1 Economic Approaches to Regulation and its Indirect Effects A brief overview Meeting of Productivity & Regulation Group AIM London, Tuesday 4 April 2006, 12:00-18:00 Gerben Bakker Department of Accounting, Finance and Management University of Essex

2 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.

3 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

4 Instruments of regulation Price Quantity Entry/exit Other variables –Quality –Advertising –Firm investment

5 The regulatory process Legislation Implementation Deregulation

6 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

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

8 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

9 Capture theory (CT) Industry captures the regulatory process so that regulation favours the existing industry Problems: –Assumes capture rather than test it –Contrary evidence

10 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

11 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

12 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

13 Effects of regulation and the role of time Immediate (=direct) effects: –Static efficiency Allocative Productive Long-run (=indirect) effects: –Dynamic efficiency

14 Regulation potentially competitive markets Competitive model –First-best effects –Second-best effects Imperfectly competitive model

15 Direct effects: the competitive model First-best effects: –Welfare loss per definition (price different from marginal cost) Minimum efficient scale of firms

16 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

17 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

18 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)

19 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

20 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

21 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

22 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

23 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

24 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 lags  Innovation   But staged (slower) adoption of innovations

25 Dynamic effects Effect of regulation on productivity growth can be substantial: –In US 12 – 21 percent of productivity slowdown during can be attributed to regulation effects

26 Methods for estimating effects of regulation: Intertemporal Intermarket Counterfactual

27 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

28 Economic Approaches to Regulation and its Indirect Effects A brief overview Meeting of Productivity & Regulation Group AIM London, Tuesday 4 April 2006, 12:00-18:00 Gerben Bakker Department of Accounting, Finance and Management University of Essex