Download MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS
An Analysis of Business Issues
Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall
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Chapter 21:
The Economics of
Regulated Industries
Objectives:
After studying the chapter, you should
understand:
1. the various theories proposed to explain
government regulation of businesses
2. the forms of government regulation like rate-ofreturn regulation, price-cap regulation, and
franchise bidding
3. the world trend to privatisation and deregulation
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Theories of Regulation
1. Public Interest Theory
(or Consumer Interest Theory)
2. Private Interest Theory
(or “Capture” Theory)
3. Regulation as Taxation
4. A General Theory of Regulation
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Public Interest Theory (or
Consumer Interest)Theory
Arguments for government regulation:
 Monopoly or natural monopoly
 Externalities: harmful or beneficial
 Provision of public good
 Imperfect information
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Private Interest Theory (or “Capture” Theory)
Stigler and Friedland (1962): They formulated an
econometric model to test the effect of regulation on
electricity prices:
Price = f(Population, Fuel, Income, Hydro, Dummy)
Results: Regulation (the dummy variable) had
insignificant effect on the average price of electricity;
regulation was more likely to protect commercial and
industrial consumers than domestic consumers.
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Capture theory of regulation
(by Stigler)
Government Regulations are designed to
protect producers.
Why protecting producers?
(1) Bureaucrats
- they gain from supplying regulations
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(2) Consumers
- they are not well informed
- they are not well organized
 large group size, smaller individual gain,
free-rider problem
(3) Producers
- better organized; benefits are concentrated
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Stigler's theory of
economic regulation (1971)

Asymmetrical distribution between
gainers and losers from regulations.

Larger damage to the majority will
become small when spread among them.
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
High costs of organising a large group.

Members of industries with smaller size
have greater incentive to acquire
information and there are smaller costs of
organising political activities.
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Regulation as Taxation (by
Posner, 1971 and 1974)



the public interest theory is flawed because case
studies have shown that government regulation
did not increase the wealth or justice of the
society
the private interest theory is also inadequate as it
cannot predict which industries will be favoured
regulation is a form of internal subsidy, whereby
firms are forced to provide unremunerative
services
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A General Theory of Regulation
Peltzman (1976):

Assumption: regulator is a vote-maximiser.

Demand for regulation: those who benefit from
regulation.
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
Supply of regulation: regulators or legislators.

Regulators gain votes from favoured group but
lose votes from those adversely affected by
regulation. Regulators choose the size of
favoured political group and the amount of
political benefits to maximise votes.
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The equilibrium quantity of regulatory
benefits to special interests
Costs &
benefits
Marginal
political costs
Marginal
political
benefits
Q*
Q1
Quantity of regulation
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Rate-of Return (ROR) Regulation

Aim: to protect the consumers to enjoy the
service at a reasonable price and allow the
regulated firm to earn a fair (or reasonable)
rate of return on capital.

Fair rate of return = cost of capital
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Regulatory process




formal request by a public utility
examination by regulatory commission
discussion and stipulation approved; or
litigation
final decisions after public hearings
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Problems of ROR regulation
1. Allocative inefficiency:

Traditional measure of static allocative
efficiency: P =MC

Under ROR regulation: P =AC not P =MC
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2. Productive inefficiency
or X-inefficiency:

losses and wastes that occur when firms fail to
combine inputs efficiently, which results in higher
production costs

Averch-Johnson effect: if the allowed rate of
return is between the profit-maximising rate and
the cost of capital, then the regulated firm will
substitute capital for other factors of production
and operate at an output at which cost is not
minimised. The result is a non-optimal
combination of resources
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3. Dynamic inefficiency:

dynamic efficiency refers to the ability of the
regulatory system to accommodate growth and
change over time; i.e. to encourage innovation and
invention and to accommodate changes in tastes
and preferences

as profits are fixed under ROR regulation,
regulated firms have little incentive to adopt costsaving innovations or to introduce new products
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4. Governance cost inefficiency:
 governance or transaction costs are
substantial under ROR regulation, as
considerable resources are spent in the
process of administrative hearings and
litigations
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5. Other problems:


asymmetric information: utility managers are
always better informed than regulators
time lag: worsen financial situations of regulated
firms when price increases lag behind cost
increases
Joskow's arguments:
Threat of disallowance and regulatory lag can
provide some incentive to minimise costs.
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Price-Cap Regulation
The origin:
 1982: the UK government announced the privatisation
of British Telecommunications (BT); Professor Alan
Walters (Prime Minister’s Economic Adviser) argued
against the use of ROR regulation

1983: a report submitted by Professor Stephen
Littlechild recommended price-cap
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
Allowed price change = change in
Consumer Price Index - X

X factor reflects productivity growth

Price-caps or price-ceilings are defined for
baskets of services
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Advantages:
1. Higher efficiency
-less vulnerable to “cost-plus” inefficiency and
overcapitalisation
2. Greater flexibility
-greater flexibility to adjust the structure of prices
to achieve optimal second-best pricing
3. Lower governance costs
-less resources are used to operate the regulatory
system
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Other advantages

help to curb inflation; more transparent in terms of
pricing; and less danger of regulatory capture as
being less discretionary

some argue that ROR regulation is more transparent
as there are public hearings
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Problems
1. Information costs
-information for setting and resetting the X-factor
-if X-factor is not set correctly, inefficiencies arise
2. Credibility
-if government commitment to the price-cap is not
credible, real danger of under-investment or avoid
increasing productivity
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3. Price flexibility
-this may lead to price discrimination and crosssubsidisation
4. Quality
-regulated firms may shirk on quality
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Franchise Bidding
and Regulation

Demsetz (1968): monopoly right can be allocated
by franchise bidding, there is no need for
government regulation of natural monopoly.

Williamson’s (1976) counter-argument:
contractual problem due to bounded rationality,
opportunism, uncertainty, and asset specificity
(idiosyncratic investment). Franchise bidding
cannot solve the problem, government regulation
is still required.
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Regulation as a long-term contract


Goldberg's (1976) argument: government
regulation is a long-term contract, which is
designed to protect the producers’ right to serve
and the consumers’ right to be served
because of huge amount of sunk investment
required for developing the infrastructure; asset
specificity and demand uncertainty, both
producers and consumers prefer to enter into longterm relational contracts
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Privatisation and
De-regulation
Basic rationale:
•right-hand end: only market forces, in a
competitive environment secured by the rule
of law, can be relied to secure a dynamic and
efficient economy
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Privatisation
programme
•Introduction of charges: setting up of trading
fund; turning a public enterprise into a public
corporation (that is corporatisation)
•Contracting out; franchising, tendering
•Full privatisation: assets of the government are
sold to the private sector either through a private
sale or a public offer of shares (that is flotation)
•A mixed model: private finance initiative; similar
to build-operate-transfer (BOT) contracts or
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contracting out, but the government pays
De-regulation and
liberalisation
Forces behind:
1. Few real natural monopolies exist anymore
because of technological change
2. Regulations have reduced competition and
resulted in inefficiencies
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Advantages of deregulation




Price reflects marginal cost, that is allocative
efficiency
Firms produce the goods or services that the
people want at the least cost and lower price,
that is productive efficiency
Encourage invention and innovation, improve
quality, that is dynamic efficiency
Save regulatory costs, that is governance cost
efficiency
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Examples of privatisation
and de-regulation:
• Telecommunications industry: long-distance
market is liberalized
• Electricity industry: power generation
market is liberalized
• Water supply, airline industry, bus industry,
gas industry, refuse collection, etc.
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