CFA Level 2 - Economics Session 4 - Reading 15 (Practice Questions, Sample Questions) 1. Amelia Andrews, CFA, is the current head of the CaliforniaUtilities Commission, the agency which has regulatoryauthority over all utilities providers in the state of California.Andrews has been head of the agency for three years, beforewhich she had spent her twenty year career in various roles atCalifornia Electric (CE), the largest producer and distributorof electricity to residential customers in California. Presently,legislators in the state of California are struggling with theissue of how to balance rising consumer demand forelectricity with an obsolete production infrastructure that isalready producing at levels approaching full capacity.Andrews has scheduled a joint meeting at the Commission’so ce with state legislators, consumer representatives, andutilities providers to address the issues.At the meeting, Andrews greets several of her formerco-workers, who are still employed by California Electric. TheChief Executive O cer of CE is Andrews’s former boss andmentor, as well as occasional golf partner. The CEO of CE is atthe meeting to acknowledge consumer concerns about risingelectricity prices, but also to explain that CE cannot make anyprice concession because their existing plants are nearly atfull production capacity and new, more e cient plants areseveral years away from completion. CE’s proposal is tomaintain the current strategy of passing on gradual priceincreases to consumers, which will then level o in the nextfew years as new plants are brought into production. Thiswould allow CE to maintain its current proﬁts margins whilestill providing excellent service to its customers.Andrews introduces herself to the representatives of theconsumer interest group, which has recently formed inresponse to the rise in utilities rates. The consumer interestgroup is represented by three concerned citizens fromdi erent cities across the state who volunteered to attend themeeting to voice the opinions of the consumers they
represent. Their main goal is to put pressure on theregulatory commission to hold electricity rates constant untilthe end of the next year, stating that electricity providers haveexperienced years of proﬁtability and now should be willing tomake concessions to the consumers. Also, the representativeswill inform meeting participants if consumer demands are notmet, consumers are willing to switch to other “alternative”sources of power, even if that means a decrease in the qualityof service or a slight increase in price.Andrews also welcomes to the meeting several California statelegislators who are in attendance. One of them, Louis Briggs,has known Andrews professionally for many years and is theperson who had originally proposed Andrews for the job ashead of the California Utilities Commission. Briggs had sent anote to Andrews before the meeting to say that he would liketo help facilitate a smooth negotiation process at themeeting in anticipation of upcoming state-wide elections. Heexpresses to Andrews that no solution will be attractive to allinterested parties, and that each of them should be willing togive up some ground.After participating in a preliminary discussion among therepresentatives of the three interested parties and listeningto each of their concerns, Andrews proposes yet anotherpossible course of action: deregulation. Andrews argues thatsome degree of deregulation for the utilities industry inCalifornia could have many advantages over the currentsystem. She requests that further discussions regarding thepros and cons of her proposal be held.In an industry in whicha natural monopoly may exist, such as the electric utilitiesindustry, regulators generally attempt to set industry pricesat a level where: A) price equals long-run average cost. B) each participant earns a competitive return on investment.C) participants cannot engage in predatory pricing practices.<Explanation:> There are di erent methods of rate regulationfor a natural monopoly, but the general goal of regulators isto set prices at a level where long-run average costs intersectthe demand curve, providing an element of proﬁt for theproducer. (Study Session 4, LOS 15.a)
In general, regulators of a speciﬁc industry are heldaccountable by three separate interested parties, which leastlikely includes which of the following groups?A) legislators. B) lobbyists and special interest groups. C) customers of the industry.<Explanation:> Lobby groups may be funded by variousconsumer groups or industry participants in order to protecttheir special interests, but regulators do not answer directlyto them. (Study Session 4, LOS 15.c) The theory that assumes that despite the original purposebehind its establishment, a regulatory agency will beinﬂuenced or even possibly controlled by members of theindustry that is being regulated is called the:A) share-the-gains, share-the-pains theory.B) feedback e ect. C) capture hypothesis. <Explanation:> The capture hypothesis assumes that sinceindustry participants have the most expertise regarding theirparticular industry, they will ﬁll regulatory positions but stillhave contact or relationships with members of the industry.Regulators will be “captured” by the very industry they wereassigned to regulate and be unable to render impartialdecisions. (Study Session 4, LOS 15.c) California Electric’s proposed plan to maintain the currentprogram of passing on gradual price increases to consumerscan best be described as:A) natural monopoly regulation. B) rate-of-return regulation. C) cost-of-service regulation.<Explanation:> CE’s plan is designed to protect its currentlevel of proﬁtability. A rate-of-return regulation approach setsindustry-wide prices based upon the cost to produce thegood or service plus a reasonable rate of the return to theproducer/provider. (Study Session 4, LOS 15.a)
If consumers change their electricity consumption inresponse to the California Utilities Commission’s proposal toincrease the rates providers are permitted to charge, it canbest be described as a: A) feedback e ect. B) creative response.C) positive e ect of deregulation.<Explanation:> A feedback e ect occurs when consumers’behavior is changed as a result of regulation. (Study Session4, LOS 15.b) According to the theory of contestable markets, Andrews’proposal of deregulation of the industry should producewhich of the following outcomes?A) A short-term increase in the level of quality of servicebecause of increased competition. B) An increase in market e ciency due to lower barriers toentry and exit. C) Unemployment rates will fall as new job openings arecreated in the industry.<Explanation:> A contestable market will operate verye ciently because any excess proﬁts in the industry willattract new entrants, which in turn will increase competitionand drive prices back to marginal cost. (Study Session 4, LOS15.a) 2. A regulatory commission that seeks to have regulatedcompanies set prices at a level that provides a reasonableproﬁt to the companies is utilizing which of the followingmethods of regulation? A) Rate-of-return regulation. B) Cost-of-service regulation.C) Social regulation.<Explanation:> Rate-of-return regulation seeks to allowindustry participants to receive what regulators determine isa normal or fair return on their investment.
3. In general, the regulatory body of an industry with a naturalmonopoly will attempt to set industry prices at which point onthe supply/demand curve? A) Average cost = demand. B) Marginal revenue = average cost.C) Marginal revenue = marginal cost.<Explanation:> At the point where average cost equalsdemand, producers would maintain proﬁtability andconsumers would pay a price somewhat lower than in anunregulated market. 4. When a ﬁrm operates with the lowest cost per unit and thecapacity to produce all of the industry’s output, thiseconomic structure is best described as:A) an oligopoly. B) a natural monopoly. C) a competitive monopoly.<Explanation:> A natural monopoly is characterized by asingle dominant ﬁrm within the industry that is the lowest costproducer and has su cient capacity to meet demand. 5. Joseph Glass, CFA, is a consultant who provides advisoryservices to large manufacturing companies. Glass has beenretained by ABCO, a leading manufacturer of widgets forautomobiles in the United States. ABCO has hired Glass toevaluate the possibility of expanding their current base ofoperations by building an additional facility in South America.Management of ABCO has identiﬁed an increase in demandfor widgets in South America over the past decade, and anynew manufacturing facility would produce goods to satisfythat void and would be distributed and sold across SouthAmerica.Glass is not familiar with the current economic climate inSouth America, but is aware that several governments haveattempted to encourage economic development in theircountries through the enactment of pro-business legislation.Two of these countries, Venezuela and Peru, both have thereputations of being “friendly” to foreign economic investmentwithin their borders. The two countries share some
similarities: both, until the past twenty years, were primarilyagricultural economies with little industrial development. Also,both countries can o er a relatively low-cost labor force,although their workers in general, are not highly skilled.The government of Peru has declared that protecting thecountry’s environment is of utmost importance, and hasestablished a regulatory body that oversees anyenvironmental concerns that may arise as the countrybecomes more industrialized. Fairly stringent regulationshave already been put into place in order to ensure thatgoing forward, the operating practices of manufacturerswithin their country’s borders will be in balance with thegovernment’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 beperformed to accurately determine both the direct andindirect costs of compliance with the regulations.The Venezuelan government has taken steps to ensure that itcan carefully manage the development of its country’semerging economy, and to ensure that a competitive marketis maintained. A regulatory agency was established ﬁve yearsago to provide guidance for any new manufacturing concernseeking to operate in Venezuela. The head of the agency isJuan Santos, the former CEO of one of the ﬁrst modernizedmanufacturing facilities in the country. During his tenure ashead of the agency, he has demonstrated his ability to renderdecisions that attempt to simultaneously satisfy legislators,industry participants, and consumers. Glass is impressed bySantos’ work so far, but realizes that over the past ﬁve years,Venezuela has experienced a period of relatively sloweconomic development. Glass believes that Santos’ skills willtruly be put to the test in the upcoming years of theanticipated economic expansion.Glass acknowledges the need for governmental regulation ofindustry, but recognizes that there always are o settingcosts, both short-term and long-term of such controls. Basedupon his knowledge of events that have occurred in theUnited States over the past thirty years, Glass recommends
that ABCO continue to carefully monitor economicdevelopments in both countries even after a site for a newmanufacturing facility is selected.Should ABCO build a newfacility in either of the two countries, it is almost a certaintythat they would be the low-cost producer of widgets, with thecapacity to satisfy nearly all demand in the region. A naturalmonopolist operating in an unregulated industry will produceat the point where:A) the marginal cost curve intersects the demand schedule. B) marginal costs equal marginal revenue. C) average costs equal marginal revenue.<Explanation:> A monopolist operating free of priceregulation will produce at a rate where marginal revenueequals marginal cost. The social regulation policies enacted by the government ofPeru would least likely to cause which of the followingoutcomes?A) Higher costs of production.B) Attempts by industry participants to avoid compliancethrough creative response. C) A disproportionately higher compliance expense for largerﬁrms rather than smaller ﬁrms. <Explanation:> Increased regulation typically results in adisproportionately higher compliance expense for smallerﬁrms, because the expense is allocated over a smaller base ofproduction than for a larger ﬁrm. If ABCO were to build its new facility in Peru, compliance withthe country’s regulatory policies will increase the price oftheir product by approximately ten percent. Some consumersmay respond by not replacing the widgets in theirautomobiles as frequently as before, which will causedecreased fuel e ciency. This unintended e ect of regulationis an example of: A) a feedback e ect. B) a creative response.C) the capture hypothesis.
<Explanation:> A feedback e ect occurs when consumerschange their behavior as a result of a regulation. In thisinstance, regulations originally enacted to protect theenvironment may unintentionally lead to practices that areharmful to the environment. The appointment of Santos, an industry “insider”, to head theregulatory agency in Venezuela has the potential to cause areaction predicted by which of the following theories ofregulatory behavior?A) Rate-of-return regulation. B) The capture hypothesis. C) Share-the-gains, share-the-pains theory.<Explanation:> The capture hypothesis assumes that at somepoint, a regulatory body will at some point be inﬂuenced oreven controlled by the industry being regulated. An industryveteran will still have contacts or relationships with currentindustry participants, which may a ect his ability to renderimpartial decisions. Santos, as the head of the main regulatory body in Venezuela,must decide how to manage the e ects of an unanticipatedsharp increase in the cost of electricity. Santos proposedregulation that will allow manufacturers to pass on theincreased costs at scheduled intervals over a ﬁve year period.This approach is an example of: A) share-the-gains, share-the-pains theory. B) cost-of-service regulation.C) rate of return regulation.<Explanation:> Under the share-the-gains, share-the-painstheory, regulators attempt to satisfy all three interestedparties of an industry: the customers, the regulators, and theregulated ﬁrms themselves. By regulating that manufacturersand customers must share the increased costs, Santos isattempting to ensure that no one party bears an unfairburden. Cost-of-service regulation is most likely a type of:A) social regulation.
B) economic regulation. C) rate-of-return regulation.<Explanation:> Cost-of-service regulation is type of economicregulation of natural monopolies. 6. Consumers sometimes alter their behavior in response tothe implementation of a new regulation. This unintendedconsequence of regulation is: A) a cost of regulation. B) a feedback e ect.C) a creative response.<Explanation:> Consumers often react to regulations in waysthat were unintended and unforeseen by regulators. Thesereactions may be positive or negative, but need to beconsidered when evaluating the full impact of a regulation. 7. Three years ago, regulators enacted a new law that wasdesigned to reduce cigarette smoking by banning it in publicworkspaces. A recent consumer survey has indicated thatalthough smoking is banned in the workplace, people aresmoking even more than before, but in their homes and cars.Consumer reaction to the regulation can best be describedas:A) the capture hypothesis. B) a feedback e ect. C) creative response.<Explanation:> The regulation intended to reduce smoking ledconsumers to modify their behavior and smoke more in other“legal” places. This is an example of a feedback e ect. 8. All of the following are beneﬁts associated with socialregulation EXCEPT:A) a less polluted environment. B) lower consumer prices. C) safer, higher-quality products and services.<Explanation:> Increased regulation tends to causesconsumer prices to rise, because producers will generallypass any expenses associated with compliance on toconsumers in the form of higher prices.
9. All of the following are negative consequences associatedwith social regulation EXCEPT:A) a decline in industry competitiveness.B) higher production costs. C) increased unemployment. <Explanation:> While some aspects of social regulation mayincrease a company’s expense per worker, increasedunemployment is generally not associated with socialregulation. 10. Which of the following statements regarding socialregulation is least accurate?A) Some form of social regulation currently exists in allindustries in the United States. B) The beneﬁts of social regulation are easily recognized andcan be accurately quantiﬁed. C) Two of the primary goals of social regulation are increasedproduct quality and improved workplace conditions.<Explanation:> It is di cult to measure the beneﬁts of socialregulation because they may be qualitative rather thanquantitative in nature, and the beneﬁts may be spread outover time. 11. Which of the following statements regarding regulation isleast accurate? A) Regulators are impartial and their actions are notinﬂuenced by industry participants. B) Regulation has often been advantageous to industryparticipants because of increased proﬁtability and decreasedcompetition.C) Regulation has often been disadvantageous to consumersbecause of higher prices and less product choice.<Explanation:> Regulators should strive to be completelyimpartial, but in reality are not because most of them areformer industry participants that are likely to still have someties to the industry. Regulators must be knowledgeable aboutthe industry they are regulating, so naturally the pool of
qualiﬁed candidates comes from those with experience in theindustry. 12. The theory of behavior where industry participants areable to exert inﬂuence over regulators employed by agovernmental regulatory agency is called the:A) share-the-gains, share-the-pains theory.B) constituency theory. C) capture hypothesis. <Explanation:> Regulators frequently have experience in theindustry they are regulating, and are likely to have ties toothers remaining in the industry. The capture hypothesiscontends that regulators may be “captured” by the specialinterests of the industry because they are former industryparticipants. 13. In accordance with the share-the-gains, share-the-painstheory of regulators’ behavior, which of the followingscenarios is most likely to occur?A) Regulators form policies that are in favor of the specialinterest lobby of the industry being regulated.B) The head of a regulatory agency agrees to discuss futureprice increases with both industry representatives and aconsumer group, but in separate meetings. C) Regulators allow a portion of an unexpected increase incommodity prices to be charged to consumers. <Explanation:> The share-the-gains, share-the pains theorywould anticipate that regulators allow industry participantsto pass only a portion of rising commodity costs on toconsumers, and then perhaps over a period of time.