In Section 3.2 of the text we reviewed the standard distinctions between allocative inefficiency, technical inefficiency, and rent-seeking costs. Now consider the following illustrative puzzle.
The demand curve for taxi trips in an area per year has the form
It is observed that the prevailing average price of a trip is 200.
Entry into the taxi business is restricted by licensing. There are 20 taxi drivers all with an equal share in the market. Retiring drivers can sell their licence to the highest bidder. The market price of a licence is currently £10 000. This sum represents the present value of the stream of monopoly rents available to individual taxi drivers. Assume regulation is expected to last indefinitely and that the market rate of interest is 10 per cent.
What annual amount of monopoly rent are drivers expecting to make?
Calculate the monopoly rent per trip implied by the market price of the licence fee and hence deduce the average price of a trip if regulation were abolished and free entry allowed.
Would you expect there to be any rent-seeking in this situation?
Suppose that a new generation of taxi drivers who have mastered new technology and who can carry passengers at 180 pence per trip would like to enter.
What will happen to the price of the licence? Will the existing drivers leave the industry?
Now assume that the licence is not tradeable.
Would there be any benefits attached to making the licences tradeable? Is the industry technically efficient with non-tradeable licences?
Section 3.1 of the text introduced the reader to the concepts of natural monopoly and contestability. Natural monopoly is associated with declining average costs as fixed costs are spread over higher output. Lack of contestability is related to sunk costs which are the result of highly specific assets being required. The time lag before an incumbent firm can respond to new entry is also important. If prices can be adjusted quickly, this favours the incumbent.
Consider a telephone network. This consists of telephone lines, switching equipment, and terminal apparatus. A bus network in contrast consists of timetabled services along specified routes through bus stations at which travellers may switch from one route to another. Contrast these various operations with respect to their natural monopoly and contestability characteristics. Consider in turn
The transmission of messages/passengers between two points.
The provision of ‘switching’ services/bus stations.
The supply of telephone equipment/travel equipment (e.g. suitcases, catering services and so forth).
In his report The Regulation of British Telecommunications Profitability Littlechild (1983) compared various possible schemes according to a set of criteria. The schemes included the following:
No explicit constraints
A maximum rate of return
Price control of the RPI–X type
The criteria included:
Protection of the consumer against monopoly
Effects on production efficiency and innovation
The burden imposed by regulation
The compatibility of the schemes with the promotion of competition
In the light of the discussion in the text, for each criterion, put the schemes in order of merit from best=1 to worst=3. Obviously this will be a subjective exercise to some extent. However, justify your ordering and turn to the answers section to compare your ranking with that of Littlechild. There we include our own rationalization of Littlechild's ordering. Please address all letters of disagreement to Professor Steven Littlechild.
Sections 3.7 to 3.8 of the text cover some of the main characteristics of monopolies and restrictive practices policy. Here we consider the problems of enforcement in more detail. A traditional economic approach to enforcement is to argue that compliance will depend upon the probability of an infringement being detected and the penalty associated with detection. For a risk-neutral firm the objective will be simply to maximize the mathematical expectation of the present value of the future flow of profits. If, therefore, a restrictive agreement can add 1000 to the present value of profits if it is not detected by the authorities, and if the probability of detection is 0.1, the penalty would have to be 10000 to discourage the firm from operating the agreement, i.e.
0.9×1000+0.1×(1000−10 000) = 0
A higher probability of detection and a higher penalty will both discourage the firm from taking the risk and running an illegal agreement. Of course other factors may also be relevant. There may be social costs of being caught, or there may be economic costs in excess of the legal penalty if publicity harms the reputation of the firm for fair dealing. Further a lower penalty may suffice to deter the firm if it is risk averse.
On the basis of the points mentioned in the text, compare the incentives to compliance embodied in the Restrictive Trade Practices Act 1976 and the new system introduced by the Competition Act 1998.
How does the possibility of a private action for damages affect compliance and the incentive to monitor the activities of firms?
In the US, lawyers can receive contingency fees (a share in the damages if awarded). What influence would this have on the incentive of private people to take legal action?
