Economics Workshop

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Economics Workshop  Better Regulation Executive
2006

• Sandeep Kapur

s.kapur_at_bbk.ac.uk
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WORKSHOP AIMS

• To provide rigorous but non-mathematical
  training in economics, enabling BRE staff to
• develop a simple but reliable toolkit for
  economic analysis
• practise its application using concrete
  regulatory problems
• explore the application of simple economic theory
  to their own work

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Objectives Day 1

• To understand
• how markets work, and their efficiency
• why markets sometimes fail to be efficient and
  how various regulatory instruments can improve
  efficiency
• how regulation can improve on other aspects of
  market outcomes, such as inequity
• how, in practice, regulatory interventions carry
  the risk of government failure

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Objectives Day 2

• To
• review the standard rationale for regulation
• the basics of regulatory impact assessment
• understand how good regulatory design can cope
  with risk and uncertainty, informational
  imperfections, and minimise distortion of
  incentives
• rationale for and implementation of RPI-X
  regulation
• the link between regulation and productivity
  growth

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Introduction to EconomicsSome Concepts and Tools
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Markets vs. Command

• The central questions given existing resources
• what goods and service to produce?
• how to produce?
• for whom?
• Alternative mechanisms
• COMMAND ECONOMY direct control, as in Soviet
  economy, or firms internal decisions
• FREE MARKET ECONOMY
• outcome determined by private transactions in
  markets, based on prices, incomes, wealth

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Degree of government intervention differs..
Hong Kong
- China - Denmark - UK - USA -
Cuba

• Most countries have mixed economies with both
• markets, which are regulated to different extent
• public production and provision

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Scale of government
Spending as share of national income ()
1880 1930 1960 2004
Japan 11 19 18 37
USA 8 10 28 36
UK 10 24 32 43
Germany 10 31 32 47
France 15 19 35 53
Sweden 6 8 31 57
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The policy question

• Markets are generally considered to be efficient
• If so, why not leave things to the market?
• Governments care about both equity and efficiency
• Free markets rarely deliver equitable outcomes,
  so some redistributive intervention is
  unavoidable
• Free markets do not always lead to efficient
  outcomes, so some interventions are motivated by
  efficiency considerations
• To understand this, we must look at how markets
  work

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How Markets WorkDemand, Supply, and Price
Adjustment
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Market

• MARKET
• any arrangement in which prices adjust to
  reconcile buyers and sellers intentions
• DEMANDquantity buyers wish to buy at each price
• SUPPLYquantity producers wish to sell at each
  price
• EQUILIBRIUM PRICEthe price at which market
  clears (i.e. quantity demanded quantity
  supplied)

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Price Adjustment
Supply curve
price
Equilibrium Price
Demand curve
Equilibrium Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
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• Price Controls

Suppose government sets minimum price above
market clearing price
Price
Supply curve
Controlled price
Equilibrium price
Demand curve

• Examples include
• Minimum wages
• Rent control
• Common Agricultural Policy

Quantity
excesssupply
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What does price controls do?

• Price controls interfere with the adjustment
  process
• minimum wages are good for equity they boost the
  income of some low-skill workers
• But such interventions may not be good for
  efficiency if employers are unwilling to hire as
  many at regulated minimum wage, some potential
  workers are deprived of the chance to work

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Economic Efficiency

• An intervention is said to improve efficiency if
  it makes someone better off and nobody worse off
• Economic efficiency an outcome where no one can
  be made better off without hurting someone else
• The key question do free, unregulated markets
  always lead to efficient outcomes?

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Markets and Choice

• In markets
• consumers buy up to the point the marginal
  benefit equals price
• competitive firms sell as long as price covers
  marginal cost of production (this is the
  opportunity cost of producing another unit of the
  good)

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The Efficiency of Markets

• Thus, in competitive markets
• prices align marginal benefit with marginal cost
• all possible gainful exchanges are carried out
• PUNCH LINE Free, unregulated markets lead to
  efficient outcomesThis is the so-called
  Invisible Hand Theorem

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But free markets are not always efficient..

• Market failure a circumstance in which free
  markets fails to achieve an efficient outcome
• Many interventions are designed to correct market
  failures, and thus to increase efficiency

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In sum why intervene?

• Economic regulation
• Aims to correct market failures, and make the
  market outcome more efficient
• (when the invisible hand does not work, the
  government can provide a helping hand)
• Social regulation
• To prevent undesirable social outcomes inherent
  in market outcomes

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Group Work Efficiency and Equity

• Government intervention in the economy is
  pervasive. For each intervention listed below
  identify the possible rationale. Is it primarily
• efficiency considerations?
• equity consideration?
• something else?

1. Income tax
2. Taxation of petrol
3. Regulating gas prices

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Group Work

1. Regulating discharge of sewage in the Thames
2. Legislation against insider trading
3. Banning the use of cocaine
4. Making primary school compulsory
5. Regulating financial advisors
6. Regulating length of the working week
7. Compelling citizens to carry identity cards
8. Minimum wage legislation
9. Regulating taxi fares

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Market Failures  Why intervene?How to
intervene?
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Sources of Market Failure

• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Coordination problems
• We will look at each of these in turn

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MARKET FAILURE Externalities

• EXTERNALITY
• A circumstance in which an individual's choices
  affects others' utility or productivity
• the effect is direct (not through market or
  prices)

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Examples

• Adverse externalities smoking, pollution
• Since costs are partly borne by others,
  self-interested decision-making might lead to
  excess
• Beneficial externalities bees and orchards,
  personal hygiene
• Since benefits partly accrue to others,
  self-interested choices lead to sub-optimal
  quantities

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Adverse Production Externality

• For social optimum, we want
• marginal social cost marginal social benefit
• At free market equilibrium E, output Q is higher
  than social optimum Q

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Why Externalities Matter

• THE ESSENTIAL PROBLEM
• Market mechanism aligns private costs and
  benefits
• Externalities imply divergence between social and
  private costs (or social and private benefit)
• If divergences exist, should not expect socially
  efficient allocations

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Correcting externalities

• Quantitative regulation or direct government
  action e.g. pollution quota
• Pigou Taxes or subsidies to correct prices
  e.g. pollution tax
• Coase Create markets assign property rights
  and enable trade in pseudo-marketse.g. carbon
  trading

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Coasean Solution

• Assign property rights and let people trade these
  rights in specially-created market
• Initial assignment of rights affects distribution
  but get an efficient outcome regardless
• This solution does not work if there are high
  transactions costs

Efficient quantity is Q
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MARKET FAILURE Public Goods

• Examples defence, broadcast TV signal
• Characteristics
• Non-rival consumption my consumption does not
  diminish what is available for you
• Non-excludability impossible or too costly to
  prevent people from consuming it

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Public goods the problem and solutions

• If you cannot exclude, people will free ride.
  But if no one pays, there is nothing to free-ride
  on (this is the paradox of free riding)
• In fact, exclusion is not efficient either
• In general, markets cannot provide public goods
• SOLUTIONS
• public provision
• compulsion
• Government needs to ensure right quantity, but
  need not produce itself

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MARKET FAILURE Imperfect competition

• The essential problem of monopoly
• Firms with market power can charge prices that
  exceed marginal cost
• which restrains consumption below efficient level
• other problems resources wasted in securing
  monopoly power (rent-seeking), and in
  maintaining it

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Solutions to monopoly problem

• Solution 1. Nationalize and finance losses
  through taxes
• politically not very feasible
• Solution 2. Break monopoly e.g. anti-trust
  legislation in US
• However, no good for natural monopoliesIndustri
  es with severe economies of scale, so having one
  producer avoids duplication of costs
• And in some sectors monopoly is good for RD, or
  for internal coordination

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More solutions to the monopoly problem

• Solution 3. Regulate Prevent abuse of monopoly
  power through price and non-price controls
• Practical issues when is regulation necessary?
  What form? How frequently?
• Solution 4. Nurture competition Encourage new
  entrants, (but will they enter and will it only
  lead to cream skimming?)
• Important to get the right mix of remedies

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MARKET FAILURE Imperfect information

• Information in markets is imperfect. Often there
  is asymmetry of information between buyer and
  seller leading to problems of
• adverse selection people who know themselves
  to be risk-prone are more likely to buy insurance
  
• moral hazard once you have insurance,
  incentive to be careful is weakened
• these distortions may result in incomplete
  markets or even missing markets e.g. low-risk
  people may not find appropriate insurance

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SOLUTIONS Imperfect information

• mitigate informational problems
• mandating provision of information (regulate
  financial advisors)
• providing information directly (publish league
  tables)
• reduce the possibility of opportunistic behaviour
  
• consumer protection
• government provision of the good or service

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Inefficiency due to strategic interaction
Individual choices do not always result in the
best collective outcomes
Country 2
No nukes Nukes
No nukes 8, 8 1, 12
Nukes 12, 1 2, 2
Country 1
SOLUTION coordinate individual choices through
agreements or regulation
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Regulating technological standards

• Problem uncertainty about new technological
  standards may slow down adoption
• VHS vs Betamax
• Blu-Ray vs HD-DVD
• Should regulation aim to guide technological
  choices?
• GSM in mobile telephony

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Lessons for Policy Makers

• Market failures makes a potential case for
  corrective intervention
• However, we must beware of the possibility of
  government failure. If so, the net effect may be
  to replace market failure with government failure

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• Well-intentioned regulation may
• end up being ineffective
• have perverse, unintended consequences
• persist beyond its purpose
• be vulnerable to regulatory creep, with high
  cumulative burden
• The scope for successful regulatory intervention
  is limited by
• informational constraints
• agency problems
• lack of correction

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Group Work Pollution control

• As the National Rivers Regulator, you must
  tackle the problem of a chemical firm that is
  polluting the Thames
• If everything could be quantified and valued,
  show in a diagram how a pollution tax can induce
  the firm to behave in a socially efficient manner.

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Group Work Pollution control

1. Instead of the tax you offer the firm a pollution
   quota (specifying the maximum pollution it can
   discharge in any year). Show the size of the
   quota in the diagram. What difference does it
   make to the efficient quantity of pollution?

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Group Work Pollution control

1. Now suppose information is harder to come by. As
   the regulator, you are not entirely certain about
   the firm's cost curve. Does this affect your
   choice between tax and quotas?

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Group Work Pollution control

• Lastly, suppose there are two chemical firms
  discharging into the river, one cleaner than the
  other. Is it better to
• set a pollution tax? (same rate per unit polluted
  for both?)
• auction pollution quotas?