Title: RPI
1RPI X Regulation
- Nick Crafts
- (University of Warwick)
2Regulation of Privatized Industries
- Regulate to prevent abuse of market power in
cases of natural monopoly or high entry barriers - British approach based on price capping whereas
traditional American version used rate of return - RPI X aims to stimulate cost reduction as well
as preventing high price cost margins
3Productivity and Prices
- In a competitive market pmcLAC (including a
normal rate of return on capital) - In the absence of productivity growth, over time
output prices would rise at the same rate as (the
weighted average) of input prices - More generally, output prices in a competitive
market rise at the rate of growth of input prices
minus productivity (TFP) growth
4Price Capping
- If prices are allowed to rise at RPI-X, the
industry will be able to maintain normal profits
providing it achieves TFP growth equal to the
national average, TFPUK, X - If TFP growth is greater than (less than) TFPUK
X, the formula implies supernormal (subnormal)
profits
5RPI-X vs Rate of Return Key Arguments
- RPI-X
- Strong incentives for cost reduction and
innovation - BUT
- Quality may suffer
- Prices exceed costs on average
- RATE OF RETURN
- Prices stay in line with costs
- Quality assured
- BUT
- Likelihood of excessive investment
- Weak incentives for productivity improvement
6The Averch-Johnson Problem
- Rate of return regulation which allows the firm
to earn a rate of return above the cost of
capital encourages the firm to accumulate an
excessive capital stock - The equity value of the firm will be proportional
to the capital stock and, provided the allowed
rate of return is above the cost of capital, the
share price will be positively related to the
capital stock - Have to rely on the regulator to identify
unnecessary projects and disallow them from the
cost base
7The Water Industry
- Regulation is a hybrid
- Its the Averch-Johnson problem that we should
fear in the long-run .. especially given
populist pressures - Excessive capital stock encouraged by
- de-luxe quality directives
- ensuring no supply interruptions
- no peak load pricing
- Key question is marginal benefit (willingness
to pay) less than long-run marginal cost?
8RPI-X Regulation Further Points
- Optimal length of price reviews trades off gains
from cost reduction against losses from excessive
prices . is shorter the lower is the sensitivity
of costs to cost-reducing effort and the higher
is price elasticity of demand - Mitigating regulatory risk with sunk costs
through credible commitment by regulator is
desirable - Uncertainty lowers advantages of price caps if
need to ensure non-negative profits - Setting X well requires good way of estimating
potential for productivity improvement
9Managerial Effort and Productivity Growth
- Implementing productivity improvements/cost
reductions requires managerial effort, i.e. has
disutility for managers - Monitoring managers in context of asymmetric
information encounters free rider problems in
private sector and may offer no reward in public
sector - Competition is antidote to agency problem
10Privatization and Managerial Effort
- Asymmetric information does not go away
- Private shareholders may improve
monitoring/incentivizing of managers - Competition may increase
- Regulator may have to try and compensate for
weaknesses of shareholders and/or competition
11Privatization and Productivity Performance (Green
and Haskel, 2004)
- TFP growth raised by the privatization process
not by private ownership per se - Productivity growth increased in some cases as X
factor made more demanding (e.g. water) - Regulation central to quality implications of
RPI-X incentive structure - Overall picture is dominated by levels effect of
eliminating inefficiency
12Total factor productivity in the UK public sector
(annual rate of increase, )
72/3-78/9 78/9-86/7 86/7-99/00
British Airways 3.0 3.3 4.2 Privatised 1987
72/3-78/9 78/9-86/7 86/7-93/4
British Coal -2.8 0.1 9.0 Privatised 1994
72/3-78/9 78/9-86/7 86/7-94/5
British Gas 8.2 2.0 1.5 Privatised 1986
72/3-78/9 78/9-88/9 88/9-97/8
British Steel -5.0 3.8 1.8 Privatised 1988
72/3-78/9 78/9-84/5 84/5-94/5
British Telecom 0.6 3.2 3.0 Privatised 1984
13Comparative Productivity electricity, gas and
water sectors, 1979-95 (UK 100)
Labour Factor Productivity
Total Factor Productivity
14Regulated Prices in the UK
15Conclusions
- Productivity performance in privatized utilities
may be affected by the incentive structures of
the regulatory framework - In practice, not clear that RPI-X has generally
been a strong driver of TFP growth - Introducing competition where possible delivers
stronger incentives to improve productivity
16GROUP WORK
- When would you expect regulation to have a
powerful impact on the productivity performance
of a privatized business? - How should a regulator decide the precise value
of X at a price review?
17Regulation and UK Productivity Performance
- Nick Crafts
- (University of Warwick)
18Costs and Benefits of Regulation
- Regulation that corrects market failures provides
gains from a more efficient allocation of
resources - Regulation also incurs costs so it is relevant to
ask how benefits compare with costs - The costs of regulation may be felt in terms of
lower GDP per person
19Questions
- In what ways can regulation affect productivity
outcomes? - How good are measures of regulation?
- Is the UK lightly regulated?
- Does regulation actually have a big impact on
labour productivity growth?
20Regulation and Productivity
- Compliance costs have direct productivity
implication - Additional adverse impacts if disincentives to
investment and to innovation - May create barriers to entry that reduce
competition - Impact has not been well quantified
21Compliance Costs
- Administrative Costs 3 to 4 GDP and Policy
Costs 7 to 8 GDP (BRTF, 2005) - Direct measurement effect will be to reduce
measured TFP by an equivalent amount of
productive resources diverted away from producing
output - No time series evidence on compliance costs but
difficult to believe these direct effects have
reduced annual TFP growth much in recent past
22Regulation as a Tax
- Investment and innovation are key determinants of
labour productivity growth - Appropriable returns underpin incentives to
investment and to innovate - Regulation may reduce net present value of
projects - For example, employment protection and ICT
expenditures (Gust and Marquez, 2004)
23Regulation as Barrier to Entry
- For example, costs of setting up new business,
licensing rules, planning restrictions - Empirical evidence of cross-country comparisons
shows tighter regulation reduces entry and raises
price-cost mark-ups (Cincera and Galgan, 2005
Griffith et al., 2006) - Retailing productivity growth example of
regulatory barriers having seriously adverse
impact in Europe compared with US (McGuckin et
al., 2005) in ICT era
24Competition and Productivity Growth
- Absence of competition allows managers to be
sleepy if ineffective control/monitoring by
shareholders - Competition is strongly positive for productivity
outcomes in UK firms without dominant shareholder
(Nickell et al., 1997) - Competition promotes better management practices
(Bloom and van Reenen, 2006) - Patenting performance of UK firms suggests
inverted U-shaped relationship with price-cost
margin which peaks at about 20 (Aghion et al.,
2005)
25Policy Impact on Rate of Technology Adoption
Firm Type
Maximizing
Agency Problems
Competition Policy
Positive
Negative
Industrial Policy
Positive
Negative
Maximizing Firms Competition Policy lowers
expected profit from innovation Industrial
Policy raises expected profit from innovation
Agency Problem Firms Competition Policy cuts
rents and raises cost-reducing effort Industrial
Policy pays subsidies and lowers cost-reducing
effort
26Regulation and the Growth Rate
- If regulation is a disincentive to investment and
innovation, they will be lower as a result - Endogenous growth models predict that the rate of
growth will be adversely affected - This would be the most serious consequence of
excessive regulation rather than the diversion of
resources through conventional compliance costs
27Measuring Regulation
- Evidence on compliance costs quite limited
- Investigators looking at relationship between
regulation and productivity performance have used
indices constructed by OECD, World Bank and
surveys of expert opinion conducted by IMD, World
Economic Forum etc. - Both product market and labour market indices
available - BUT how good are they?
28Measures of Regulation
- Subjective vs Objective
- Comprehensive?
- Take account of enforcement and litigation?
- Include extraneous aspects?
29IMD Survey Questions
- Business Regulations
- Regulation intensity does not restrain the
ability of companies to compete - Labour Regulations
- Labour regulations do not generally hinder
business activities
30OECD Regulation Indices
- Product Market Regulation (Conway et al., 2005)
index designed to reflect the extent to which the
regulatory environment is conducive to
competition including indicators of state
control, barriers to entrepreneurship - Employment Protection (OECD, 2004) index
designed to reflect legislation as employer-borne
tax on employment adjustment including difficulty
of dismissal and extent of severance pay
31Is the UK Lightly Regulated?
- OECD measures say yes
- Subjective indicators more equivocal, cf. IMD
scores where UK has been slipping down the league - Overall, within OECD UK closer to relatively
liberal group including Australia, Canada,
Denmark, Ireland, USA than the relatively
strict group including France, Germany, Greece,
Italy, Portugal and Spain
32Business Regulations, 2005 (0-10) (Source IMD,
2005)
33Labour Regulations, 2005 (0-10)
34Product Market Regulation (0-10)
1998 2003
France 4.17 2.83
Germany 3.17 2.33
Italy 4.67 3.17
Spain 3.83 2.67
UK 1.83 1.50
USA 2.17 1.67
35Product Market Regulation and Productivity Growth
- Regulation that creates barriers to entry raises
mark-ups and reduces innovation, investment and
productivity growth (Griffith and Harrison, 2004
Griffith et al., 2006) - At the macro level de-regulation has been
associated with better TFP growth (Nicoletti and
Scarpetta, 2003) - Product market regulation is negatively
correlated with the contribution of ICT-using
services to aggregate productivity growth
(Nicoletti Scarpetta, 2005) - UK shows up well on OECD measures compared with
other European countries
36Multifactor productivity acceleration and product
market regulation
Difference in average MFP growth rate between
1990-2000 and 1980-1990 Adjusted for hours worked
Correlation coefficient -0.51 t-statistic -2.29
Product market regulation, inward oriented, 1998
Source Nicoletti Scarpetta (2005)
37Regulation and the contribution of ICT-using
services to aggregate productivity growth
ICT using services, 1996-2001
Correlation coefficient -0.62 t-statistic -3.35
Product market regulation (inward-oriented), 1998
Source Nicoletti Scarpetta (2005)
38Retail Trade Labour Productivity Growth ( per
year)
1990-5 1995-2001
US 2.0 6.5
EU 1.7 1.3
Germany 2.8 0.7
UK 1.2 3.7
France 2.1 1.9
Italy 1.3 1.1
39Implications for Regulatory Impact Assessments
- The Competition Assessment component is important
- In practice, this is often cursory and there is
scope for more timely liaison with OFT (National
Audit Office, 1006) - Traffic Light Scores 1 7 5
- Is the competition filter (5 yes out of 9) in the
RIA too weak?
40ICT Expenditure and Employment Protection
Legislation
- Are inversely correlated
- Firing costs delay adoption of ICT but do not
generally deter investment - Effective use of ICT often involves upgrading
labour force skills and re-organization, i.e.
labour turnover
41Employment Protection Index (0-10)
1980 1990 1998 2003
France 6.50 7.05 7.00 7.00
Germany 8.25 7.60 6.50 5.60
Italy 10.00 9.45 7.50 4.85
Spain 9.55 8.70 7.00 7.50
UK 1.75 1.75 1.75 1.75
USA 0.30 0.50 0.50 0.50
42IT Expenditures and Employment Protection
Legislation
IT Expenditures ( of GDP), 1999
Correlation -0.72
Employment Protection Legislation, Index, 1998
43Reduction in PMR and UK Productivity Performance
- Nicoletti and Scarpetta (2003) results imply UK
has had modest TFP growth advantage over France
and Germany in the past 20 years - This is reflected in decline in TFP (but not
other) component of labour productivity gap.
44A Decomposition of UK Labour Productivity Gap
(percentage points)
France/UK Germany/UK
1979
Labour Productivity Gap 31 30
Labour Quality 6 5
Physical Capital 17 9
TFP 8 16
2000
Labour Productivity Gap 21 17
Labour Quality 4 4
Physical Capital 17 12
TFP 0 1
Note In 1979 Germany is West Germany only.
45Change in TFP Growth over 10 years from Adopting
Best Regulatory Practice ( points)
46Conclusions
- Regulation does have implications for TFP
- In particular, this is true of regulation that
inhibits competition - Administrative costs of compliance are not the
key issue