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Economic Approaches to Regulation and its Indirect Effects A brief overview

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.

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Economic Approaches to Regulation and its Indirect Effects A brief overview

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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, 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 • Regulation and the regulatory process • Theories of regulation • Effects of regulation—general • Static effects: Direct • Static effects: Indirect • Dynamic effects • Methods to determine effect of regulation • 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 • Regulation and the regulatory process • Theories of regulation • Effects of regulation—general • Static effects: Direct • Static effects: Indirect • Dynamic effects • Methods to determine effect of regulation • 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 • Regulation and the regulatory process • Theories of regulation • Effects of regulation—general • Static effects: Direct • Static effects: Indirect • Dynamic effects • Methods to determine effect of regulation • 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 1973-1977 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

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