The argument for price caps seems to be that a monolopy has a backwards sloping supply-demand curve. So basically if you produce less you can make more $. but we also know that price caps lead to shortages as history shows us. My question is does putting a price cap on what a monopoly sells if the price is less then the production costs (including profit) basically change the model to that of a comodity where the suply-demand curve is ‘normal’.
Basically a price cap introduces an artifical competator that produces nothing but causes the price to be held at a certain level.
No that’s not exactly right. For a competitive market (lots of firms that cant individually affect the market) there are two curves. There is a DEMAND curve that always slopes downward. The higher the price, the less quantity demanded by the market. Then there is a SUPPLY curve that always slopes upward. The higher the price, the more product a firm wants to produce. The point where they intersect is the market price. This is the point where a competitve firm maximizes its profit.
In a monopoly (one firm), the suply curve for the company is the supply curve for the entire market. Unlike a competitve market, a monopoly can influence the price by setting the supply. Because of this, a different model is used to model the equilibrium price of a monopoly. A monopoly maximizes its economic profit by setting the supply at the point where its marginal costs = marginal revenue (the supply level where the cost of producing the next unit = the additional revenue gained from prodcing the next unit). In other words, producing more units or fewer units will result in lower profits.
If the price cap is greater than the total costs but less than the MR=MC price, the monopoly firm simply makes lower profits. If the price cap prevents the firm from meeting its variable production costs, the firm shuts down because it loses money on every unit it sells. if the price cap is less than the fixed costs, the firm goes out of business.
There won’t be shortages as long as the firm earns a profit on each unit they sell. Remeber that the monopoly firm sets the supply level for the entire market. Either the firm supplies the entire market or they lose money on each unit sold and they shut down.
Setting prices also does not take into account other factors that create a monopoly. Barriers to entry or economies of scale prevent other firms from entering the market. Some industries (like utilities) also lend themselves to “natural monopolies” (its not cost effective to string 10 sets of power lines/pipes/etc).
msmith that sure brought back some memories - thanks for the refresher.
There is less insentive to produce when margins shrink if you expect the price to go up again. As you are making less on each unit it’s an ideal time to shut down a plant and do some maintance. That is if you have the capital to weather the storm so to speak. If you are in desprate need of capital then you might want to crank out as many as you can while neglecting maintanence but utilities don’t seem to be in this position.
Right. If the price cap is above the competitive price but below the monopoly price, the monopolist will make lower profits. Examination of the relevant charts shows that the effective marginal revenue curve over a certain interval flattens. Consequently, for
P(monopoly)>P(price cap}>P(competition),
Q(competition)>Q(price cap)>Q(monopoly). In words, the price cap induces the monopolist to produce more, since cutting back on output any further will no longer result in higher prices.
If prices are set below the competitive level, output will decline. If prices are set below the point where the marginal cost curve meets the y axis, no output will be produced.
Let me add a caveat. Sometimes when a business can’t cover the interest payments on its capital, the business liquidates, but is then sold and reopened under new managers. Some of the 19th century canal companies did this. Railroads made it difficult for canal owners to recoup their investment. Following bankruptsy, however, the canals still had positive value, so later owners were able to run them well into the 20th century, IIRC. In retrospect, they should not have been dug, but once in place it made sense to keep using them. Much like certain nuclear power plants, IMHO.
However, the limited profit potential will do one thing - curb investment. When shortages occur (or monopoly pricing occurs), the potential for higher profits attracts investment capital. If you cap the profit potential, some of your investment capital goes away.
As usual, markets are complex. And unpredicable. Screw with them at your peril.
Sam: 1) The electrical market is and has been one of the most heavily regulated in the world. I dare say that CA’s regulated version worked a heck of a lot better than its less regulated version. And I don’t want to hear about “fake deregulation”: including incentives for producing excess capacity seems like an intervention to me.
IMO, (only MO) there does exist a deregulated format superior to the typical regulated market structure. Its exact characteristics, however, are not in my mind. (Though I strongly suspect that it would involve real-time pricing.)
You are correct to imply that the situation is more complicated than the simple monopoly model implies. For one thing, there is free entry in the medium run (though not the short run). For another, it is more the case of an oligopoly facing an exceedingly steep demand curve.
Empirically, as long as P(cap)>P(competitive) there would be, if anything, potential for overinvestment, since super-competitive profits would be possible for a while.
One short run argument against price caps is that the government doesn’t know the market and won’t be able to set proper cap. This doesn’t apply, since FERC and various Public Utility Commissions have ample experience with regulated electricity markets and have a pretty good sense of the industry’s cost structure.
Another argument is that government program often start out adequately, but end up promoting inefficiency as public oversight fades and the agency becomes subject to bureaucratic sclerosis and increasingly sensitive to the concerns of well organized and focused interests. You suggested in another thread that this has happened with rural electrification. 20th century railway regulation is another example. IMO, this is a particularly devastating critique within the libertarian arsenal.
Corporations are also subject to inertia, but this is offset by market competition. The corresponding check in the public sector is a free press, which doesn’t do a particularly good job in covering such exciting agencies as the Import/Export Bank and Nuclear Regulatory Commission, absent a high-profile disaster or scandal.
Feinstein proposes to authorize price caps for 2 years. But authorizations can be extended (as we both know) and I confess (notwithstanding #1) that I don’t know whether there exists an ungameable market structure without price caps. I assume there is. I don’t know that.
RE: The OP: BTW, when there are price caps, the marginal revenue curve becomes discontinuous. Just thought you might like to know. [sub]zzzzzzzzzzzzzzzzz[/sub]
Those 2-year price caps will be politically impossible to remove, unless the natural price falls below the cap and makes it irrelevant. If it doesn’t, you’ve got a scenario for an even larger disaster, because if prices are held artifically below market levels for an extended period of time, it’s bound to lead to distorting problems thoughout the electricity distribution system in CA.
But most of your points are well taken, and the effect of and need for price caps is certainly not clear in the markeplace mess that is the strangely regulated California energy system.
Hm. I guess I didn’t make myself clear. Notwithstanding the preceding caveats (in particular, #5), I think there remains a strong case for price caps on Western electric power.
I disagree that markets are really that unpredictable, at least qualitatively: the assumption that firms pursue profits actually leads to a number of well-defined, testable and mostly supported propositions. *
In this case, that certain firms have an incentive to withhold output in CA is something that could be demonstrated. That they have done so is indicated by the combination of historically high prices on electrical capacity and an historically high share of capacity being held off line. Now, admittedly, this is based on a rather quick analysis. But those who have looked at the issue in more depth appear to agree with my assessment.
As for the long run problems, I’ll note that most utilities have lived with governmental price regulation for over 50 years; if they were that awful, I daresay that the Western world could not have enjoyed it’s extraordinary period of Post-war growth.
There’s one final element that may make such price regulation unnecessary, however. If the electric grid was sufficiently connected (say from California to Kentucky) so that a holder of, say 8000MW, still had a tiny share of the entire electrical market, then gaming the system might become less plausible. (Especially when the preceding is combined with long term contracting and real-time pricing.) So, we can’t dismiss a more libertarian future for the electricity market just yet.
[sub]Indeed, if markets were unpredictable and inherantly unstable, that might strengthen the case for central planning, IMHO.[/sub]
