getting may
lead the regulator to converge with a
cost-of-service regulation. Since it can
pretend to increase the frequency of
tariff revisions