Economics Workshop
Better Regulation Executive
2006
Sandeep Kapur
WORKSHOP AIMS
To provide rigorous but non-mathematical
training in economics, enabling BRE staff to
• develop a simple but reliable toolkit for
economic analysis
• practise its application using concrete
regulatory problems
• explore the application of simple economic
theory to their own work
Objectives: Day 1
To understand
• how markets work, and their efficiency
• why markets sometimes fail to be efficient and how
alternative regulatory instruments can improve
efficiency
• how regulation can improve on other aspects of market
outcomes, such as inequity
• how, in practice, regulatory interventions carry the risk
of government failure
• the basics of regulatory impact assessment
Objectives: Day 2
To
• review the standard rationale for regulation
• understand how good regulatory design can cope with
risk and uncertainty, informational imperfections, and
minimise distortion of incentives
• rationale for and implementation of RPI-X regulation
• the link between regulation and productivity growth
Introduction to Economics
Some Concepts and Tools
Markets vs. Command
The central questions: given existing resources
• what goods and service to produce?
• how to produce?
• for whom?
Alternative mechanisms
• COMMAND ECONOMY
direct control, as in Soviet economy, or firms’ internal
decisions
• FREE MARKET ECONOMY
outcome determined by private transactions in
markets, based on prices, incomes, wealth
Degree of government intervention differs..
Cuba - China - Denmark - UK - USA -
Hong Kong
Most countries have mixed economies with both
• markets, which are regulated to different extent
• public production and provision
Scale of government
Spending as share of national income (%)
1880
1930
1960
2004
Japan
11
19
18
37
USA
8
10
28
36
UK
10
24
32
43
Germany
10
31
32
47
France
15
19
35
53
Sweden
6
8
31
57
The policy question
Markets are generally considered to be efficient
If so, why not leave things to the market?
Governments care about both equity and efficiency
• Free markets rarely deliver equitable outcomes, so
some redistributive intervention is unavoidable
• Free markets do not always lead to efficient
outcomes, so some interventions are motivated by
efficiency considerations
To understand this, we must look at how markets work
How Markets Work
Demand, Supply, and Price Adjustment
Market
• MARKET
any arrangement in which prices adjust to reconcile
buyers and sellers intentions
• DEMAND
quantity buyers wish to buy at each price
• SUPPLY
quantity producers wish to sell at each price
• EQUILIBRIUM PRICE
the price at which market clears
(i.e. quantity demanded = quantity supplied)
Price Adjustment
Supply curve
price
Equilibrium
Price
Demand curve
Equilibrium
Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
Price Controls
Suppose government sets minimum price above market
clearing price
Price
Supply curve
Controlled price
Equilibrium price
Demand curve
Examples include
• Minimum wages
• Rent control
• Common Agricultural Policy
excess
supply
Quantity
What does price controls do?
Price controls interfere with the adjustment process
• minimum wages are good for equity: they boost the
income of some low-skill workers
• But such interventions may not be good for efficiency: if
employers are unwilling to hire as many at regulated
minimum wage, some potential workers are deprived of
the chance to work
Economic Efficiency
An intervention is said to improve efficiency if it makes
someone better off and nobody worse off.
Economic efficiency: an outcome where no one can be
made better off without hurting someone else.
The key question: do free, unregulated markets always
lead to efficient outcomes?
Markets and Choice
In markets
• consumers buy up to the point the marginal benefit
equals price
• competitive firms sell as long as price covers ‘marginal
cost’ of production (this is the opportunity cost of
producing another unit of the good)
The Efficiency of Markets
Thus, in competitive markets
• prices align marginal benefit with marginal cost
• all possible gainful exchanges are carried out
• PUNCH LINE: Free, unregulated markets lead to
efficient outcomes. This is the so-called Invisible Hand
Theorem!
But free markets are not always efficient..
Market failure: a circumstance in which free markets fails to
achieve an efficient outcome
Many interventions are designed to correct market failures,
and thus to increase efficiency
In sum: why intervene?
‘Economic regulation’
• Aims to correct market failures, and make the
market outcome more efficient
(when the ‘invisible hand’ does not work, the government
can provide a helping hand)
‘Social regulation’
• To prevent undesirable social outcomes inherent
in market outcomes
Group Work: Efficiency and Equity
Government intervention in the economy is pervasive. For
each intervention listed below identify the possible
rationale. Is it primarily
a. efficiency considerations?
b. equity consideration?
c. something else?
1. Income tax
2. Taxation of petrol
3. Regulating gas prices
…Group Work
4.
5.
6.
7.
8.
9.
10.
11.
12.
Regulating discharge of sewage in the Thames
Legislation against insider trading
Banning the use of cocaine
Making primary school compulsory
Regulating financial advisors
Regulating length of the working week
Compelling citizens to carry identity cards
Minimum wage legislation
Regulating taxi fares
Market Failures
Why intervene?
How to intervene?
Sources of Market Failure
• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Coordination problems
We will look at each of these in turn
MARKET FAILURE: Externalities
EXTERNALITY
• A circumstance in which an individual's choices affects
others' utility or productivity
• the effect is direct (not through market or prices)
Why Externalities Matter
THE ESSENTIAL PROBLEM
• Market mechanism aligns private costs and benefits
• Externalities imply divergence between social and
private costs (or social and private benefit)
• If divergences exist, should not expect socially efficient
allocations
Examples
• Adverse externalities: smoking, pollution
Since costs are partly borne by others, self-interested
decision-making might lead to excess
• Beneficial externalities: bees and orchards, personal
hygiene
Since benefits partly accrue to others, self-interested
choices lead to sub-optimal quantities
Adverse Production Externality
F
MSC
G
E
MPC
Demand
Q*
Q
Quantity
For social optimum, we want
marginal social cost = marginal social benefit
At free market equilibrium E, output Q is higher than social
optimum Q*
Correcting externalities
1.
2.
3.
Quantitative regulation or direct government action:
e.g. pollution quota
[Pigou] Taxes or subsidies to correct prices
e.g. pollution tax
[Coase] Create markets: assign property rights and
enable trade in pseudo-markets
e.g. carbon trading
Coasean Solution
MC (for you)
MB (to me)
Q*
Q
Quantity
Efficient quantity is
Q*
• Assign property rights and
let people trade these rights
in specially-created market
• Initial assignment of rights
affects distribution but get
an efficient outcome
regardless
• This solution does not work
if there are high transactions
costs
Regulating the market for knowledge
PROBLEM
R&D has a beneficial externality, so that unregulated
markets may not produce enough
SOLUTIONS
• Patents: confer time-bound legal monopoly on creator
• Procurement: government research labs
• Patronage: provide subsidies to universities
MARKET FAILURE: Public Goods
Examples: defence, broadcast TV signal
Characteristics
• Non-rival consumption: my consumption does not
diminish what is available for you
• Non-excludability: impossible or too costly to prevent
people from consuming it
Public goods: the problem and solutions
• If you cannot exclude, people will ‘free ride’. But if
no one pays, there is nothing to free-ride on (this is
the paradox of free riding)
• In fact, exclusion is not efficient either
In general, markets cannot provide public goods
SOLUTIONS
• public provision
• compulsion
Government needs to ensure right quantity, but need
not produce itself
MARKET FAILURE: Imperfect competition
The essential problem of monopoly
• Firms with market power can charge prices that exceed
marginal cost
• which restrains consumption below efficient level
• other problems: resources wasted in securing monopoly
power (‘rent-seeking’), and in maintaining it
Solutions to monopoly problem
Solution 1. Nationalize and finance losses through taxes
politically not very feasible
Solution 2. Break monopoly
e.g. anti-trust legislation in US
However, no good for ‘natural monopolies’
Industries with severe economies of scale, so having
one producer avoids duplication of costs
And in some sectors monopoly is good for R&D, or for
internal coordination
More solutions to the monopoly problem
Solution 3. Regulate
Prevent abuse of monopoly power through price and nonprice controls
Practical issues: when is regulation necessary? What form?
How frequently?
Solution 4. Nurture competition
Encourage new entrants, (but will they enter and will it only
lead to cream skimming?)
Important to get the right mix of remedies
MARKET FAILURE: Imperfect information
Information in markets is imperfect. Often there is
asymmetry of information between buyer and seller
leading to problems of
• ‘adverse selection’: people who know themselves to be
risk-prone are more likely to buy insurance
• ‘moral hazard’: once you have insurance, incentive to be
careful is weakened
• these distortions may result in ‘incomplete markets’ or
even ‘missing markets’: e.g. low-risk people may not find
appropriate insurance.
SOLUTIONS: Imperfect information
1.
mitigate informational problems
• mandating provision of information
(regulate financial advisors)
• providing information directly
(publish league tables)
2.
reduce the possibility of opportunistic behaviour
• consumer protection
3.
government provision of the good or service
Inefficiency due to strategic interaction
Individual choices do not always result in the best
collective outcomes
Country 2
Country 1
No nukes
Nukes
No nukes
8, 8
1, 12
Nukes
12, 1
2, 2
SOLUTION: coordinate individual choices through
agreements or regulation
Regulating standards
Problem: uncertainty about new technological standards
may slow down adoption
• VHS vs Betamax
• Blu-Ray vs HD-DVD
Should regulation aim to guide technological choices?
• GSM in mobile telephony
Lessons for Policy Makers
• Market failures makes a potential case for corrective
intervention
• However, we must beware of the possibility of government
failure. The scope for successful regulatory intervention is
limited by
• informational constraints
• agency problems
• lack of correction
Well-intentioned regulation may
• end up being ineffective
• have perverse, unintended consequences
• persist beyond its purpose
• be vulnerable to regulatory creep
The cumulative burden of regulation could be quite high
If so, the net effect may be to replace market failure with
government failure
Group Work: Pollution control
As the National Rivers Regulator, you must tackle the
problem of a chemical firm that is polluting the Thames
a. If everything could be quantified and valued, show in a
diagram how a pollution tax can induce the firm to
behave in a socially efficient manner.
Group Work: Pollution control
b. Instead of the tax you offer the firm a pollution quota
(specifying the maximum pollution it can discharge in
any year). Show the size of the quota in the diagram.
What difference does it make to the efficient quantity of
pollution?
Group Work: Pollution control
c. Now suppose information is harder to come by. As the
regulator, you are not entirely certain about the firm's
cost curve. Does this affect your choice between tax
and quotas?
Group Work: Pollution control
d. Lastly, suppose there are two chemical firms
discharging into the river, one cleaner than the other. Is
it better to
• set a pollution tax? (same rate per unit polluted for
both?)
• auction pollution quotas?
Regulatory Impact Assessment
COST-BENEFIT ANALYSIS
Analysis that quantifies costs and benefits of any decision,
including items that the market does not value properly
Useful for
 capital projects and disposal of existing assets
 procurement decisions
 impact of policy proposals, including regulatory proposals
environmental standards, health and safety, business
regulation
OTHER FORMS OF APPRAISAL
 Financial Appraisal
Compare revenue & costs (as private firms do)
 Cost-effectiveness analysis
If benefits are hard to quantify, compare costs of achieving
some target level of benefits
THE PROCESS
1. Justify action and set objectives
2. Identify all options
incl ‘do minimum’ and politically infeasible ones
3. Identify costs and benefits of each option, including nonmarket costs or benefits
4. Other considerations
a) risk and optimism
b) distributional impact
5. Choose the best option
6. Develop and implement solutions
7. Evaluation
THE PROCESS
1. Justify action and set objectives
•
•
Identify the market failure or the socially-undesirable
outcome that calls for regulatory intervention
discharge of pollutants in atmosphere reduces air quality:
the objective is to reduce pollutant levels
congestion externality causes traffic jams in Central
London: the objective is to reduce peak-time traffic by 20%
THE PROCESS
2. Identify all options
•
•
•
•
•
prescriptive regulation (quotas, speed limits)
provide incentives to change behaviour (taxes and
subsidies)
create arrangements or institutions that will change
behaviour (tradable permits)
provide information/educate to alter behaviour
(public campaign on dangers of excessive salt)
encourage voluntarism: no intervention
THE PROCESS
3. Identify costs and benefits of each option
• Evaluate direct policy costs & implementation
(administrative) costs of each regulatory intervention
• Ask the right counterfactual: what will happen in the
absence of regulation?
• Identify unintended consequences and cost them too
• Identify benefits and evaluate them as far as possible
• Identify distributional implications
THE PROCESS
Valuing non-market impacts
• externalities, including environmental ones
• ‘prevented’ fatality (saving human life)
• catastrophic risk
Can sometimes infer prices from revealed preferences
If not, use stated preference through contingent valuations
• Willingness to Pay (WTP)
• Willingness to Accept (WTA)
THE PROCESS
4. Other considerations
•
•
Correct for risk and uncertainty
Assess distributional impact
THE PROCESS
5. Choose the best option
•
Forecast costs and (if feasible) benefits flow generated
by the regulatory policy over its lifetime
• Discounting allows us to convert future benefits and
costs to their present value (Green Book requires
discount rate 3.5% pa, lower for long-term impacts)
• Calculate the net present value of each option (or just
net present cost if benefits can’t be quantified)
• Choose the option with highest Net Present Value (or
lowest cost)
All this is easier said than done.
THE PROCESS
6. Develop and implement solutions
Issues in regulatory design
•
ease of ensuring enforcement
•
incentive-based systems require ability to monitor and
verify choices
•
setting robust targets (Goodhart’s Law!)
•
proportionality, accountability, consistency
THE PROCESS
7. Evaluation
•
•
•
Review costs and benefits of regulation periodically to
assess its usefulness
If necessary, use sunset clauses to force evaluation at
later date
Likewise, reassess the ‘no intervention’ decision in the
light of new information and developments
Green Accounting: A Case Study
Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars
1985
1986
1987
1988
1989
1990
Children's health
Adult blood pressure
Other pollutants
Maintenance
Fuel economy
Total benefits
-Refining costs
Net Benefits
223
1724
0
102
35
2084
-96
1988
600
5897
222
914
187
7821
-608
7213
547
5675
222
859
170
7474
-558
6916
502
5447
224
818
113
7105
-532
6573
453
5187
226
788
134
6788
-504
6284
414
4966
230
767
139
6517
-471
6045
Children's health: lead in blood is related to IQ-impairment.
Lead causes hypertension and increased heart-attacks: a statistical life was valued at $1 mn
Low lead levels reduce other pollutants, economies in fuel & maintenance
Group Work: Impact Assessment
For each category of regulation below, assess the social
costs and benefits (including the costs and benefits of
any unintended consequences).
1.
2.
3.
4.
Taxation of cigarettes
Legislation to keep pubs smoke free
Regulating taxi fares and quality
Regulating price of calling mobile phones from
fixed line phones
5. Regulating the introduction of new drugs
6. Regulating the production of GM crops.
Risk and Uncertainty
Risk and Uncertainty
What if benefits and costs are uncertain?
Risk evaluation and management is an important part of
good policy design
Steps involve
• Identifying risk and uncertainty
• Evaluating their consequences for the policy
• Managing the risk
Identifying Risk in Regulatory Proposals
Risk of a mismatch between expectation and outcome
• Cost over-runs & benefits shortfalls: optimism bias
• Design risk
• Technology-related risk
• Reputational risk
• Potential irreversibilities
Evaluating Risk in Regulatory Proposals
• Avoid concentrating on most likely scenarios: evaluate
costs and benefits for the entire range of possible
scenarios
• Sensitivity analyses to look at any proposal under
alternative assumptions about the value of uncertain
parameters
• Correct for optimism bias, using past experience with
similar proposals
• Assess the cost of potential irreversibilities
Managing Risk in Regulatory Proposals
• Where possible at reasonable cost, transfer risk to party
best placed to control it: outsourcing of technology
elements to private sector
• Use pilot programmes to learn more about the true costs
and benefits of intended regulation
• Use flexible format to avoid the risk of being hostage to
fortune
• Use sunset clauses to force revaluation once more
information is available
• Where irreversibilities are involved, consider delaying
proposal to allow learning: if you have to go ahead, raise
threshold for acceptance of project
Information and Incentives
An overview
Regulation amounts to state-imposed limitation on individual
discretion, usually supported by the threat of sanctions
(stick) or by the provision of appropriate incentives (carrot or
stick)
Individual choices depend on their information and incentives
The questions
• how do information and incentives affect scope of
regulation?
• how does regulation distort information and incentives?
Information
Two relevant aspects. Information tends to be
• imperfect (we do not know everything)
• de-centralised (we differ and know different things)
These lacunae can be corrected, but at some cost
Imperfect Information
For the class of decisions where
• individuals’ information is imperfect AND
• the state could better informed,
state regulation can correct for individuals’ ignorance and
protect their interests
Examples
• product safety regulation
• health and safety regulation
Why might the state be better informed?
•
Individuals cannot easily assess safety aspects of poor
product design
• Employees cannot always assess riskiness of work
environment, especially if damage comes with a lag
(asbestos exposure, coal dust)
Here the state can be better informed (commission scientific
studies) and regulate if necessary
Is statutory regulation necessary?
Regulation not necessary if markets create incentives for firms
to protect consumer / employee interests. For instance,
• Reputational concerns may persuade firms to maintain
product quality / work-place safety
• Risk of legal actions helps too
However, these mechanism are less effective when firms are
small or new
Sometimes self regulation works..
If reputational mechanism does not work, collective self
regulation may emerge
• ABTA for travel agents
• Kite marks
Voluntary codes may work because insiders can better monitor
each other
Even if it does not..
Regulation may not be necessary. It may be easier to
provide information
• require product labelling (‘smoking kills’)
• provide information directly (advertising)
• use price-based incentives (e.g. taxes) to alter behaviour
The other problem with information
•
•
Information is de-centralised: there are many contexts in
which individuals or firms know more about themselves than
the government can know about them
This informational constraint makes it harder to regulate
these aspects of individual behaviour
The informational efficiency of markets
•
•
•
In a market, individuals or firms make decisions based on
private information.
Prices convey the essential bits of information to everyone
Thus, markets can often make do with de-centralised
information
Without information, command is harder
•
•
•
Control, as in a command economy, requires centralisation
of information
Likewise, regulation, to be effective, needs a lot of
information
The problem: usually the government does not have enough
information
... and efficient regulation hard to achieve
•
•
•
•
When firms / individuals have unequal compliance costs,
it is economically efficient to impose unequal standards (ask
‘dirty’ firms to do more)
but lack of information about compliance costs make it
harder to tailor-make legislation
the same legislation may pose too much burden on some
and not enough on others (identity cards, for instance)
and getting information a bit trickier
•
•
•
In principle, the government could try and gather more
information
but regulation distorts incentives for providing information
for example, all regulated firms would like to argue that their
costs are high
Information affects choice of instrument
•
•
Some regulatory instruments are better able to cope with
informational constraints
Tradable permits, for instance
Incentives
•
•
•
•
Individuals choice also depend on incentives
Markets provide strong incentives, both carrot and stick
For example, profits and risk of bankruptcy, promotion vs.
threat of a being sacked
Markets are said to provide sharp (‘high-powered’)
incentives
Regulatory sticks
•
•
•
•
•
A lot of regulation relies on sticks (threat of penalties)
But it is not easy to fine-tune these: road safety is only
crudely regulated through speed
People invest a lot in avoiding detection
Better monitoring technology helps but cannot always solve
the problem
If penalties are not proportional to violation, it may create
perverse incentives
Regulation changes behaviour
•
•
Regulation changes incentives
Changed incentives affect behaviour
Examples
• Safety devices may have a ‘lulling effect’, lower effort in
safety and even increase risk levels
• Employment regulations that protect workers from being
fired reduce incentives to hire them
• Average-rate-of-return regulation distorts capital structure
Regulatory Targets
•
•
•
•
Regulation often sets targets (with carrot and sticks)
but it is not always easy to find robust targets (i.e., those
consistent with regulatory objectives)
Targets are often met in way that do not match regulatory
objectives
Train companies ‘slow down’ their schedules to reduce
the risk of delay-related penalties
Future of Regulation
Appraising Policy Choices
for a Dynamic Economy
There is good regulation..
Some regulation provides the framework of civil society
• regulations to protect private property: essential spur to
investment
• regulation to protect Intellectual Property Rights: provide
incentives for R&D and innovation
• regulations against insider-dealing: allow capital markets
to exist
..and bad regulation
Other regulation stifle growth
• price regulations inhibit investment
• labour-market regulations create inflexibilities: Eurosclerosis
• regulations that make it hard to set up / wind up business
make the economy less responsive to social change.
A broad correlation...
• High regulation, especially in developing countries, seems
to stifle growth
.. and a cautionary note
• Of course, growth is not an end in itself
• the aim is greater welfare
• some forms of regulation increase welfare directly, even if
they lower growth rates on the margin
The broad trend
The last two decades have seen a trend towards
• deregulation
• regulatory reform
Economic regulation is down
• State monopolies have been replaced by privatised firms,
with lighter regulation overall
• firms’ entry and exit has become easier
• financial deregulation, though there is ‘prudential regulation’
now
but social regulation is up
• Not surprisingly, richer societies invest more in health
and safety, environmental regulation
Some deregulation is unavoidable
• Globalisation limits the power of individual governments to
control behaviour
consider the Internet
• The greater role of technological innovation makes it
important to remove impediments to innovation
• In any case, regulation cannot always cope with fastchanging technologies
Why does some regulation persist?
Competing theories
• Regulation corrects persistent market / information failures
• Regulatory capture
• Stiglerian perspectives on voting power and rents
Political economy of import restrictions
Consider tariff restrictions on imports
• Import restrictions hurt consumers through higher prices ($85 bn in the US), but cost for each consumer is small
• Domestic producers: higher profits (+$68 bn)
• Each producer gains a lot so is more likely to lobby for
protection than consumers
• Net efficiency goes down (-$17 bn)
• Similar story for many other regulations
The benefits of past regulatory reform
Elimination of economic restrictions have reduced prices.
Casual estimates suggest
• Airlines: 33% price reduction in UK, US
• Electricity: 9-15% reduction in UK
• Financial services: 70% price reduction in UK
• Telecom: 60% price reduction in UK, but how much due to
technological change
Note that you should not expect existing firms to support such
reforms!
Scope for future gains
• Some of the inefficiencies associated with monopoly power
might have already been eliminated in the UK
• If so, scope for further gain may be lower
• However, anything that supports innovation or labourflexibility is still worth aiming for
The future of social regulation
• We should expect social regulation to rise, but aim to
minimise the cumulative cost of these
• We should be alert to regulatory spillovers: higher
standards in rich countries may only export dangerous
production and pollution to poorer countries
• International coordination is desirable
Policy Conclusions
• Free markets are usually efficient: the invisible hand
works
• However, markets are not always efficient. Market
failures make a potential case for government
intervention to improve efficiency: when the invisible
hand does not work, the government can lend a helping
hand
• Beware the risk of government failure: the helping hand
may hurt rather than help (heavy-handed intervention)
• Informational problems affect both private decisionmaking and public interventions: regulation may have
perverse effects (fumbling hand)
• Further, the helping hand may become self-serving (the
grabbing hand of a predatory state)
Good regulation combines economic theory with practical
understanding