Regulation. E. Glen Weyl. Lecture 9 Price Theory and Market Design Fall University of Chicago

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1 E. Glen Weyl University of Chicago Lecture 9 Price Theory and Market Design Fall 2013

2 Introduction Why Average Cost Pricing? Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Today: regulatory solutions to monopoly distortion 1 Why average cost pricing is so common Marginal cost pricing as hopeless ideal Average cost pricing as workable alternative Average cost pricing from free entry 2 Distortions from average cost pricing Static distortion: basic economies of scale case Distortions with diseconomies or entry Dynamic distortions from regulation 3 Application to selection in insurance markets Selection and the measurement of cost curves Measuring market collapse Applications to health insurance policy

3 Marginal cost pricing Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Now let s turn to solutions to natural monopoly Case with sub-additivity over some range Simplest solution is to mandate price at marginal cost However, usually below average cost Follows (almost) directly from economies of scale Not totally immediate because can be on increasing part Thus marginal cost pricing usually requires subsidy Thus requires not just regulator, but whole government Comes from tax on some or all consumer Income tax, sales tax, etc. as from last lecture Operated like a public good, service Some examples? Public transportation usually makes loses Postal service often makes loses Most government services (DMV, etc.)

4 Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Information problems with implementing ideal However, all of these solutions require lots of information 1 Marginal cost regulation Need to know whole cost curve Both regulate down to cost, and determine subsidy Raising inframarginal costs doesn t even raise price = Very little incentive to restrain costs 2 Pigouvian subsidies Requires knowing fair bit about demand Not whole curve, but slope over range 3 Perfect price discrimination Requires firm knowing each person s WTP 4 Extracting via franchise bidding Requires several competitors knowing value 5 Worth creating the service at all? More in Lecture 12

5 Regulatory capture Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Another problem is capture and corruption can quickly become means of corruption Regulators are cozy with the regulated, easy to control Consumers diffuse...same as with licensure Some evidence that this partially happens Organized consumer groups can help balance Happens most when things are opaque Makes it hard for consumers to monitor corruption Is this really different from information problems? Maybe pushes back one level, but same issue If it was transparent, should not be a problem = Key is putting in charge good incentives, information

6 Average cost regulation in theory Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing To address concerns, more common to use average cost Also called rate of return or cost-plus regulation Profits made by utility capped at some low rate Meant to cover natural return on capital investment Simple model of this is price cap at average cost Benefits over marginal cost pricing (costs soon)? 1 Doesn t require any external subsidies Helps politically, with all other issues 2 Easier to measure average costs More similar to accounting, marginal cost hard 3 Only need to know average cost at one point 4 If consumers buy at price, worth creating = Average cost pricing lessens information problem

7 Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Examples of average cost regulation Average cost regulation extremely common in many areas? 1 Power, water, heat utilities State regulatory boards determine Overseen (how well?) by consumer advocates 2 Public transit and infrastructure Sometimes take subsidies, but often cover costs Even sometimes required to make back fixed costs 3 Telecommunications Until mid-1980 s (still in other countries) national regulation Local calling was subsidized by higher long-distance ATT broken up in 80 s, forced to give access to locals But now competition diminishing again...back to monopoly? 4 Abusive pricing and broader regulation Many countries implicitly regulate through laws

8 Free entry and average cost pricing Marginal cost pricing and its limitations Average cost regulation Free entry and average cost pricing Average cost pricing can arise from free entry If anyone can come into industry, free entry: 1 Must be large number of equally able managers 2 Must have access to capital, industry not rocket science 3 No barriers to entry In this case, any profits will attract an entrant Thus equilibrium must involve zero profits = Average cost pricing Arises from equilibrium without regulation Very common assumption in economic models Perhaps not so realistic because of heterogeneity... But often offers useful benchmark, way of looking at things = Competition sometimes mimics average cost pricing

9 Static distortion Why Average Cost Pricing? The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion AC MC! = Average cost pricing is not efficient When MC pricing lead to loses, AC above MC Thus AC pricing higher than MC pricing = At AC pricing, too little produced Not dissimilar to monopoly distortion, but not a extreme Wedge is AC MC; calculate social loss as usual Harberger triangle... AC MC = AC q = marginal distortion proportional to 1 Size of the market 2 Slope of average cost curve Note: possible to have natural monopoly with MC > AC

10 Quantity Why Average Cost Pricing? The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Figure 3 Adverse Selection with Additional Cost of Providing Insurance The standard distortion from average cost pricing A Demand curve B AC curve Price P eqm C P eff MC curve D E F G H Q eqm Q eff Q max

11 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Distortion with market collapse or increasing cost Most classical distortion, but others perhaps more important 1 Market collapse/failure of entry; how? With average cost pricing, no entry if demand below AC But this does not mean not social value to market Demand may be below AC but above MC q x=0 q = P(x)dx q Average utility AU(q) U(q) Note that by envelope P(q) = U (q) (marginal utility) = Same relation to P(q) as AC to MC or P to MR This v. AC should determines optimal entry If AC pricing causes entry to fail death spiral or collapse 2 Marginal cost above average cost; how? With natural monopoly, MC may be above AC at equilibrium Even more common in other reasons for AC pricing In this case quantity is excessive; over-supply Opposite Harberger triangle

12 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Other static distortions of average cost pricing

13 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Collapse with and without fixed costs

14 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Unregulated monopoly v. average cost pricing So clearly AC pricing is not an ideal solution But is it still better than unregulated monopoly? To the extent that the problem is under-provision, yes If market collapse, no monopolist will want to enter In fact, condition exactly the same And no monopolist produces below AC, so AC better However, if MC > AC so too much production, not obvious Monopoly under-produces (P > MC) but AC over produces Either can be better; optimum in between = AC better than market power in classic case But watch out for the reverse

15 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Comparing regulated and unregulated monopoly

16 The static average cost pricing distortion Comparison to unregulated monopoly Dynamic distortion Long-term effects of cost-plus regulation At least as important is effect on longer-term incentives Companies can easily affect their costs: 1 Making efforts to cut costs, workers 2 Innovating to create more efficient production processes 3 Choosing cheaper over more expensive inputs 4 Last year s problem set looked at these Unless all of these controlled, monitored by regulator... Firm has no incentives to reduce costs at AC pricing In fact, if regulator learns about cost, you want to increase! Budgeting and my father s story Other causes of average cost pricing similar: If when company innovates, others follow... Then no incentive to innovate! This is the topic of Lecture 12 (next Thursday)

17 Cost curves and selection Selection and cost curves Market collapse in the real world Insurance policy One important source of non-linear costs is selection Markets where different consumers have different value Consider cost to the government of insurance coverage q = fraction of population covered, p prevailing price Cost not linear because people differ in risk 1 Adverse selection if riskiest people first in; slope of curves? Marginal, average cost slope downward 2 Advantageous selection if risk-averse, educated first? Marginal, average cost slope upward May be important if uneducated, poor don t get insurance 3 Mixture may also be possible over different ranges Note: cost curve of industry as a whole Not of any individual insurer But insurance social concern, so can think in same terms

18 Measurement of selection Selection and cost curves Market collapse in the real world Insurance policy Thus selection= slope of cost curve Slope of average cost enough, gives wedge This is what Einav et al. (2010) measure Large aluminum manufacturer offers two plans 1 First plan very low/minimal coverage 2 Second plan fairly comprehensive Individual division managers choose price They claim this is basically random...questionable But if yes, we can see what happens at different q They measure average cost of coverage (claims) Draws out average and thus marginal cost curve Difference between these is marginal distortion Total distortion size also depends on demand Harberger triangle length

19 Einav 914 et al. QUARTERLY (2010) data JOURNAL OF ECONOMICS 1,000 Selection and cost curves Market collapse in the real world Insurance policy AC curve Demand curve (Q eqm =0.617,P eqm =463.5) C CDE=$ MC curve D E (Q eff =0.756,P eff =263.9) FIGURE V Efficiency Cost of Adverse Selection Empirical Analog

20 Selection and cost curves Market collapse in the real world Insurance policy Hendren s study of market collapse This indicates selection distortion quite small Other studies find advantageous = too much Bit of a let down: what about adverse selection? One view is these markets exist, so selection not so bad Markets with real problems have already collapsed! To investigate, Hendren (Forthcoming) studies rejections? Markets where you can t get insurance at any price Ask whether selection is cause Survey individuals, ask to project health/ risk status If they know a lot more than firms can price on... Then selection will be major problem Do this with average v. marginal cost Focus on first unit of insurance: most benefit there Finds private information imposes large tax in rejections Very small tax in non-rejected areas; explains pattern!

21 Hendren s data.2 Why Average.1 Cost Pricing? Selection 0 and cost curves.1.2 Distortions from AverageEstimated Cost Pricing Residual MarketPrivate collapse ininformation the real world Insurance policy No Reject Reject Figure 2c: Estimated Residual Private Info Life Density Estimated Residual Private Information No Reject Reject

22 Selection and insurance policy Selection and cost curves Market collapse in the real world Insurance policy Same types of approaches can(not) solve problem here: 1 Subsidies for insurance? Widely advocated policy solution Requires knowledge of cost function Perhaps a bit easier given competition, but capture danger 2 Mandates for universal coverage? May well go too far: coverage good but... Administrative costs of insurance quite high May not be efficient to insure everyone 3 Price (cost) discrimination? Much adverse selection because of lack of personalization = More discrimination could help solve But this is politically explosive Also adds to risk when changing insurers...

23 Other policy issues in insurance Selection and cost curves Market collapse in the real world Insurance policy All of these issues come up in other selection contexts: 1 Markets for murky assets (crisis) 2 Markets for consumer lending (credit cards, mortgages) 3 Labor markets for skilled workers, etc. While these focus, a variety of other issues crucial: 1 Irrational brand loyalties Consumers care about name of insurer for no good reason Stick with insurers they had in the past (can help selection!) 2 Short-run and long-run insurance Fail to insure against long-run, insurer switching risk No incentives for preventative, someone else s problem 3 Lack of competition Excludes by monopoly, but solves other problems? Long-short, adverse selection, etc.

24 Application to ObamaCare Selection and cost curves Market collapse in the real world Insurance policy Selection gives language for understanding US health debate ObamaCare had two components: 1 Non-discrimination based on pre-existing conditions 2 Individual mandate to for all to purchase insurance The logic of selection/death spiral justifies these together 1 Non-discrimination without individual mandate? Would create terrible selection problem, destroy market? 2 Mandate w/o non-discrimination? Would be far too expensive for sick to afford Why institute these policies? 1 Helps provide long-term insurance against reclassification 2 Individuals use health care anyway, so better organized Arguments against policies? 1 Excessive insurance may reduce self-care 2 Universal system may cover too many frivolous things

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