Regulating a natural monopoly

Overview

This application uses a PG&E as an example of a natural monopoly, and then walks the students through different outcomes, depending on whether PG&E is regulated or unregulated, and if the former, what kinds of regulations it might face.

Expected Student Learning Outcomes

- Analyze the demand curve for a monopoly, and determine the output that maximizes profit
- Evaluate regulatory policies for a natural monopoly

Information Given to Students

This is the first exercise in a module that includes monopoly, oligopoly, externalities, and public goods. Before tackling this application, students have read the chapter on monopoly, and they are also familiar with economies of scale from module 1 (competitive markets).

Application 1 focuses on a stylized version of a real-life scenario, the provision of electricity in California by PG&E.

Parts 1 and 2 aim at providing a common starting point for all teams, making sure all teams understand the basic cost and demand structure of a natural monopoly.

Part 3 explores the profit maximization for an unregulated single-price natural monopolist. This is the first time teams attempt to find the profit maximizing quantity and price for a monopolist. Teams are usually good at find the quantity at which MC = MR (partly a carry-over from module 1), but sometimes may miss establishing the price on the demand curve, instead of at the MC = MR point. This may lead to a discussion on the relationship between the demand and marginal revenue curves for a single-price monopolist. Finding the profit area is mostly a skill carried over from module 1.

Part 4 makes students think about what would happen if a natural monopoly is forced to behave like a competitive firm, pricing its product at marginal cost. The discussion may lead into questions of efficiency, fixed vs. variable costs, subsidies.

Part 5 allows the teams to explore another type of regulation, where the natural monopoly is making zero economic profits. Beyond the graphical analysis, this part leads to a discussion across teams on the effectiveness of this regulation, the possible incentive to inflate costs, and propose refinements of this type of regulation that would work better.

Note that in my class each team has a small whiteboard (sometimes called a huddleboard) to respond to most questions, and they share their results by raising their whiteboards simultaneously (the whiteboards/huddleboards are small and light enough that they can be raised by one person, and they are big enough that everyone can observe the results of all other teams).

Observation of student responses during discussion. Capstone test at the end of the module. Final exam also tests these learning outcomes.