Monopoly regulation under asymmetric information: prices versus quantities

• Author: Nicolás Figueroa,Leonardo J. Basso,Jorge Vásquez
• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/1756-2171.12187
• Date: 01 August 2017

RAND Journal of Economics

Vol.48, No. 3, Fall 2017

pp. 557–578

Monopoly regulation under asymmetric

information: prices versus quantities

Leonardo J. Basso∗

Nicol´

as Figueroa∗∗

and

Jorge V´

asquez∗∗∗

Wecompare two instruments to regulatea monopoly that has private information about its demand

or costs: fixing either the price or quantity. For each instrument, we consider sophisticated

(screening) and simple (bunching) mechanisms. We characterize the optimal mechanisms and

compare their welfare performance. With unknown demand and increasing marginal costs, the

sophisticated price mechanism dominates that of quantity, whereas the sophisticated quantity

mechanism may prevail when marginal costs decrease. The simple price mechanism dominates

that of quantity when marginal costs decrease, but the opposite may arise if marginal costs

increase. With unknown costs, both instruments are equivalent.

1. Introduction

The design of regulatory mechanisms to control monopoly market power whenthe fir m has

better information than the regulator is a problem whose practical relevance is irrefutable. On

one hand, the fact that the firm probably has better information about its costs than the regulator

was well explained by Weitzman (1978): “[...] even the managers and engineers most closely

associated with production will be unable to precisely specify beforehand the cheapest way to

generate various hypothetical output levels. Because they are yet removed from the production

process, the regulators are likely to be vaguer still about a firm’s cost function.” On the other hand,

there are also good reasons for a firm to have or acquire better information than the regulator about

∗Universidad de Chile; lbasso@ing.uchile.cl.

∗∗Pontificia Universidad Cat´

olica de Chile; nicolasf@uc.cl.

∗∗∗Bank of Canada; jvasquez@bankofcanada.ca.

We thank the Editor, Mark Armstrong, Tom Ross, Roberto Cominetti, and anonymous referees for very insightful

comments. We also thank participants at various seminars and conferences for their comments. Basso and Figueroa

gratefully acknowledge financial support from the Complex Engineering Systems Institute, ISCI (ICM-FIC: P05-004-

F, CONICYT: FB0816). Figueroa acknowledges additional financial support from Fondecyt 1141124 and Millennium

Nucleus Information and Coordination in Networks ICM/FIC RC13000.

C2017, The RAND Corporation. 557

558 / THE RAND JOURNAL OF ECONOMICS

the demand. Lewis and Sappington (1988) argue that a firm might have better information about

the quality and reliability of its product. Another reason is that firms usually invest resources

to learn about the demand they face, information that is hardly, or partially, shared with the

regulator. Moreover, over time, the firm is the one that will learn directly the behavior of its

demand, as it is the one interacting with it routinely. A third possibility arises when a firm is at

the top of a vertical structure, as in the case of, for example, ports and airports, in which the

demand for the good or service is derived from the equilibrium of the downstream market; thus,

if the regulator has imperfect information about either the costs or demand of the downstream

firms, then this will be reflected in inferior information about the demand of the firm to be

regulated.

Many articles have looked into the issue. For instance, Baron and Myerson (1982), Baron

and Besanko (1984), Laffont and Tirole (1986), Sappington (1983), and Sappington and Sibley

(1988) focus on cases in which the firm has private information about its costs. In this setting, price

and quantity regulation are equivalent from a social welfare perspective, as the demand function

is known by the regulator; we discuss this issue at the end of Section 5. On the other hand,

Riordan (1984) and Lewis and Sappington (1988) focus on price regulation on settings in which

the firm has private information about its demand; see Armstrong and Sappington (2007) for a

survey.Somewhat surprisingly, quantity-based mechanisms havenot been studied as an option for

monopoly regulationwhen there is asymmetric information on the demand. Yetin many real-world

settings in which the market demand is likely to be unknown, economists and authorities have

considered implementing quantity-based mechanisms to induce a desired outcome. Examples of

such mechanisms are the determination of the level of flights (departures/arrivals) per unit of

time at an airport, as in four slot-controlled airports in the United States (Chicago O’Hare, New

York LaGuardia, New York Kennedy, and Washington National), or the Reliability Must-Run

Generation contracts (used in California, the Phillipines, and India, among other places), where

the regulatory body mandates some plants to produce a minimum amount of energy at times,

in exchange for compensation. It is then natural to ask: What would be the features of optimal

quantity regulation of market power?Which instrument would be preferable, prices or quantities?

The way price regulation works is probably more natural to imagine. The regulator either

sets a price and a transfer or offers a menu of prices and transfers to/from the monopolist to

choose from. Once the price is fixed, the monopolist must sell to everybody willing to buy at

the regulated price. The monitoring issue remaining is that the monopolist may prefer not to sell

some units after the transfer has been received. Yet, according to Lewis and Sappington (1988),

this issue is unlikely to arise, as consumers would report to the regulator wheneverthe firm denies

a purchase.

How would quantity regulation work? A monopolist regulated by quantity would either be

told how much to produce and the transfer it will receive (or pay), or it may be offered a menu

of quantities and transfers to choose from. Once the quantity is fixed, the monopolist must sell at

a price that ensures that all produced units are sold. To ensure this, the regulator could ask the

monopolist to conduct a uniform price auction so that the value for each unit equals the market

clearing price (with the revenues of the sale going to the firm). In fact, in the airport market, the

Federal Aviation Administration (FAA) has been considering auctions to ration slots (Berardino,

2009; Brueckner, 2009). However, if auctions are not feasible,the regulator must monitor whether

the regulated quantity is actually sold, otherwise the mechanism would lose much of its power.

This may turn out not to be so difficult, as many industries indeed havetheir production and sales

routinely monitored already: those in which what is being produced is a flow. This is the case

of utilities such as electricity generation, water, and natural gas, for which firms already have to

report the per-unit of time consumption of households and companies. It is also the case of many

transport markets, such as public transport (buses and subway), trains, air travel and airports,

ports, and highways, which must report the flow of passengers and goods to authorities. In any

of those cases, the quantity to be produced and sold in a period of time can be easily checked,

C

The RAND Corporation 2017.