INCENTIVE REGULATION FOR MULTIPRODUCT MONOPOLY FIRM

What does incentive regulation mean?

Incentive regulation means that the regulator delegates certain pricing decisions to the firm and that the firm can reap profit increases from cost reductions.
Topics to be discussed:

The regulatory adjustment process for optimal pricing by multiproduct monopoly firms Modified regulatory adjustment process

Optimal degree of pricing discretion

The regulatory adjustment process for optimal pricing by multiproduct monopoly firms: -

Assumptions: consumers' surplus exists and is convex in prices and continuously differentiable. market demand functions are stable over time. The inverse demand function P(q) is continuous and nonnegative. the monopoly firm's cost function displays decreasing ray average costs, is stable over time. There is no intertemporal cost effects. firm's management maximizes profits in each period j = {1,2,.,N} subject to the constraint imposed by the regulator. the firm's management knows the cost and market demand functions, while the regulator knows only that the firm's cost function has the decreasing ray average cost property.

The regulators objective is to

max W(P) subject to (P)= q(P).p C(q(P)) 0 Where W(P) : consumers surplus and (P) : profit of the monopoly firm and C(q) : cost function of monopoly firm P = {P1 , P2 ,., Pn } q = {q1 , q2 ,., qn } F.O.C : (P - C/q) = - q(P) where, 0 1 This condition is generalized as Ramsey formula. The regulatory agency defines the set of feasible prices for each consecutive period j + 1, j N, by Rj = {P qj P - C(qj) 0 } 0 = qj Pj - C(qj) j qjp - C(qj) [qjpj - C(qj)] [qjp - C(qj)] j

Modified regulatory adjustment process: Assumptions:

The regulated firm is assumed to be a multiproduct monopoly serving markets i = 0, . . ., n. Let Pi denote the price of good i, P denote the vector of n + 1 prices, and q(P) the vector of n + 1 quantities demanded. Output 0 represents the service market, with qo(P) = 1, where Po is defined as the payment by the regulator to secure the operation of the firm. This payment will be positive when there are transfers from the regulator to the firm, and negative when there are transfers from the firm to the regulator. Restrictions on the size of any such transfers can be represented by the constraint Po p. The firm's minimum cost of producing output quantities q is C(q), which is known to the firm's management, as are the market demand functions. firm's interest to earn less than maximum profits during some period t by incurring waste expenditures Wt. Earnings in period t will be represented by Et, where Et = (pt) - Wt, where Wt 0 for each period t.

The firm's objective is to choose a sequence of prices P1 , P2, . . . and

waste expenditures W1 , W2 ,... maximize the present value of its stream of earnings under regulation. i.e., maximize t=1 t-1Et subject to price adjustment constraints imposed by the regulator. : discount rate , < 1
The regulator's objective is max CS(p) + (p) subject to (p) 0, and Po p F.O.Cs: (1) (P)/P i =[ 1/(1+)] q i (P) for i= 1,2,.,n (2) = 0 for i=0 (3)(p) = 0, (4) (P-p0) = 0, (p)0 (P-p0)0 and 0 and 0

The regulatory constraint to the monopoly firm: (Ps - Pt+1)q(Pk) Ek for s t+ Where s t and t+ is the set of s t at which at which earnings are positive, k: the most recent period for which earnings were positive. Proposition 1. Given any vector of prices Pt, the firm will be able to find prices Pt+1 which satisfy the price-adjustment constraints and for which (Pt+1) 0. Proposition 2. Given that (Pt) 0, the value-maximizing firm will never find it optimal to choose Pt+1 for which (Pt+1) < 0. Thus it is optimal for the firm to choose Pt+1 = (P0,t - (Pt), P 1,t, . .. , Pn,t )

Optimal price discretion: symmetric cases Cost uncertainty: LH = HL

The regulator offers the firm a choice of four price vectors, say = {(PLL, PLL), (PHH, PHH), (PL, PH), (PH, PL)} IC PLL
=

PHH

Participation constraint: 2 (p) F

Four incentive compatibility constraints :

2H (p) H(PL) + H(PH) 2L(p) L(PL) + L(PH) L(PL) + H(PH) L(P) + H(P) L(PL) + H(PH) L(PH) + H(PL)

The regulator maximizes expected total welfare E[v + ] subject to the constraints mentioned earlier. [Ramsey problem] The solution to the problem is given by P*: H(P*) = F/2 P*L: (P*L - cL )/ P*L =/(P*L) P*H : ( P*H cH ) /P*H = /(P*H), P*H > P*L so it is optimal to provide price discretion. Demand uncertainty : In each market demand functins can be either qL(p) or qH(p) In this case also we get the same result as before when H(P) L(P). However, it is not optimal to grant ay discretion to the firm when H(P) L(P) . Thus in this case P* = P*L = P*H

Cost and demand uncertainty:In each market there are four possibilities: the firm could have high or low cost, and high or low demand. p* is given by, (p* - cH)qL(p*)=F/2 Social optimality requires that (cH cL)/cL > [F/(2cLqL) ][(H L)/ L ]

If the relative cost difference is large enough relative to the relative elasticity difference then the firm can profitably use the discretion allowed in , the price set offered by the regulator to the firm.

Optimal price discretion: asymmetric case

Suppose that in market 1 the firm's unit cost could be cL with probability , and cH > cL with probability 1 - . In market 2 the unit cost is c for certain. Known demand in markets 1 and 2 is q1(p) and q2(p) respectively. Suppose the regulator offers the firm the choice of two price vectors: {(pH1, pH2), (pL1, PL2)}.

participation constraint: H(pH1) + (pH2) F

two incentive compatibility constraints: H(PH1) + (PH2) H(PL1) + (PL2) and L(PL1) + (PL2) L(PH1) + (PH2)

Let (p1R, P2R) denote the Ramsey prices for the high cost firm under full information.
Optimal pricing require price discretion to firm:PH1 > p1R ; PH2 < P2R and p1L < p1H

Conclusions:-

Using incentive regulation the regulator regulates monopolist with falling average cost in such a way that at each period the regulated firm bounds to lower its cost so as to reap profit. The prices at the optimal level are the Ramsey prices. When firm actually wants to maximize its lifetime profit and so make intentional losses for some period, its optimal for the regulator to put the regulatory constraint in which the prices are set according to the last nonnegative profit made by the firm.

The desirability of pricing discretion depends on whether private and social interests concerning its exercise are aligned or opposed. When uncertainty is about costs they are aligned. With demand uncertainty, however, private and social interests may or may not be aligned.

References: Incentive Regulation and Competition in Public Utility Markets: A 20 Year Perspective Ingo Vogelsang A Theory Of Incentives in Procurement and Regulation J. J. Laffont, J. Tirole A Regulatory Adjustment Process for Optimal Pricing by Multiproduct Monopoly Firms - Ingo Vogelsang, Jorg Finsinger. Regulation by Price Adjustment James Hagerman Multiproduct Price Regulation under Asymmetric Information Mark Armstrong, John Vickers.