Question

Write your own numerical example and explain how Loeb-Magat (1979) Proposal works. How would you solve the known issues with this proposal? Explain

Answer 1

Loeb‐Magat Proposal (1979)

~If the regulators had perfect knowledge about the costs and demands of the monopolist, then optimal pricing mechanisms could be used.
The monopolist really has a much greater view of its costs than the regulators do.

~The company's income would increase with higher prices, thereby creating an opportunity to overestimate its costs (which is the normal justification the regulator uses for setting prices).

~Loeb and Magat (L‐M) believed the monopolist knows completely about costs and demands information, but the regulator knows only demand. (Issue is much more important if regulators have a sketchy understanding of dd)

~Given this knowledge asymmetry and the presumption that the goal of a monopolist is to maximize income, what should the agency do to induce efficient pricing?

~L‐M suggests allowing the monopolist to choose his own product, but the government would subsidize the business at the chosen product by an amount equivalent to the market surplus.

Form of subsidy L—M.
~Cost of the company, C(Q, e), is not reported to the regulator.

~The regulator is known for the market, Q(P), and the commodity surplus, V(P).

~Regulator puts equal weight on the business surplus and benefits = Max W(P, e)=V(P)+π(P, e)

~Loeb and Magat mechanism:

a) Pay client lump-sum transfer equivalent to (observed) customer surplus.

b) Adjust the competitive function of a company to be equal to the function of welfare = Max V(P)+π(P, e).

c) The business has internalized impact on market surplus choices and can choose optimum prices and optimum level of effort.
d) Gain technological and allocative performance.
e) Distribution issues because customers are not having any export gains.

Understanding the plan L- M
~The monopolist has decreasing demand (AR) and believes that the TC fn is K + c. X; thus, MC is stable and equal to c.

~The business will charge a certain P0 amount. Then profit = P*DEB – K, consumer part (OX0EP0) and regulator part (P0EB) part.
~However, it can do better by paying P * in the L-­‐M system. Benefit= P*AB-K

~Since AR is now, in fact, MR with a subsidy, and MR = MC, it is now a profit-maximizing solution for the monopolist.

~Solution is successful i.e. enabling private companies to charge P = MC but challenged on the distributional ground. That solves the problem of information but worsens the problem of losses.