2-Insights On Competitive Structures II

1
Exam question (February 4th 2021)
3) There is a monopoly in a retail market with an inverse demand curve given by p = 10 – (1/2)q, no
fixed costs and use of only 1 input for each unit of output (e.g. 1 engine for 1 car). Now suppose that
the wholesale market where this input is produced is also a monopoly, and the wholesale monopolist
bears a constant marginal cost for producing the input equal to 2. Please indicate the price settled by
the monopolist in the retail market.
a) 2.
b) 4.
c) 6.
d) 8. BONUS
MR curve for the retailer = Demand curve for the wholesaler: p = 10 – q

MR curve for the wholesaler: 10 – 2q; MC for the wholesaler: 2
MR = MC: 10 – 2q = 2; q = 4; price settled by the monopolist in the retail Mkt:
P = 10 – (1/2) 4 = 8.
Business and Industrial Economics
A.Y. 2022/2023
Prof. Luca Grilli
Insights on Competitive Structures:

Part 2
3
Note3: Sometimes a monopoly is better than

everything
NATURAL
MONOPOLY
Natural Monopoly
• Natural Monopoly Subadditivity of cost function

• [a]n industry in which multi-firm production is
more costly than production by a single firm
(Baumol, 1977, p. 810)
QUANTITY
QUANTITY
COSTS IN
CASE OF
MORE THAN COSTS OF
ONE FIRM ONE FIRM
n
TC (Q)   TC (qi ) n
q i  Q, n  2
i 1 i 1
Note: Scale economies are a sufficient but not a necessary

condition to prove subadditivity
Natural Monopoly: Example on Natural Gas
transportation
Average cost
transportation
[Euro/Mln cm]
MES- Minimum
efficient scale
25.000
15.000
12.000
10.000
100.000 Mln cm - year

Scale
economies
Strong scale economies: why?
• General reasons
A. Great amount of indivisible resources
• Resources that should be present even for small scale operations
• Examples: Central delivery points, Rapid interventions team,
Regulatory Office, …
B. Specialization of workforce
• Less specialized employees, lower productivity
• Geographically specialized network planners and operators
• Specific reasons
C. Pipelines: “volumetric returns to scale”
• As the diameter of the pipe doubles, its volume increases by a factor
of 4, while its surface area only increases by a factor of 2
D. Administrative costs
• Administrative/bargaining costs for acquiring the right to transit
bargained with (local) governments which are relatively insensitive to
the volume of gas transported
Natural Monopoly
• Natural Monopoly
 Size of the market close or slightly higher than MES
 Question: What is the most cost-efficient market configuration?
Average cost
transportation
[Euro/Mln cm]
National Market= 125.000 Mln cm - year
25.000 MES
15.000
12.000
10.000
100.000 Mln cm - year
Natural monopoly
• National Market= 125.000 Mln cm - year

• What if we make produce this quantity to more than a firm?
N° of firms Average cost Total transportation

transportation costs
1 10.000 Euro/Mln cm-year 1.250 Mln Euro

Public utilities 9
Natural monopoly was and still is the crucial economic concept

behind public service utilities and many network industries.
Natural Gas, Electricity, Telecommunications (Water, Railroads, among others):

all businesses that delivers an essential good or service through a wide
network infrastructure.
Natural Monopoly in Network industries 10
• Gas, Electricity, Telecommunications
Production/Generation/TLC Network service
Transportation/Transmission/TLC backbone
Distribution/TLC local loop
Sale
Liberalization processes in Network industries
• Gas, Electricity, Telecommunications
Production/Generation/TLC Network service
Transportation/Transmission/TLC backbone
these 2 infrastructures remain in natural monopoly
Distribution/TLC local loop
Sale
12
Why?
• 2 main reasons (mutually reinforcing):
- demand-side explanation
- -supply side explanation

Example: electricity, demand-side 13
Source IEA 2021

Example: electricity, supply-side 14
Public intervention: Regulation of a Natural monopoly15
• Productive efficiency Single firm

• Single firm (if market non contestable) Monopoly outcome
Can the public actor re- Loss in allocative efficiency

balance the loss in
allocative efficiency while
keeping productive
efficiency?
Regulation
Economic Regulation 16
• Ex-post regulation: ANTITRUST (later in the course):

collection of laws which regulates the conduct and
organization of business corporations to promote fair
competition for the benefit of consumers. 2 areas of great
importance:
-Anticompetitive practices (e.g. cartels)
-Abuse of dominant position
Policy intervenes to punish anticompetitive behavior
• Ex-ante regulation: specific REGULATORY

COMMISSIONs that right from the beginning set invasive
and pervasive “rules of the game” (e.g. including prices of
final or intermediate services/products).
2 important reasons reinforce the need to regulate network
industries rather then only natural monopoly
Non-redeployable
investments (sunk costs)
REGULATION Inelastic
NECESSITY demand
Inelastic demand 18
 Gas, electricity, telecom: very much “necessity goods”

with no or imperfect substitutes
p  MC 1

 Monopolist optimum price : p 
Non-redeployable investment
• “Non-redeployable” investment
 Difficult to assess how much residual value one can get from the investment in case of exit
from the market
 Example:
2000 2020 2040

New Asset Exit from Asset to be
the market susbtituted
100 Ml Euro 100 Ml Euro
Case A:
Redeployable
investment Sale = 50
Ml Euro
Case B: Non- Loss value

redeployable
investment Sale = 25
Ml Euro
Why are network infrastructure often “scarcely-
redeployable” investment?
Second-hand markets are highly imperfect

Investments are specific to a given
geographical, product and institutional
context: this reduces n° of credible
acquirers: high bargaining power of
potential acquirer(s)
Difficult from the other side (potential
acquirer) infer the “true” value of the
asset: information asymmetries
Non-redeployable investment
• Non-redeployable investment : Implications
A. Under-investment, No infrastructure (unless State steps in,

i.e. Government's s ownership at the every onset)
B. No (potential) competition
• Exit barriers for incumbent
– Fear to lose all the investments made in case of
exit
– Best to remain in the market even if profitability
is low
• Entry barriers for new entrants
– Risk to be locked-in in case of entry
– Consciousness of the resilience of incumbents
How to regulate? We will also see it later in the 22
course…..
Braeutigam 1989:
Optimal policies for natural
monopolies
in Schmalensee R., Willig R. D. (a
cura di), Handbook of industrial
organization, vol. II, North Holland,
Amsterdam, pp. 1289–1346.
References 23
• Cabral [Industrial Organization I edition, 2000: chapters 2.1;

5.1; 5.2; 6.1; 6.4; 11.1; or Industrial Organization II edition,
2018: chapters 2.1; 5.3; 5.6; 4.1; 4.3; 7.3; 13.1 (only double
marginalization problem, pp. 334-336)].
• Shy (Industrial Organization, chapter 8.5)
• Further reading:
Varian, Intermediate Microeconomics, subparagraphs on

“Natural Monopoly” and “What causes Natural Monopoly”

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1

Exam question (February 4th 2021)

MR curve for the retailer = Demand curve for the wholesaler: p = 10 – q

Prof. Luca Grilli

Insights on Competitive Structures:

Note3: Sometimes a monopoly is better than

• Natural Monopoly Subadditivity of cost function

Note: Scale economies are a sufficient but not a necessary

100.000 Mln cm - year

• National Market= 125.000 Mln cm - year

N° of firms Average cost Total transportation

1 10.000 Euro/Mln cm-year 1.250 Mln Euro

2 15.000 Euro/Mln cm-year 1.875 Mln Euro

3 25.000 Euro/Mln cm-year 3.125 Mln Euro

Natural monopoly was and still is the crucial economic concept

Natural Gas, Electricity, Telecommunications (Water, Railroads, among others):

• Gas, Electricity, Telecommunications

Production/Generation/TLC Network service

Distribution/TLC local loop

• Gas, Electricity, Telecommunications

Production/Generation/TLC Network service

these 2 infrastructures remain in natural monopoly

Distribution/TLC local loop

• 2 main reasons (mutually reinforcing):

- -supply side explanation

Source IEA 2021

• Productive efficiency Single firm

Can the public actor re- Loss in allocative efficiency

• Ex-post regulation: ANTITRUST (later in the course):

Policy intervenes to punish anticompetitive behavior

• Ex-ante regulation: specific REGULATORY

 Gas, electricity, telecom: very much “necessity goods”

2000 2020 2040

Case B: Non- Loss value

Second-hand markets are highly imperfect

• Non-redeployable investment : Implications

A. Under-investment, No infrastructure (unless State steps in,

• Cabral [Industrial Organization I edition, 2000: chapters 2.1;

• Shy (Industrial Organization, chapter 8.5)

Varian, Intermediate Microeconomics, subparagraphs on

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