MANAGERIAL ECONOMICS An Analysis of Business Issues

1. MANAGERIAL ECONOMICSAn Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2. 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-of-return regulation, price-cap regulation, and franchise bidding 3. the world trend to privatisation and de-regulation

3. 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

4. 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

5. 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.

6. Capture theory of regulation (by Stigler) Government Regulations are designed to protect producers. Why protecting producers? (1) Bureaucrats - they gain from supplying regulations

7. (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

8. 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.

9. 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.

10. 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

11. A General Theory of Regulation Peltzman (1976): • Assumption: regulator is a vote-maximiser. • Demand for regulation: those who benefit from regulation.

12. 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.

13. The equilibrium quantity of regulatory benefits to special interests Costs & benefits Marginal political costs Marginal political benefits Q* Q1 Quantity of regulation

14. 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

15. Regulatory process • formal request by a public utility • examination by regulatory commission • discussion and stipulation approved; or litigation • final decisions after public hearings

16. Problems of ROR regulation 1. Allocative inefficiency: • Traditional measure of static allocative efficiency: P =MC • Under ROR regulation: P =AC not P =MC

17. 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

18. 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 cost-saving innovations or to introduce new products

19. 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

20. 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.

21. 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

22. 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

23. 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

24. 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

25. 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

26. 3. Price flexibility -this may lead to price discrimination and cross-subsidisation 4. Quality -regulated firms may shirk on quality

27. 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.

28. 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 long-term relational contracts

29. 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

30. 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 contracting out, but the government pays

31. 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

32. 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

33. 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.