ECW3830

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ECW3830
Competition and Regulation
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Lecture 2
Theories of regulation
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Week 7 Hilmer report and industry restructuring
Week 5-6 Regulating monopolies and access to
essential facilities
Week 8 Liberalisation in aviation
Week 4 Theories and practice of privatisation
Competition and Regulation
Week 9 Structural reform and regulation in
electricity
Week 3 Deregulation rationales and experiences
Week 10 Competition and regulation in
telecommunications
Week 2 Theories of regulation
Week 11 Mergers, Cartels and restrictive
practices
Week 1 Rationale for competition policy and
regulation
Week 12 - Research topic. Regulation,
deregulation and privatisation in small open
economies
Week 13 Revision
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AimsOn completion of the topic students should
be able to

• Explain the rationale for regulation
• Distinguish types of economic regulation
• Explain the rationale for and merits of different
  theories of regulation

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Essential Reading
Theories of Regulation

• Church, Industrial Chapter 24, p 747-762,
  765-775
• Pelzman, S (1998), The Economic Theory of
  Regulation after a Decade of Deregulation, in R
  Baldwin, C Scott and C Hood (eds) A Reader on
  Regulation, Oxford UP, p93-130
• Additional reading available on line
• Stigler, G (1971), The Theory of Economic
  Regulation, Bell Journal of Economics, vol.2
  p3-21
• Joskow, P Rose, N (1989), The Effects of
  Economic Regulation in Schmalensee, R Willig,
  R. Handbook of Industrial Organization, North
  Holland. p1449-1499

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Reasons for regulation
What is regulated
Who regulates
Direct control, rules, regulations
Types of economic regulation
Financial incentives
Price controls and monopoly regulation
Entry and capacity control
Public interest theories
Theories of regulation
Private interest theories
Does regulation promote efficiency?
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Key definitions and concepts
Regulation
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Key definitions and concepts
Regulation
Product market, consumers
Product
A Firm
Capital
Labour
Labour market
Capital market
Material of financial flows
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Key definitions and concepts
Regulation
Product market, consumers
Product
Price
A Firm
Wage rate
Capital
Labour
Price, Interest rate
Labour market
Capital market
Material of financial flows
Market information
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Rationale for competition policy and regulation
Key definitions and concepts
Regulation
Tax rates Tariffs Retail trade regulation
Product market, consumers
Product
Price
Tax rates tariffs, barriers to entry Product
quality and safy
A Firm
A regulator
Official Interest rates
Wage rate
Capital
Labour
Price, Interest rate
Tax rates workplace relations regulation
Labour market
Capital market
Material of financial flows
Market information
Regulator's (official ) control signals
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What is regulated
Product Regulation. Consumer safety
Structure, conduct an performance of the industry
Foreign investment and foreign interest
involvement in national economy
Industry protection (Trade policies)
Environment conservation
Workplace
Property rights
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What is regulated
Product Regulation. Consumer safety

• Where private and social benefits cannot be
  matched by market forces
• Car/ motorbike safety
• Health care
• Pharmaceuticals
• Air
• Noise

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What is regulated
Structure, conduct an performance of the industry

• Where the industry structure deviates from a
  perfectly competitive market
• Restricted trade practices
• Cartels, collusions
• Access prising

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What is regulated
Foreign investment and foreign interest
involvement in national economy

• Where foreign interest might contradict national
  interest
• Which industries
• The share of foreign interests
• The size of foreign investments
• (In Australia the Foreign Investment Review
  Board)

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What is regulated
Industry protection (Trade policies)

• Where the government acts on behalf of interest
  groups (of producers or consumers)
• Tariffs
• Import quotas
• Export quotas
• Export subsidies
• Quarantine regulations

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What is regulated
Environment conservation

• Where negative externalities affecting the
  environment take place
• Forestry
• Greenhouse emission
• Water usage
• Nuclear Energy
• Mining
• Automotive

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What is regulated
Workplace

• Where there is now perfect competition in the
  labour market (employers and/or employees
  exercise some market power)
• Workplace relations
• Where negative externalities affecting workers
  take place
• Occupational safety

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What is regulated
Property rights

• Where industry conduct is concerned
• Real estate trading
• Securities trading
• Publicly listed companies conduct with relation
  to shareholders

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Who regulates

• The government
• In Australia 3 levels
• Independent agencies appointed by the government
• ACCC
• Australian Securities Commission
• The Reserve Bank
• Foreign Investment Review Board
• Self-regulation by the industry concerned
• Victorian Medical Board

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Reasons for regulation
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Reasons for regulation
For allocation purposes

• Public goods
• the market mechanism is perceived unable to
  determine the "right" amount which should be
  produced.
• Externalities
• The product attracts too many or too few
  resources, depending on whether the externality
  is negative or positive
• Declining average cost (the case of natural
  monopoly)
• Access regulation

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Reasons for regulation
For the correction of competitive imperfections

• Antitrust legislation (in US and formerly in
  Australia)
• Restrictive trade practices legislation (broader
  context)
• Entry licensing

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Reasons for regulation
For the correction of the distribution of wealth

• Social security
• Access to essential facilities/goods
• Price regulation

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Reasons for regulation
For avoiding negative externalities

• Consumer protection
• Environment conservation
• Aviation safety

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Types of economic regulation
Direct control, rules, regulations
Financial incentives
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Types of economic regulation
Direct control, rules, regulations

• Legislation/enforcement
• Rules codified by the legislature
• Regulation/rules/codes
• Issued by bureaucracy based on the existing
  legislation
• Licenses
• Mines
• Taxies
• Airlines
• Broadcast frequencies
• Quotas
• import/export
• Allocations
• water
• Broadcast frequencies

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Types of economic regulation
Financial incentives

• Tax breaks
• Subsidies to industries
• Interest rates
• Tariffs
• Export subsides
• Prices for public goods

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Entry and capacity control

• Entry licensing on a rule or case by case basis
• Airlines
• Taxies
• Mines
• Educational institutions
• Capacity control cap on the output
• Forestry
• Fishery
• Waling

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Price controls and monopoly regulation

• Price-cap regulation price cap is assigned to
  monopolys product
• Marginal cost regulation
• Revenue-cap regulation where total revenue is the
  regulated variable.
• Rate-of-return regulation - utilities are
  permitted a set rate of return on capital
• (See diagrams on a few further slides and compare
  them with the one on page 105 (Reeding 3) of the
  Unit book)

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Price controls and monopoly regulation
Price-cap regulation
Lowest feasible cap P1cap min for a private
monopoly or P2 cap min - If it is a publicly
owned ran monopoly only responsible for its cash
flow.
D
Pmarket
AC
MC
MR
Y
Ymarket
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Price controls and monopoly regulation
Marginal cost regulation
Feasible if PPMC AC for a private monopoly or
If it is a publicly owned ran monopoly only
responsible for its cash flow.
D
AC
MC
MR
Y
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Theories of regulation
Towards classification of theories
Normative theories
Public interest theories
Positive theories
Private interest teories
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Theories of regulation
Towards classification of theories
Positive theories Answer the question How
does regulation work The role of regulation
policies in advantaging of different sectoral
groups
Normative theories Answer the question What
and how to regulate Approaches to and methods
for the correction of market failure
Public interest theories
The Pareto Principle
The problem of second best
Capture theories
Stiglers theory Private interest
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Theories of regulation
Normative theories
The Pareto Principle
The goal of regulation is maximum welfare of the
society
Societys resources will be used efficiently if
the result is maximum welfare.

• What is welfare?
• How to measure welfare?
• How to allocate welfare among the members of
  society?

The Pareto Principle Welfare is at maximum when
no change in the way resources are used of goods
and services are distributed can make anybody
better off without reducing welfare at least of
one person
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Theories of regulation
Normative theories
The Pareto Principle
The Pareto Principle is fulfilled if

• For each pair of goods and any pair of consumers
  MRSxy(Consumer
  A) MRSxy(Consumer B) MRSxy(Consumer C)
• MRSxyPx/Py
• MRTSKLPK/PL,and
• all producers operate at PMC

and if

• No public goods (the market mechanism can't
  determine the amount to be produced)
• No externalities
• No declining cost industries

The regulation is necessary to compensate
non-fulfillment of last three assumptions
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Theories of regulation
The problem of second best
Normative theories
The theory that neglects usefulness of any
normative approach ln the real life at least
one of Paretian conditions is not
fulfilled. Therefore the best solution -
Paretian optimum is impossible and should be
replaced with a second best one. However, there
are no any rules a normative theory for the
selection of second best and therefore The
science of making a regulatory decision is
replaced with art of politics, which can be
explained only by positive theories.
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Theories of regulation
Positive theories
Attempts to explain the nature and mechanisms of
regulation Based on multi-disciplinary
studies Include elements of economics, political
science, sociology and social psychology
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Theories of regulation
Positive theories
Public interest theory
The regulation is necessary to compensate
inequitable and/or allocatively inefficient
market outcomes to protect public interest
public interest consumer interest, employment
maintenance,
infrastructure maintenance, etc
The reason of failure of regulatory measures -
mismanagement
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Theories of regulation
Positive theories
Capture theories
The deficiency of public interest theory it
ignores differences in the interests of different
groups of the society (consumers, producers,
policy makers, etc).
Life-cycle theories
Private interest theories
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Theories of regulation
Positive theories
Capture theories
Life-cycle theories
Regulation intended to serve some particular
public interest. However, the groups of
regulated industries become to be able to affect
their regulators (governmental regulatory bodies)

or
Regulation was imposed by a majority political
group to serve public interest. However,
overtime it becomes to serve the interest of the
supporters of that political group.
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Theories of regulation
Positive theories
Capture theories
Private interest theories
Stiglers theory
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Theories of regulation
Positive theories
Stiglers theory
Main ideas The regulation serves industry not
public interest A regulated industry is a
state-sanctioned cartel
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Theories of regulation
Positive theories
Stiglers theory
The Demand for Regulation

• Barriers to entry
• A direct subsidy of money
• State regulation affecting substitutes and
  complements
• State price fixing

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Theories of regulation
Positive theories
Stiglers theory
Supply costs

• Non-profit-maximising form of delivery.
  Equalisation of advantages from regulation
• The very cost of the bureaucracy of regulation
• The distribution of advantages outside the
  industry

The industry seeks for the level and structure of
regulation where benefits superseed costs
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Does regulation promote efficiency?

• Milton Friedman
• Government should limit its involvement in
  economies to protecting individual rights (life,
  liberty, property) rather than diminishing
  individual autonomy and responsibility for the
  sake of remedying any sort of "market failure.
• The notion of market failure is wrongly used to
  justify coercive government action to further
  various political agendas,
• Government intervention creates more problems and
  than it is supposed to solve
• Some of these interventions may be because
  government officers are incapable of accurate
  economic calculation

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Does regulation promote efficiency?

• The Austrian School economists (Ludwig von Mises
  and others)
• Regulations as problematic not only because they
  disrupt market processes, but also because they
  tend only to bring about more regulations.
• Every regulation has some consequences besides
  those originally intended when the regulation was
  implemented.
• If the unintended consequences are undesirable to
  those with the power to regulate, there exist two
  alternative possibilities
• do away with the existing regulation, or
• keep the existing regulation and institute a new
  one as well to treat the unintended consequence
  of the old one. (Thr second option is often
  preferred)

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Revision questions for the next weektutorial

• Stigler argued that regulation rather than being
  imposed on an industry was in fact actively
  sought by the industry concerned.
• Why might an industry seek to be regulated
• Bring an example of a regulatory policy which is
  an advantage for a regulated industry
• Bring an example of a regulatory policy which
  seems to be a disadvantage for a regulated
  industry, but an advantage for the welfare of
  nation
• Bring an example of a regulatory policy which
  seems to be a disadvantage for a regulated
  industry, but also appears to be a disadvantage
  for the welfare of nation.
• Bring an example of a regulatory measure in
  Australia (or in any other country) which was
  supposed to serve public interest but in fact
  serves private interest