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1
Economic Approaches to Regulation and its
Indirect Effects A brief overview Meeting of
Productivity Regulation Group AIM London,
Tuesday 4 April 2006, 1200-1800
Gerben Bakker Department of Accounting, Finance
and Management University 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 regulationgeneral
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

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

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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 regulationgeneral
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

14
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 gt 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 gt MC, entry prohibited
• Effect 1 excessive non-price competition
• Quality (e.g. warranty, advertising,
  characteristics, RSD, 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 lt 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 regulationgeneral
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
  RD/innovations

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Dynamic effects

• Regulation ? entry ? ? innovation ?
• Price ? p gt MC ? too much RD
• ? p lt MC ? too little RD
• non-price competition ?? ? RD, adv. ??
• Regulatory lags
• Innovation ?
• 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 Group AIM London,
Tuesday 4 April 2006, 1200-1800
Gerben Bakker Department of Accounting, Finance
and Management University of Essex