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Economic Approaches to Regulation and its Indirect Effects

A brief overview

Meeting of Productivity & Regulation GroupAIM London, Tuesday 4 April 2006, 12:00-18:00

Gerben Bakker

Department of Accounting, Finance and ManagementUniversity of Essex

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• These slides are based on W. Kip Viscusi, John M. Vernon and Joseph E. Harrington, Jr , Economics of Regulation and Antitrust (Cambridge, Mass., MIT Press, 4th ed., 2005), mainly chapters 10 and 16.

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Structure

1. Regulation and the regulatory process

2. Theories of regulation

3. Effects of regulation—general

4. Static effects: Direct

5. Static effects: Indirect

6. Dynamic effects

7. Methods to determine effect of regulation

8. Conclusion

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Instruments of regulation

• Price• Quantity• Entry/exit• Other variables

– Quality– Advertising– Firm investment

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The regulatory process

• Legislation• Implementation• Deregulation

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The regulatory process

• Legislation– Selecting regulatory agency

• Rule making process– Substantive rule making– Case-by-case basis– Challenges:

» Delay» manipulation

– Its powers– Setting of general policy objectives for it

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Theories on regulation

• Normative analysis as a positive theory (NAPT)• Capture theory (CT)• The economic theory of regulation (ET)

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Normative analysis as a positive theory

• Market failure– Natural monopoly– Externalities

• Problems– Assumes market failure rather than test it– No evidence, or contrary evidence– Limited effect of regulation on monopoly pricing

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Capture theory (CT)

• Industry captures the regulatory process so that regulation favours the existing industry

• Problems:– Assumes capture rather than test it– Contrary evidence

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The economic theory of regulation (ET)

• Regulation as the outcome of competition between interest groups that all want to maximise their income

• Two major models/approaches:– Stigler/Peltzman model: regulator maximises political

support– Becker model: the relative effects of competing

interest groups

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The economic theory of regulation (ET)

• Benefits small groups with strong preferences• Regulatory outcomes are generally not profit-maximising

because of the constraining effects of consumer groups• Regulation most likely in:

– Competitive industries– Monopolistic industries

• Market failure makes regulation more likely

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Structure

1. Regulation and the regulatory process

2. Theories of regulation

3. Effects of regulation—general

4. Static effects: Direct

5. Static effects: Indirect

6. Dynamic effects

7. Methods to determine effect of regulation

8. Conclusion

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Effects of regulation and the role of time

• Immediate (=direct) effects:– Static efficiency

• Allocative• Productive

• Long-run (=indirect) effects:– Dynamic efficiency

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Regulation potentially competitive markets

• Competitive model– First-best effects– Second-best effects

• Imperfectly competitive model

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Direct effects: the competitive model

• First-best effects:– Welfare loss per definition

• (price different from marginal cost)• Minimum efficient scale of firms

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Direct effects: the competitive model

• First-best effects (continued):– Effect 1: classic deadweight consumer loss– Effect 2: inefficient market structure

• Average costs per firm higher– Entry prohibition limits welfare loss– Reduction no. of firms may reduce it further

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Direct effects: the competitive model

• Second-best effects:– Theory of second-best

• Spread of regulation does not reduce welfare necessarily

• Unregulated firms can undercut regulated ones– E.g. trucks vs. railroads

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Direct effects: imperfectly competitive model

• Firms restrict supply to keep price > marginal costs• Regulation to reduce price may increase welfare• Free entry can lead to too much firms (inefficiency)

– Effects of entry/exit regulation unclear• Practical problem:

– Difficult to know right costs and prices (information; asymmetry)

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Indirect effects: price and entry regulation

• P > MC, entry prohibited

• Effect 1: excessive non-price competition– Quality (e.g. warranty, advertising, characteristics,

R&SD, service)– Dependent on:

• Available technology for differentiating products• Ease of collusion

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Indirect effects: price and entry regulation

• Effect 2: productive inefficiency:– Workers extract rents K/L higher than optimal

(substitution)– Inefficient firms are not replaced by entrants

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Indirect effects: price and exit regulation

• p < MC; exit prohibited• Effect 1: cross-subsidization

– E.g. telephone, post, airlines• Effect 2: reduced capital formation

– Higher r because of higher risk

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Structure

1. Regulation and the regulatory process

2. Theories of regulation

3. Effects of regulation—general

4. Static effects: Direct

5. Static effects: Indirect

6. Dynamic effects

7. Methods to determine effect of regulation

8. Conclusion

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Dynamic effects

• The effects so far were in a static situation• Dynamic (long-run) effects can be considered indirect

per definition• They mainly concern the incentive to invest in

R&D/innovations

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Dynamic effects

• Regulation entry innovation Price p > MC too much R&D

p < MC too little R&D

non-price competition R&D, adv.

Regulatory lagsInnovation But staged (slower) adoption of innovations

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Dynamic effects

• Effect of regulation on productivity growth can be substantial:

– In US 12 – 21 percent of productivity slowdown during 1973-1977 can be attributed to regulation effects

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Methods for estimating effects of regulation:

• Intertemporal

• Intermarket

• Counterfactual

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Conclusion:

• Three major theories of regulation: NAPT, CT and ET• The economic theory of regulation best approach• Indirect effects:

– Based on time of effect– Price and entry/exit regulation

• Unforeseen/unintended effects: seems a bit more difficult in ET

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Economic Approaches to Regulation and its Indirect Effects

A brief overview

Meeting of Productivity & Regulation GroupAIM London, Tuesday 4 April 2006, 12:00-18:00

Gerben Bakker

Department of Accounting, Finance and ManagementUniversity of Essex