A local electric utility faces a downward demand curve given by P = 100 ? Q, where Q is millions ofmegawatt hours demanded annually. The monopoly has constant marginal costs of $20 per megawatt hourand has annual fixed costs of $1.2 billion.(a) If the electric utility is unregulated, what price will it set? What are the monopolist?s profits?(b) If the regulator sets linear prices so that the electric utility breaks-even (ie. Profits = 0), what pricewill he/she set?(c) Suppose that demand for electricity varies over the course of the day and is most inelastic in themiddle of the day. Illustrate how the regulator could use this information to improve on theoutcome in (b)? Would there be any challenges that would prevent regulators from using theprices you describe?(d) Explain how the regulator would use the optimal two-part tariff to cover the monopolist?s fixedcosts while maximizing welfare. How much does welfare increase relative to the linear pricesused in part (b)?(e) As an alternative to a regulated private company, the government can provide electricity service.In this case, assume that the government finances the fixed costs by taxing other goods and sellselectricity to the public at marginal cost. But taxing other goods creates deadweight loss of itsown ? suppose that each dollar of tax revenue collected by the government creates $0.20 ofdeadweight loss.From a welfare-perspective, is state ownership preferable to private ownership under linear pricesin part (b)?(f) Suppose that the firm?s annual fixed costs consist of $1 billion in actual fixed costs and $0.2billion in amenities for executives (e.g., corporate jets with gold-plated washrooms.)The CEO makes decisions about the second piece of fixed costs every year. In particular, theCEO can cutback on amenities, but it makes the CEO feel like this ? ?.The CEO?s utility function is given by: UCEO = Firm Profits ? 5*X2, where Firm profits aremeasured in billions of dollars and X denotes the amount amenities are cut-back, also in billions ofdollars. Thus, if the CEO chooses amenity $0.15 billion in amenities, X = 0.05.What level of cutbacks will the CEO choose if the firm is regulated under cost-plus regulation(assuming prices are immediately adjusted to reflect any cost reduction)?What level of cutbacks will the CEO choose if the firm is regulated under fixed-price regulationwhere regulators don?t adjust rates in response to changes in fixed costs?(Hint: think about how much profits would rise if the firm cut back fixed costs by X dollars, undereach of the two forms of regulation)

ECN121B - Industrial Organization II Prof. Muehlegger PROBLEM SET 4 Due: Start of class, February 26th Instructions: Group Work: I encourage all of you to work on the problem set in groups, but each member of the group must write up his or her own solutions. Problem sets that are verbatim copies will receive a zero. When submitting your problem set your problem set in make sure that you hand it in: 1. Stapled 2. With your name at the top 3. Listing of all of the people with whom you worked Question 1: A local electric utility faces a downward demand curve given by P = 100 - Q, where Q is millions of megawatt hours demanded annually. The monopoly has constant marginal costs of $20 per megawatt hour and has annual fixed costs of $1.2 billion. (a) If the electric utility is unregulated, what price will it set? What are the monopolist's profits? (b) If the regulator sets linear prices so that the electric utility breaks-even (ie. Profits = 0), what price will he/she set? (c) Suppose that demand for electricity varies over the course of the day and is most inelastic in the middle of the day. Illustrate how the regulator could use this information to improve on the outcome in (b)? Would there be any challenges that would prevent regulators from using the prices you describe? (d) Explain how the regulator would use the optimal two-part tariff to cover the monopolist's fixed costs while maximizing welfare. How much does welfare increase relative to the linear prices used in part (b)? (e) As an alternative to a regulated private company, the government can provide electricity service. In this case, assume that the government finances the fixed costs by taxing other goods and sells electricity to the public at marginal cost. But taxing other goods creates deadweight loss of its own - suppose that each dollar of tax revenue collected by the government creates $0.20 of deadweight loss. From a welfare-perspective, is state ownership preferable to private ownership under linear prices in part (b)? (f) Suppose that the firm's annual fixed costs consist of $1 billion in actual fixed costs and $0.2 billion in amenities for executives (e.g., corporate jets with gold-plated washrooms.) The CEO makes decisions about the second piece of fixed costs every year. In particular, the CEO can cutback on amenities, but it makes the CEO feel like this . The CEO's utility function is given by: UCEO = Firm Profits - 5*X2, where Firm profits are measured in billions of dollars and X denotes the amount amenities are cut-back, also in billions of dollars. Thus, if the CEO chooses amenity $0.15 billion in amenities, X = 0.05. ECN121B - Industrial Organization II Prof. Muehlegger What level of cutbacks will the CEO choose if the firm is regulated under cost-plus regulation (assuming prices are immediately adjusted to reflect any cost reduction)? What level of cutbacks will the CEO choose if the firm is regulated under fixed-price regulation where regulators don't adjust rates in response to changes in fixed costs? (Hint: think about how much profits would rise if the firm cut back fixed costs by X dollars, under each of the two forms of regulation)