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Theory of Regulation
2nd week – October 9th, 2012
Outline
o Introduction
o Theoretical approaches to regulation
o
o
Becker‘s model
Stigler‘s model
o Historical development
o
o
o
o
o
Structure – Conduct – Performance Paradigm
Chicago School of Political Economy
Virginia School of Public Choice
Contestable Market Theory
Rate of Return (RoR) Regulation
o Literature
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Regulation vs. Antitrust
Regulation
• Often applied to specific
industries e.g. utilities,
industries with high fixed
costs, natural monopolies
• Regulators (typically)
intervene ex ante, have
extensive powers and
their involvement is longterm
Antitrust/Competition
Policy
• Applied to all industries
• Form of rules/laws
• Authorities/regulators
(typically) intervene
ex post and occasionally
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Normative vs. Positive Theory
Normative Theory
• A normative statement
expresses a judgment
about whether a situation is
desirable or undesirable
• A normative statement
expresses a judgment
about what ought to be
• There is no way of
disproving normative
statement
Positive Theory
• A positive statement is a
statement about what is
(what exists)
• A positive statement
contains no indication of
approval or disapproval
• A positive statement can
be wrong
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Theoretical Approaches to Regulation
• Normative vs. Positive Theory
• NTPT
– Normative Theory as a Positive Theory
– Exists because market failures (e.g. imperfect competition, public
goods, externalities, information asymmetry – moral hazard, adverse
selection) exist therefore regulation is “needed”
– Doesn’t explain regulation in all industries e.g. agriculture (not all
markets fail)
– heavily criticized –> new theory – Capture theory
• Capture Theory (George Stigler, Chicago)
–
–
–
–
Opposite of NTPT
Regulation is misused by the regulated firms to increase profits
Regulator is “captured” by information asymmetry and moral hazard
heavily criticized –> new theory – Economic theory of Regulation
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Theoretical Approaches to Regulation
• Economic Theory of Regulation
– Regulation is shaped by interest groups and their political
pressure/support
– The interest groups are rational economic agents – maximize their
utility
– State supplies regulation and interest groups demand it (economic
setting)
– That is why it is Economic Theory of Regulation because interest
groups compare costs of political pressure/support with profits in case
of favorable regulation
– There is no public interest just economic criteria!!!
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Becker‘s model (in a nutshell)
• see the article (in library) - the Quarterly Journal of
Economics, Aug 1983, A Theory of Competition among
Pressure Groups for Political Influence by Gary Becker
• Becker’s conclusions
1.
2.
3.
4.
Political effectiveness of an interest group is determined by the
relative effectiveness of the other group (not the absolute
effectiveness) –> the equilibrium is not Pareto-effective
Regulation that increases efficiency has better chances than the
one that decreases it.
Politically successful group(s) (subsidized ones) are usually
relatively small compared to the group(s) that pay the taxes.
The competition between interest groups favors effective methods
of taxation and subsidizing.
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Stigler‘s model (in a nutshell)
• Ec. Theory of Reg.; interest groups compete to shape
regulatory initiatives; rational agents; max utility
• Regulation is one of the means by which state power is
exercised to benefit specific groups
• Political support fcn: M=M(ℝ, Π) dM/dℝ < 0; dM/dΠ > 0
– ℝ rates established by authority for the regulated company
– Π allowed level of profit earned
• There is a trade-off between political support from firms and
political support from firm’s customers (have opposite
objectives) represented by iso-political support fcn = all
combinations of ℝ’s and Π’s that yield equal political support
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Structure-Conduct-Performance
Paradigm
• SCP Principle
– Industries are situated on a continuum between the
fictional extremes of perfect competition (highest
possible benefit for society, efficient) and perfect monopoly
(wasteful allocation of resources, inefficient)
– Concentrated industries fall close to monopoly
• SCP Implication
– Negative correlation between industry concentration and social
welfare produced by market
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Structure–Conduct–Performance (SCP)
• Harvard School during 1950s and 1960s
–Normative theory of regulation,
–Markets fail => state interference is needed (and “justified“ by market failures)
• Exogenous market structure (e.g. oligopoly) determines market
behavior = market conduct (e.g. collusion) which afterwards
determines market performance (e.g. high profits)
• Market Structure
–Measured by concentration indices
• Market Performance
–Measured by the difference between Marginal Costs (MC) and Price (P)
• Policy Implication
–The concentrated market fails = suboptimal outcome => scope for regulatory
intervention of state to lower the market concentration
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Market structure
Good
Perfect competition
Monopolistic competition
Oligopoly
Duopoly
Bad
Monopoly
• However there are practical and theoretical challenges…
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Structure-Conduct-Performance
Structure
•
•
•
Market structure
Where on the continuum
(perfect competitionmonopoly) are we?
Market concentration
(indices)
Conduct
•
•
•
•
•
Price
Quantity
Market strategy
R&D
Innovation
Performance
•
•
•
Does the market
benefit society?
Efficiency
Profitability
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Structure-Conduct-Performance
Product differentiation
influences market structure
Structure
Mutual interaction of the firms
influences their behavior on market
Conduct
Performance
Profitability of firms influences their
number in the next period
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Definition of the Relevant Market
• Very problematic part of regulatory policy
• Criteria
– Physical characteristics of a product
– Geographical parameters
– Time
• Measuring similarity of a product (substitutability)
– Cross elasticity of demand = CED = % change in quantity of x
% change in price of y
• SSNIP test (see the lecture on Competition Policy)
–Small but significant non-transitory increase in price
–Would a hypothetical monopolist find it profitable to increase price above
current level in a non-transitory way by 5%?
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Definition of the Relevant Market
• According to the EU definition the relevant market
combines the product market and the geographic
market, defined as follows:
– a relevant product market comprises all those products and/or
services which are regarded as interchangeable or substitutable by
the consumer by reason of the products' characteristics, their
prices and their intended use;
– a relevant geographic market comprises the area in which the
firms concerned are involved in the supply of products or services
and in which the conditions of competition are sufficiently
homogeneous.
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Concentration Indices
• Concentration is related to the market share and
degree of competition (from perfect competition to monopoly)
• Market share
–The proportion of industry sales of a good or service that is controlled
by the company
•Indices
– CRn – n firm concentration ratio
n
– Herfindahl index
H   ( Si ) 2
– Lerner index
n
CRn   Si
i 1
i 1
L  ( P  MC ) / P
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Chicago School of Political Economy
• SCP turned out to be insufficient
– criticized because it relied on single static
• Chicago School
– First, emphasized the characteristics of the individual firm (rather
than the industry as a whole), particularly the cost structure and its
implied competitive stature
– Second, emphasized the incentives that the legal structure
imposed on rational, cost and benefit calculating firms and
individuals
– Therefore, rising profits were now viewed as the result of
economies of scale producing falling short-run costs, not monopoly
pricing
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Chicago School of Political Economy
• Positive theory of regulation
– costs determined by structure
– conduct determined by incentives
• Competitive environment of an industry is determined by the
cost structure of the firms in the market
• Industry structure might be balanced by economies of scale
• Literature
– Stigler, G. J.: Chicago Studies in Political Economy, pp. 85-105,
The University of Chicago Press, Chicago and London 1988
– Becker, G. S.: A Theory Of Competition Among Pressure Groups For Political
Influence
– Peltzman, S.: Toward a More General Theory of Regulation
– Stigler, G. J.: The Theory of Economic Regulation
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Virginia School of Public Choice
• Virginia School (early 1970s)
– investigated the origins and effects of antitrust
– applied the public choice theory to the Federal Trade Commission
(FTC) and Department of Justice (DOJ) of the USA
• For Virginia School political agents are
characterized by the same rational choice theory
used to explain economic agents behavior
– applied to antitrust regulators and congressional overseers it
suggests the way antitrust worked in practice
• As such antitrust was to suppress competition to
redistribute wealth from relatively competitive firms
to their less competitive rivals (socially costly)
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Virginia School of Public Choice
• Theory of capture in the early 1970s
• Strong positive theory of regulation
–
the regulator has come into existence to serve interest of the captured
• Weak positive theory of regulation
– once regulation has come to existence (for whatever reason), it is captured by
interest of the regulated
• Rational choice models applied to regulators
• State fails – is captured and redistributes to less competitive firms
• Literature
– Tollison, R.D. (1985) “Public Choice and Antirust.” Cato Journal 4: 905–16.
– Buchanan‘s and Tullock‘s work
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Contestable Market Theory
• 1980s more dynamic view of competition
– Costs define the structure of the market
– Industry structure determines the competitiveness of the market
• Concentration- number of firms in the market – is not
related to the industry structure
– Multiproduct firms taken into account
• Focused primarily on the conditions of entry and
exit to the market
– If incumbent producers in market face competition either from
existing firms or potential entrants, then the incumbent producers
will price competitively
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Contestable Market Theory
• Antitrust “revolution”
– concentration has little to do with industry structure
• Conditions to entry and exit from the market matter!!!
• Positive theory - monopolists under free entry behave as under
competition
– Baumol, W.J.; Panzar, J.C.; and Willig, R.D. (eds.) (1988) Contestable
Markets and the Theory of Industry Structure. San Diego, Calif.: Harcourt
Brace Jovanovich/Academic Press.
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Price Cap Regulation System
• initial price cap - acceptable set of prices
• regulated firm can sells at any price below or equal
to this cap
• price floor (may be set) to prevent anti-competitive
pricing
• price cap may be adjusted over time
The main goal of a price cap formula is to eliminate, or
at least weaken, the linkage between cost and rates,
without greatly deviating from the results under
effective competition.
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Rate-of-Return Regulation
• restricts the amount of profit (return) that the regulated firm
can earn
• it has been used extensively to regulate utilities in many
countries
– e.g. in the U.S. where public utility regulation began in the early
1900‘s
• There are two steps to implementing rate of return regulation:
– First, determine the economically appropriate revenue
requirement (RR). This is based on prudently incurred expenses
and a “fair” return on invested capital, and
– Second, set prices for individual services so revenue earned from
all the regulated services is not greater than the revenue
requirement.
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Rate-of-Return Regulation
• The revenue requirement (RR) is generally calculated
using the following formula:
Revenue Requirement = Operating Expenses +
Depreciation + Taxes + (Net Book Value * Rate of
Return)
• set prices that allow the regulated firm to collect its RR
• In order to calculate prices under RoR regulation the
regulator first needs a reasonable forecast of demand for
the regulated services!!!
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Rate-of-Return Regulation
• The problem of optimal regulation
•
1.
2.
3.
Rate-of-return on investment
Rate-of-return on output
Rate-of-return on sales
Rate-of-return on costs
similar, close to the second best solution
• Under the constraint (RoR set by the regulator) the firm sets capital (K),
labor (L), price (P) and quantity (Q) and earns preset (regulated)
1. Amount on every unit of output in case of RoR on output
2. Fraction of its sales in case of RoR on sales
3. Fraction of its costs in case of RoR on costs
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Rate-of-Return on Investment
• First used in Federal Power Commission v. Hope
Natural Gas Company 320 U.S. 591 (1944)
• Returns should reflect the returns to investments in
other industries with similar risk
• Difficulties with determining returns
– problems with benchmarking
– which costs to choose: historical accounting or current market or
according to the costs capital (problem with cyclicity)
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Rate-of-Return on Investment
• Possible input inefficiencies
– Averch-Johnson effect, gold plating
– Empirical findings: Courville (1974): inefficiently high capital/labor
ratio K/L, costs higher by 11%
– Lack of incentives to buy the cheapest inputs
• Inefficiencies if firm produces more outputs
– e.g. in case of monopoly peak and off-peak prices
• Decrease in innovations
– Empirics: Sweney (1981)
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Rate of Return on I: Calculation
• Example:
– Return stipulated by regulator S: 10%
– Price of capital r: 8%
– Allowed economic profit: 2%
Invested capital
100 mil.
200 mil.
Total profit (S) Economic profit (S-R)
10 mil.
2 mil.
20 mil.
4 mil.
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Literature
• López, E.J. (2001): New Anti-merger theories: A Critique,
Cato Journal, Vol. 20, Number 3 (Winter 2001) - in library
• http://www.ictregulationtoolkit.org/en/Section.1639.html
• SCP Paradigm is today presented by neoclassical
microeconomic models
– Gravelle, H. - Rees, R.: Microeconomics. Second Edition, London New
York, Longman 1992
Kreps, David M.: A Course in Microeconomic Theory. Princeton, Princeton
University Press 1990.
Chapters 11 +
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