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LOS a: Explain the rationale for government regulation in the form of (1) economic regulation of natural monopolies and (2) social regulation of nonmonopolistic industries.

Amelia Andrews, CFA, is the current head of the California Utilities Commission, the agency which has regulatory authority over all utilities providers in the state of California. Andrews has been head of the agency for three years, before which she had spent her twenty year career in various roles at California Electric (CE), the largest producer and distributor of electricity to residential customers in California. Presently, legislators in the state of California are struggling with the issue of how to balance rising consumer demand for electricity with an obsolete production infrastructure that is already producing at levels approaching full capacity. Andrews has scheduled a joint meeting at the Commission’s office with state legislators, consumer representatives, and utilities providers to address the issues.

At the meeting, Andrews greets several of her former co-workers, who are still employed by California Electric. The Chief Executive Officer of CE is Andrews’s former boss and mentor, as well as occasional golf partner. The CEO of CE is at the meeting to acknowledge consumer concerns about rising electricity prices, but also to explain that CE cannot make any price concession because their existing plants are nearly at full production capacity and new, more efficient plants are several years away from completion. CE’s proposal is to maintain the current strategy of passing on gradual price increases to consumers, which will then level off in the next few years as new plants are brought into production. This would allow CE to maintain its current profits margins while still providing excellent service to its customers.

Andrews introduces herself to the representatives of the consumer interest group, which has recently formed in response to the rise in utilities rates. The consumer interest group is represented by three concerned citizens from different cities across the state who volunteered to attend the meeting to voice the opinions of the consumers they represent. Their main goal is to put pressure on the regulatory commission to hold electricity rates constant until the end of the next year, stating that electricity providers have experienced years of profitability and now should be willing to make concessions to the consumers. Also, the representatives will inform meeting participants if consumer demands are not met, consumers are willing to switch to other “alternative” sources of power, even if that means a decrease in the quality of service or a slight increase in price.

Andrews also welcomes to the meeting several California state legislators who are in attendance. One of them, Louis Briggs, has known Andrews professionally for many years and is the person who had originally proposed Andrews for the job as head of the California Utilities Commission. Briggs had sent a note to Andrews before the meeting to say that he would like to help facilitate a smooth negotiation process at the meeting in anticipation of upcoming state-wide elections. He expresses to Andrews that no solution will be attractive to all interested parties, and that each of them should be willing to give up some ground.

After participating in a preliminary discussion among the representatives of the three interested parties and listening to each of their concerns, Andrews proposes yet another possible course of action: deregulation. Andrews argues that some degree of deregulation for the utilities industry in California could have many advantages over the current system. She requests that further discussions regarding the pros and cons of her proposal be held.

In an industry in which a natural monopoly may exist, such as the electric utilities industry, regulators generally attempt to set industry prices at a level where:

A)	each participant earns a competitive return on investment.

B)	price equals long-run average cost.

C)	participants cannot engage in predatory pricing practices.

There are different methods of rate regulation for a natural monopoly, but the general goal of regulators is to set prices at a level where long-run average costs intersect the demand curve, providing an element of profit for the producer. (Study Session 4, LOS 15.a)

A)	lobbyists and special interest groups.

B)	legislators.

C)	customers of the industry.

Lobby groups may be funded by various consumer groups or industry participants in order to protect their special interests, but regulators do not answer directly to them. (Study Session 4, LOS 15.d)

A)	share-the-gains, share-the-pains theory.

B)	capture hypothesis.

C)	feedback effect.

The capture hypothesis assumes that since industry participants have the most expertise regarding their particular industry, they will fill regulatory positions but still have contact or relationships with members of the industry. Regulators will be “captured” by the very industry they were assigned to regulate and be unable to render impartial decisions. (Study Session 4, LOS 15.d)

A)	rate-of-return regulation.

B)	natural monopoly regulation.

C)	cost-of-service regulation.

CE’s plan is designed to protect its current level of profitability. A rate-of-return regulation approach sets industry-wide prices based upon the cost to produce the good or service plus a reasonable rate of the return to the producer/provider. (Study Session 4, LOS 15.a)

A feedback effect occurs when consumers’ behavior is changed as a result of regulation. (Study Session 4, LOS 15.c)

A)	A short-term increase in the level of quality of service because of increased competition.

B)	Unemployment rates will fall as new job openings are created in the industry.

C)	An increase in market efficiency due to lower barriers to entry and exit.

A contestable market will operate very efficiently because any excess profits in the industry will attract new entrants, which in turn will increase competition and drive prices back to marginal cost. (Study Session 4, LOS 15.e)

A regulatory commission that seeks to have regulated companies set prices at a level that provides a reasonable profit to the companies is utilizing which of the following methods of regulation?

A)	Rate-of-return regulation.

B)	Cost-of-service regulation.

C)	Social regulation.

A regulatory commission that seeks to have regulated companies set prices at a level that provides a reasonable profit to the companies is utilizing which of the following methods of regulation?

A)	Rate-of-return regulation.

B)	Cost-of-service regulation.

C)	Social regulation.

Rate-of-return regulation seeks to allow industry participants to receive what regulators determine is a normal or fair return on their investment.

In general, the regulatory body of an industry with a natural monopoly will attempt to set industry prices at which point on the supply/demand curve?

A)	Marginal revenue = average cost.

B)	Average cost = demand.

C)	Marginal revenue = marginal cost.

In general, the regulatory body of an industry with a natural monopoly will attempt to set industry prices at which point on the supply/demand curve?

A)	Marginal revenue = average cost.

B)	Average cost = demand.

C)	Marginal revenue = marginal cost.

At the point where average cost equals demand, producers would maintain profitability and consumers would pay a price somewhat lower than in an unregulated market.

When a firm operates with the lowest cost per unit and the capacity to produce all of the industry’s output, this economic structure is best described as:

A natural monopoly is characterized by a single dominant firm within the industry that is the lowest cost producer and has sufficient capacity to meet demand.

Joseph Glass, CFA, is a consultant who provides advisory services to large manufacturing companies. Glass has been retained by ABCO, a leading manufacturer of widgets for automobiles in the United States. ABCO has hired Glass to evaluate the possibility of expanding their current base of operations by building an additional facility in South America. Management of ABCO has identified an increase in demand for widgets in South America over the past decade, and any new manufacturing facility would produce goods to satisfy that void and would be distributed and sold across South America.

Glass is not familiar with the current economic climate in South America, but is aware that several governments have attempted to encourage economic development in their countries through the enactment of pro-business legislation. Two of these countries, Venezuela and Peru, both have the reputations of being “friendly” to foreign economic investment within their borders. The two countries share some similarities: both, until the past twenty years, were primarily agricultural economies with little industrial development. Also, both countries can offer a relatively low-cost labor force, although their workers in general, are not highly skilled.

The government of Peru has declared that protecting the country’s environment is of utmost importance, and has established a regulatory body that oversees any environmental concerns that may arise as the country becomes more industrialized. Fairly stringent regulations have already been put into place in order to ensure that going forward, the operating practices of manufacturers within their country’s borders will be in balance with the government’s concern for their county’s natural resources. Regulations cover areas of concern such as air emissions, water conservation and the use of sustainable resources. Glass advised ABCO that a cost-benefit analysis must be performed to accurately determine both the direct and indirect costs of compliance with the regulations.

The Venezuelan government has taken steps to ensure that it can carefully manage the development of its country’s emerging economy, and to ensure that a competitive market is maintained. A regulatory agency was established five years ago to provide guidance for any new manufacturing concern seeking to operate in Venezuela. The head of the agency is Juan Santos, the former CEO of one of the first modernized manufacturing facilities in the country. During his tenure as head of the agency, he has demonstrated his ability to render decisions that attempt to simultaneously satisfy legislators, industry participants, and consumers. Glass is impressed by Santos’ work so far, but realizes that over the past five years, Venezuela has experienced a period of relatively slow economic development. Glass believes that Santos’ skills will truly be put to the test in the upcoming years of the anticipated economic expansion.

Glass acknowledges the need for governmental regulation of industry, but recognizes that there always are offsetting costs, both short-term and long-term of such controls. Based upon his knowledge of events that have occurred in the United States over the past thirty years, Glass recommends that ABCO continue to carefully monitor economic developments in both countries even after a site for a new manufacturing facility is selected.

Should ABCO build a new facility in either of the two countries, it is almost a certainty that they would be the low-cost producer of widgets, with the capacity to satisfy nearly all demand in the region. A natural monopolist operating in an unregulated industry will produce at the point where:

A)	the marginal cost curve intersects the demand schedule.

B)	marginal costs equal marginal revenue.

C)	average costs equal marginal revenue.

A monopolist operating free of price regulation will produce at a rate where marginal revenue equals marginal cost.

A)	A disproportionately higher compliance expense for larger firms rather than smaller firms.

B)	Higher costs of production.

C)	Attempts by industry participants to avoid compliance through creative response.

Increased regulation typically results in a disproportionately higher compliance expense for smaller firms, because the expense is allocated over a smaller base of production than for a larger firm.

A feedback effect occurs when consumers change their behavior as a result of a regulation. In this instance, regulations originally enacted to protect the environment may unintentionally lead to practices that are harmful to the environment.

A)	The capture hypothesis.

B)	Rate-of-return regulation.

C)	Share-the-gains, share-the-pains theory.

The capture hypothesis assumes that at some point, a regulatory body will at some point be influenced or even controlled by the industry being regulated. An industry veteran will still have contacts or relationships with current industry participants, which may affect his ability to render impartial decisions.

A)	share-the-gains, share-the-pains theory.

B)	cost-of-service regulation.

C)	rate of return regulation.

Under the share-the-gains, share-the-pains theory, regulators attempt to satisfy all three interested parties of an industry: the customers, the regulators, and the regulated firms themselves. By regulating that manufacturers and customers must share the increased costs, Santos is attempting to ensure that no one party bears an unfair burden.

A)	deregulation.

B)	the theory of relevant markets.

C)	the theory of contestable markets.

Under the theory of contestable markets, an industry can be competitive even when government-imposed barriers to entry are removed and there are only a few firms in the market.