GSPP 805 Economics for Policy Analysis
ECONOMIC REGULATION
Background
Market failure - The failure of the unregulated economy to achieve allocative efficiency or
social goals because of externalities, market impediments, or market imperfections.
Question for students: Why just allocative efficiency? What about productive efficiency?
Examples of social goals that have been used to justify government intervention:
o income distribution (equity, poverty), e.g. minimum wages, unemployment insurance
o provision of a minimum level of services (education, health care)
o provision of public goods (defence).
o stabilization of increasing instability, e.g. temporary wage-price controls.
Pareto optimality (maximum allocative economic efficiency) - Given available resources,
technology and the distribution of wealth, in a situation of Pareto optimality it is impossible to
make one person better off without at least one other being worse off. Requires:
o perfect competition
o no externalities in production or consumption
o all products are divisible.
Recall the conditions for perfect competition:
o Each market participant is a price-taker (no monopoly power) - large number of buyers
and large number of sellers so that no participant buys or sells enough of the good or
service that their actions influence the price.
o Homogeneous goods.
o Perfect information or knowledge.
o Freedom of entry and exits to the industry for firms and factor mobility.
o No economic friction - no significant transactions costs, e.g. transport, labour mobility.
Perfect information for the entire economy includes:
o perfect knowledge about products by consumers
o perfect knowledge of technology and factors of production by producers
o perfect knowledge of employment opportunities by owners of factors of production.
Public goods or collective consumption goods - Goods or services that, once produced to
provide a benefit to one group in society, can be extended to more consumers at a marginal cost
that is negligible or zero or Goods that must be supplied communally since they cannot be
withheld from one consumer without withholding them from all (indivisible goods or nonrivalrous non-excludable goods), e.g. traffic lights. Such goods can thus only be provided by
government and financed through public expenditure.
© Brian Christie, March 2001, October 2006
Quasi-public goods - Goods or services supplied by the state and financed from taxation (or
government borrowing) because otherwise the quantity and/or quality of supply provided by the
market would be inadequate (e.g., education).
Failure of the market to satisfy any of the conditions of perfect competition results in market
imperfections and, potentially, allocative inefficiency, providing grounds for government
consideration of market intervention.
Externalities in consumption exist when the level of consumption of some good or service by
one consumer or group of consumers has a direct effect on the welfare of another consumer
(other than indirectly through the price mechanism). (Examples?)
Externalities in production exist when the level of production of some good or service by one
firm has a direct effect on the welfare of another firm or a consumer (other than indirectly
through the price mechanism or cost of production). (Examples?)
Externalities can be either positive or negative. Whether positive or negative, without some
regulatory framework, externalities are not reflected in market prices and, therefore, are not taken
into account in the consumption and/or production decisions of market participants. This likely
produces allocative inefficiency.
No externalities means that all benefits (and disbenefits) of consumption accrue to the buyer/
consumer of a good and all costs of production accrue to the producer.
Coase’s Theorem - When property rights are clearly assigned, externalities need not result in
allocative inefficiency.
Economic Regulation and Deregulation
Regulation is the imposition by government of rules and controls that are designed to direct,
restrict or change the economic behaviour of individuals and/or businesses and that are supported
by penalties for non-compliance.
Characteristics of economic regulation:
o Does not include regulation of social or moral behaviour (e.g. crime, civil rights, health
and safety) - although these activities can have economic consequences.
o Affects the choices and decisions of economic agents and thus modifies market results
(often limits them):
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prices,
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quantity produced or consumed,
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quality of goods and conditions of production,
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distribution and marketing (e.g. advertising, labelling, warranties)
© Brian Christie, March 2001, October 2006
o Administered by a commission, agency or bureau that
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interprets statutes from which it derives its authority,
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establishes or proposes more detailed regulations,
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may have considerable autonomy.
o Rules are supported by penalties or sanctions (fines, loss of licence, imprisonment)
o Does not involve the direct provision of a good or service, although a government
enterprise may be regulated by another agency (e.g. CBC regulated by CRTC).
An alternative to economic regulation may be the provision of a good or service by a government
enterprise.
Types of regulation:
o Price regulation: floors or ceilings.
o Licences, charters and quotas: controlled entry to an industry (e.g., tv stations, banks,
fishing boats, taxis)
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May control amount of production or sale or conditions of service, (e.g.,
location, number of businesses).
o Promotion of competition:
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Business and labour practices - prevent or limit abuse of market power
(e.g. anti-collusion, price-fixing, establishment of unions)
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Anti-trust/ anti-combines regulation.
o Standards - e.g., weights and measures, advertising, construction and design, labelling,
environmental, workers’ safety.
Scope of Regulation
Regulation is pervasive in the Canadian economy. In 1979 the Economic Council of Canada
estimated that over one quarter of the Canadian economy was subject to direct regulation of
prices and production, including the following sectors: transportation, communications, natural
resource extraction, agriculture and food, financial markets and institutions, and cultural
activities. As well, the following are significantly regulated: business practices, ownership of
intellectual property, labour markets, professional practices. Has this scope changed since 1979?
Regulators
o Government departments - as part of their responsibilities, e.g. environment, consumer and
corporate affairs.
o Statutory Regulatory Agencies (SRA’s) - crown regulatory agencies
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have varying degrees of autonomy depending on the legislation, resources
provided, practice.
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aim is to distance regulatory activities from political considerations.
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appeals available: to courts on points of law (usually process).
to cabinet (depending on legislation) on major policies.
© Brian Christie, March 2001, October 2006
The Theory of Economic Regulation
There is no universal theory of regulation. Various theories fit different situations.
1. Public Interest Theory
In this theory, regulation exists to correct market failures or increase societal wealth or welfare.
Government acts in the public interest to move markets closer to Pareto optimality or social
goals, maximizing welfare and efficiency, reducing harm and misinformation, managing
common property to reduce externalities, promoting technological development and product
evolution. Examples include:
a) Regulation of a natural monopoly allows the realization of the productive efficiency (i.e., the
economies of scale) that result from large scale production in some industries while avoiding the
deadweight loss that results from monopoly pricing and production.
Alternatives:
o Government enterprise - raises the risk that the public body will act opportunistically, e.g.
produce and price in same manner as a private monopolist. Or manage inefficiently
having the ability to pass on the higher costs.
o Auction off the monopoly rights and distribute the proceeds to customers or taxpayers.
But must address the need for tenure to induce a producer to make the long-lived
investments in specialized assets, e.g. power grids.
b) Restrictions on the use of common property or user charges to address the negative
externalities of production.
c) Regulation of quality standards to address problems of asymmetric information.
d) Promotion of market stability and economic stability
o Stabilization of agricultural markets that are subject to considerable fluctuations in prices
and, therefore, producers’ incomes in order to assure stable prices and supplies for
consumers.
o Wage and price controls to dampen rapid price inflation and the resulting destabilizing
expectations, particularly with respect to administered prices (those set by government)
where market forces do not operate well.
e) Pursuit of social goals - objectives that may move the economy away from Pareto optimality
(or from one optimal situation to another) but are viewed collectively as socially desirable, e.g.,
income redistribution, provision of quasi-public goods that have positive externalities (e.g.,
education).
© Brian Christie, March 2001, October 2006
Income policy - Pareto optimal conditions may include large variations in income distribution,
extreme wealth and poverty. Government has a responsibility (moral, electoral, consideration of
the externalities of poverty such as crime, health costs, lost productivity, etc.) to ensure all
incomes reach minimum acceptable levels. Possible means include:
o tax and transfer system
o education, training and labour support services (subsidized day care)
o agricultural support policies to assist farmers and keep food costs low
o minimum wage laws
o regulations to promote cross-subsidization of services (e.g., telephone, bus routes)
o provision of affordable necessities of life (e.g., public housing)
2. Special Interest Theory
According to this analysis, special interest groups use the political process to extract wealth
and/or income from other groups. This may involve redistribution of income or wealth or
monopolistic profits. Pareto sub-optimal conditions result because of political/bureaucratic
considerations or the pursuit of other governmental goals.
a) Capture theory - regulatory agencies are captured by those regulated who use them to subvert
their purported purposes. Regulatory agencies weaken over time in the face of large, powerful
firms or industry associations which have more resources, expertise and knowledge of the
industry, lobbyists, supporting interest groups, prospective rewarding career opportunities for
bureaucrats, and public and political influence. Regulators, forced to rely on industry for
information, find themselves in a reactive mode of operation.
The results may include restriction on entry into the industry, reduced competition among firms,
reduced research and development and reduced investment in new technology (that lower costs
and raise short-term profits), and/or guaranteed rates of return on capital and no penalty for
mistakes and/or inefficiency.
Evidence of capture theory in operation may include opposition to deregulation by the regulated
and/or technological stagnation followed perhaps by bursts of innovation when the pent-up
demand for change bursts through.
Capture can be offset by actions of well-informed, well-funded consumer groups. (There is
theory and research around the costs, benefits and impacts of new information on consumer
behaviour - rational ignorance when costs of obtaining information exceeds expected benefits.)
Government can give the regulatory agency broader scope so that more resources can be justified
and it can receive information from natural competitors of individual industries, e.g.,
transportation agency regulating rail, trucking, plane and marine shipping industries.
b) Cartel theory - industries seek regulation in order to operate legally as a cartel, increasing
profits. Regulation is used to limit entry of competitors and enforce compliance in cartel
© Brian Christie, March 2001, October 2006
decisions (no free riders). Success in achieving and maintaining such regulation depends on
political influence and/or ability to convince government that a natural monopoly exists and
therefore regulation produces least cost production.
c) Public choice theory - the economic study of non-market decision-making or the application
of economics to political science. Derives from observations of the behaviour of regulators.
Political parties/elected officials “sell” regulatory benefits to industry and workers (e.g., higher
prices, profits, and wages; job security) in return for campaign contributions and votes.
Regulation itself is a good with demand and supply functions. Politicians supply regulation in
exchange for votes or contributions to campaign funds; industries demand it for the ability to
achieve super-normal profits. Consumers also have votes to buy regulation or deregulation. The
amount of regulation delivered results from politicians’ efforts to maximize votes and
contributions from all sources.
The more that prices in a regulated industry rise above the competitive market price, the more it
becomes worthwhile for consumers to inform themselves and campaign and vote against the
regulatory regime.
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This model implies that the regulation of monopolistic and competitive industries
will command more support than the regulation of oligopolies. Regulation of a
monopoly reduces prices and raises the quantity of the product available so that
the consumer benefits, even if the regulation still leaves in place some superprofits. The monopolist is satisfied by continuing protection from competition
and the resulting high profits. Regulation of a competitive industry (e.g.,
agriculture) will aim to raise prices (per unit) marginally. Large volume producers
who benefit substantially will support the policy. Consumers, whose votes are
based on many issues, will be largely indifferent.
This theory of voter sensitivity explains why governments prefer “hidden” taxes
(cf. the GST), including those created by regulation that raises prices above costs.
Subsidy-seekers prefer such approaches as well since they require less (costly)
lobbying and lower risk of deregulation.
d) The Theory of Bureaucracy - bureaucrats’ actions can be understood in terms of budgetmaximizing. Most of the benefits they seek (monetary and non-monetary, present and future)
derive from the size and power of their bureaux (offices). Bureaucrats, therefore, ally themselves
with the politicians who oversee bureaux (i.e., the cabinet) and those who have influence with
them. All, therefore, have an interest in larger bureaux which offer greater opportunities for
vote-buying.
3. Public Finance Theory of Regulation
This approach draws from both public interest and special interest theories. Regulation is seen as
© Brian Christie, March 2001, October 2006
one of a number of potential policy instruments for subsidy and taxation: for effecting transfers
among consumers, workers, owners of factors, and firms. Examples include subsidization of 1)
rail passengers and grain movements from general freight revenues or 2) of local telephone
service from long distance profits or 3) specialty cable stations from cable subscribers.
Regulatory cross-subsidization is more likely to occur in industries providing infrastructure
services (e.g., utilities, common carriers) which are difficult or impossible to resell. Crosssubsidies often reflect a political decision that a service should be widely available or that lowcost services are necessary for economic development of the hinterland.
Example of the automobile industry: Canadian consumers were/are not allowed to import new
cars duty-free while producers can do so. This keeps the Canadian prices of cars high. This
arrangement was part of a deal between the government and the manufacturers to expand
production in Canada. The Canadian government traded off consumer interests for jobs and the
economic impact of auto industry (and votes in populous Ontario and Quebec).
Costs and Benefits of Regulation
Benefits are often hard to quantify. “What if” questions: benefits to society are usually costs
prevented or avoided. Special interest theory brings into question the societal economic benefits.
Costs
o Direct administrative costs - costs of operating regulatory agencies. 1986 estimate: 2.4%
of the federal government’s expenditures.
o Compliance costs - costs incurred by industry in complying with regulators: from formfilling to huge capital investments (pollution scrubbers). Paper-burden, legal counsel,
consultants, testing, advisors. Increased operating costs lead to higher consumer prices.
o Political activity costs - in government negotiations, courts, lobbying and the legal costs
of firms. In some industries, business executives have been found to spend up to 1/3 of
their time dealing with government and regulatory issues.
o Reduced innovation - R&D funds spent defensively on safety. Regulation increases the
time to move new technology to market, reduces the return on research expenditures and,
therefore, the amount of R&D. Reduced competition reduces the incentive for
innovation.
o Reduced economic growth (as measured by the GNP) - diversion of financial resources to
safety, environmental requirements, etc. reduces funds for productivity-enhancing
investment. (But this argument depends on what is included in measures of economic
output and social welfare.)
o Reduced employment from regulation such as minimum wages and fish stock protection.
o Price regulation that employs rate of return approaches can result in over-capitalization
and productive inefficiency.
o Promotion of monopolistic industry structures - compliance costs may create barriers to
© Brian Christie, March 2001, October 2006
entry, reasons for exit for small start-up firms. Leads to the productive and allocative
inefficiency of monopolistic industry structures.
Surveys suggest that for large firms the primary burdens are lost efficiency, innovation,
expansion of business, new product development. Small firms complain mostly about the cost of
paper burden and the diversion of the time and energy of owner/managers.
In general, most complaints are not about the need for regulation but about the process and costadding inefficiencies. This finding creates a strong argument for cost-benefit analysis of all new
regulatory regimes and regulations. (The federal government requires a regulatory impact
assessment for all new regulations.)
Regulatory Reform
Regulatory reform or deregulation includes improvements in regulatory process, deregulation,
and privatization of government enterprises. The recent trend to deregulation has arisen out of a
questioning of the need for, effectiveness of, and cost of regulation. Arguments were made that
regulation was accomplishing little and even creating inefficiency, for example by limiting
innovation. Successful deregulation in one country or one industry demonstrates potential
benefits and leads to deregulation elsewhere. For example, successful deregulation of California
intrastate air transportation (lower fares, increased competition through expanded services) led to
US national airline and trucking deregulation and then deregulation of the same industries in
Canada. Canadian air deregulation was in part motivated by loss of Canadian passengers to US
carriers. (Only later did the airline failures begin.)
Deregulation has also been motivated by political philosophies about the role of government.
Public interest theory suggests that deregulation would/should occur if original market
imperfections disappears e.g., a change in technology eliminates a natural monopoly
(telecommunications?). Or if it can be determined that the cost of regulation exceeds the losses
that would occur without regulation. Or if the regulatory process is captured by industry or
workers so that regulation is no longer in the public interest.
Deregulation
Deregulation has taken various forms:
o elimination of regulatory legislation, agencies and regulations
o sunset clauses on new regulations
o initiatives to “cut red tape”, streamlining regulatory processes
o application of cost-benefit analysis to regulation
o privatization of government enterprises, in whole or part.
o market-based solutions such as increasing competition through expanded licencing or
fostering new technologies, requiring utilities to purchase from or sell to private
© Brian Christie, March 2001, October 2006
competitors (e.g. power, telephone).
o use of pollution taxes or tradeable emissions permits (application of Coase’s Theorem)
o increasing the contestability of markets through tax measures such as more generous
capital cost allowances (more rapid write-off of equipment expenses).
Regulatory Pricing Policies
Regulatory agencies regulate prices (fares, rates) in certain industries, particularly utilities, often
those that are “natural” monopolies or oligopolies. The choice of the appropriate pricing policy
for regulated industries overlaps the discussion of public pricing policies (user charges) for
public goods and services (next lesson).
1. Short-run Marginal Cost Pricing, where possible, is the allocatively efficient pricing policy. In
practice, marginal cost pricing may be difficult to apply.
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Marginal cost pricing may lead to losses in declining-cost natural
monopolies, particularly those requiring large capital investments,
necessitating government subsidies if the good or service is to be available
to consumers.
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The marginal cost may be difficult to determine, especially if there are
joint costs of production of several related products.
2. Long-run Incremental Cost Pricing, while not allocatively efficient, allows capital costs to be
covered.
3. Average Cost Pricing assures that firm can operate, but is not allocatively efficient and may
reward waste and poor management.
4. Average Incremental Cost Pricing or Fully-Distributed Cost Pricing assigns all costs to some
usage or consumption decision. Promotes efficient consumption.
5. Benchmark Pricing employs some established reference price such as the price in an earlier
period or in another market. This approach may be used when the regulated firm produces a
large number of products, not all of which are price-regulated. For example, the Canadian Patent
Medicine Prices Review Board has established the following benchmarks for reviewing whether
price increases for patent medicines in Canada are appropriate :
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If the drug was marketed in Canada before December 1987, then the December
1987 price increased by the change in the Consumer Price Index.
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If the drug is new, then the therapeutically-adjusted price of the included patent
medicine, based on the price per kilogram of the active ingredient(s).
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If no existing therapeutic class, then the median international price.
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Otherwise, cost-based pricing.
© Brian Christie, March 2001, October 2006
6. Price Discrimination (of the third degree) may be used by the regulator
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for rationing of a scarce product,
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to generate increased revenues for the firm to cover fixed costs,
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to attain greater allocative efficiency (marginal cost equal to marginal revenue),
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for equity considerations or to increase the extent of and access to services, or
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for conservation purposes.
Examples:
o Value of Service Pricing aims to approximate the relative values of the good or service
for various classes of consumers, e.g. telephone service is viewed as being of more value
to a firm than to a household and therefore commercial rates are set higher than
residential rates. (This approach increases the revenue of the firm if, and only if, the
elasticity of demand for commercial customers is lower than that of residential
customers.)
o Inverse Elasticity Pricing or Ramsey Pricing. Economist/mathematician Frank Ramsey
developed this approach in 1927 as a means of minimizing the net welfare loss resulting
from the application of taxes on goods or services sold to customers with different
elasticities of demand. It has been extended to regulatory pricing policy, usually for
industries where marginal cost pricing would result in operating losses. Under this
approach, the ratio of the price markups, (p-mc)/p, in any two market for the firm’s
products should be inversely related to the ratio of the price elasticities of demand.
7. Block Pricing (price discrimination of the second degree), whereby the price of the service
declines as successive blocks of the service are purchased, allows coverage of initial service costs
and fixed costs while providing an incentive to increased consumption, generating more revenue.
Increasing block pricing may be used to encourage conservation or for equity or rationing
purposes.
8. Peak-load Pricing, Time of Day Pricing, can be used to shift demand or reduce it when
otherwise it might exceed capacity. Reduces congestion or delays or brownouts or capital
investment requirements.
9. Cross-subsidization: when a utility produces multiple services or serves multiple markets,
prices may be set higher than average cost for some market(s) to finance provision of service at
lower prices in some other market(s) for equity or access reasons.
10. Rate of Return Regulation. In addition to, or in place of, regulating prices, the regulator may
regulate the overall earnings of the firm to a specified (expected) return on capital.
r = [TR - (OC+CD)]/[V - AD]
© Brian Christie, March 2001, October 2006
where TR = total revenue
OC = operating costs
CD = current depreciation
V = value of capital assets
AD = accumulated depreciation
r = allowable rate of return
Issues:
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What are allowable operating costs? Regulators may decide what costs are
excessive and what costs (or how much of them) may be included, e.g.
advertising, executive salaries and expense accounts.
V-AD, the rate base. Are cost overruns on construction allowable? How
rapidly can/must equipment be written off?
What is the fair rate of return, r? It should be the rate needed to attract
capital into the regulated industry - rate on bonds, preferred shares, cost of
government borrowing (if bonds are guaranteed).
If the regulator sets prices expected to generate the target rate of return,
then in the short run the firm benefits from any increase in sales (if price
exceeds marginal cost) and from improved management (lower costs).
But a long run perspective may induce deliberate inefficiency (poor
management, use of old technology) to maximize profits.
Over-capitalization: approach rewards excess use of capital compared to
other factors of production (the rate base effect or Averch-Johnson effect).
This inefficient use of resources increases costs and, therefore, prices.
Price Cap System: a variation on rate of return pricing allows firm to set
prices within an established band of prices and maximize profit (or
political returns if a public enterprise) without detailed oversight. The idea
is to encourage productive efficiency.
© Brian Christie, March 2001, October 2006