Sustainable Energy Systems
Theory of Regulation
PhD, DFA
M. Victor M. Martins
Semester 2
2008/2009
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest group theory
1.2 Theories of regulation normative and positive theory,
interest group theory and economic theory of regulation
Bibliography
{
VVH ( chap. 10 )
{
Posner , R. A. 1974 “ Theories of Regulation” , Bell Journal of Economics and
Management Science, 25 (1), Spring, pp. 335- 373.
{
{
Stigler, J. G. 1971, "The Theory of Economic Regulation," Bell Journal of
Management Science, 2 (1), Spring, pp. 3 - 21.
Peltzman, S. 1989 "The Economic Theory of Regulation after a Decade of
Deregulation," Brookings Papers on Economic Activity: Microeconomics, pp. 1 41.
Slide 2
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest goup theory
Economists explain government policies:
1. As an instrument to correct market failures and
improve social welfare ( normative theory )
z
z
z
(i) optimizing, rational choice behavior
(ii) modified by incentives from various sources, and subject
to
(iii) political and other institutions.
2. As an instrument to serve the individual or group
interest ( positive theory )
z
z
Models of public choice theory
Collective action problems
3. As a mix of the approaches 1. and 2..
Slide 3
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest goup theory
{
{
Theories of regulation
Two alternative approches to analyse regulation policy
outcomes:
z
z
Public interest theory : regulatory intervention occurs in the
interest of the public at large ( Joskov and Noll 1981 )
Private interest theory: regulatory intervention is the result of
( individual ) powerful interest groups exerting pressure on
polititians and regulators to capture rents at the expense of
more dispersed groups ( Stigler, 1971; Peltzman, 1976;
Becker, 1981 )
Slide 4
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation :public interest theory
{
Public interest theory – PIT- ( Normative
analysis)
z
z
Government regulation exists to correct some of
the shortfalls of the free market economy ( market
failures: monopoly power and externalities )
PIT is a way to:
Insure competition
{ Impact externalities
{ Stabilize economy
{ Introduce social objectives in economic policies
{
Slide 5
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
Four models of Market Structure
Nº of firms
Ease of
entry/exit
Product type
Perfect
competition
Many
Easy
Standardized
Monopolistic
competition
Many
Easy
Diferentiated
Oligopoly
Few
Dificult/Barriers Standardized/
Diferentiated
Monopoly
One
Very difficult
Unique
Slide 6
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
{
Different market structures are associated with
different levels of social welfare and deadweight loss.
z
z
{
Cournot and Bertrand oligopoly are better than monopoly
and collusive oligopoly.
Firms within oligopolies can be thought of as playing games
where they attempt to maximise profits by choosing levels of
variables under there control in the light of assumed
reactions of other firms.
Economic regulation is important where monopoly
exists and conditions make sustained collusion likely.
Slide 7
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
{
Perfect competion and monopoly
MR=MC
P=MC
P
P
D
S
Consumer
surplus
Pc
0
CS
PM
MC
D
DWL
CS=>PS
Pc
Producer
surplus
Qc
Quantity
0
QM
QC
Quantity
Slide 8
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
{
Public interest theory- PIT
z
z
z
Under ( natural ) monopoly productive efficiency suggests we
should have one firm and P=MC but this does not happen in
an unconstrained market;
This sort of market failure, along with the general need for
mechanisms of regular public disclosure by business, make
regulation critical if the public interest is to be protected.
PIT suggests that in this circunstance we should have
regulation in order to correct market falure and improve
social welfare
Slide 9
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theories
Rational choice paradigm vs. public choice school of
thought.
z Public choice models start from the premise that politicians have
an incentive to be re-elected and maintain power and control.
z Decisions made by a politician can be evaluated in terms of the
objective of attracting the necessary support for successful
reelection.
Stigler (1971) argued that firms will lobby legislators for
regulation when such regulation provides:
z (1) direct monetary subsidies,
z (2) constraints on substitute products or subsidies on
complementary products,
z (3) easier price-fixing/collusive atmosphere, and
z (4) incumbent firms with the ability to control entry by potential
new rivals.
Slide 10
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Capture theory ( Stigler )
z Firms capture the regulatory process because each firm has a
lot at stake.
z While the public as a whole has a lot at stake, any one
person has only a very small stake and so has little incentive
to invest resources in affecting the regulatory process.
z There are few firms relative to the overall public decreasing
costs of organizing
z Firms have the incentive and the opportunity to successfully
invest resources in lobbying for favorable regulation.
Evidence supporting the capture theory of regulation:
z revolving door deals - high-level regulators and other officials
leave government and find high-level jobs in the same
industry that they had been responsible for regulating.
z E.g. the EPA and the hazardous waste industry.
Slide 11
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Economic theory of regulation: improvement of capture
theory
z
{
{
Peltzman model (Peltzman. S. "Toward a More General Theory of Regulation,"
Journal of Law and Economics, August 1976:211-240. )
Various groups (e.g., consumers and regulated firms) compete
against each other in the political arena to increase their income
and wealth, or to achieve other objectives (such as
environmental cleanliness). That is, groups vie to shape
regulatory initiatives in a way that will serve their own
(sometimes narrowly-defined) interests.
Agents are rational in choosing actions that are utilitymaximizing.
Slide 12
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Basic assumption:
{ Regulation is one means by which state power can be
exercised to the benefit of specific groups. Regulation
is supplied by utility-maximizing politicians and
regulators in response to the demand for regulation by
interest groups.
{
Those who control regulatory policy do so to maximize
political support. Political support comes in the form of
votes or campaign contributions.
Slide 13
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation: private interest theory
Model
{ Let the political support function (M) be described by:
M = M(R, L)
{ Where R is rates established for the regulated service
(e.g., electricity) by the regulatory authority (e.g., the
ERSE) and L is the allowed level of profit earned by
the regulated firm (e.g., REN, EDP-Distribuição).
{ Notice that M is inversely related to R, ceteris paribus,
and directly related to L, ceteris paribus. That is:
∂M / ∂R < 0
{
∂M / ∂L > 0
Profits depend on price rates : L=L(R)
Slide 14
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
In other words:
z
Regulators or politicians prefer to set low rates,
other things being equal, since this strategy will
garner political support from the customers of
regulated firms.
z
On the other hand, allowing the regulated firm to
earn high profits (which would mean higher rates,
by the way) puts the regulated in good stead with
business and social elites that own/control
regulated firms.
Slide 15
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Thus we have two interest groups with conflicting
agendas:
z Consumers want low rates; whereas regulated firms
want high profits.
z
z
The politicians/regulators face a trade-off. If they allow
higher profits, they gain political support from firms they
regulate but lose support from consumers. The reverse is
also true. This trade-off is illustrated by the iso-political
support function.
The iso-political support function illustrates all
combinations of R’s and L’s that yield equal political
support.
Slide 16
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Iso-political support functions
Profit of the reg. firms
M3
M2
M1
L2
L1
0
X
Z
Y
M3 prefered
to M2
prefered to
M1
R2
R1
Utility rates per KWh
Slide 17
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Optimal regulatory policy
Profit of the reg. firms
M3
M2
M1
Y
Lmax
Profit
function
X
L1
L=L(R)
0
Rc
R*
RM
Utility rates
per KWh
Slide 18
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Profit of the reg. firms
Extreme outcomes
Regulator
captured by
consumers
MC
MF
LMAX
X
Regulator
captured by reg.
firms
Profit function
L=L(R)
0
Y
RC
RM
Utility rates
per KWh
Slide 19
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest goup theory
• Optimal solution
z Somewhere between “Y” and “X” ( slide 19 )
z Slope of the regulator/legislator indiference curve
M is positive ( slide 18 )
Optimal policy is at R* ( slide 18), between a
competitive price and a monopoly price
Implication: Industries most likely to be regulated (
broad sense ) are either relatively competitive (
agriculture, taxis,etc..) or relatively monopolistic (
network industries ).
z
Slide 20
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Main Results
z
z
z
Usually the imperfect information about the gains
and losses resulting from regulation, along with
organizational costs of groups looking for political
favors, lead to a reduction of the winner coalition.
The winner coalition will not receive a gain as big
as it could be by the regulator
Even if groups organize themselves looking for
their economic interests, it would be in favor of the
regulator to produce a coalition that includes
members of the loser group.
Slide 21
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Main results ( cont)
z
z
It is expected to observe regulation in industries that are in
perfect competition (agriculture) or monopoly (electricity) but
not in intermediate industries between those two points
(automobiles). This hypothesis seems to be confirmed by
empirical evidences.
As the legislator/regulator takes into account the opposition
offered by the losers, he will regulate up to the point where
the obtained marginal support equals the marginal
opposition. This means that the regulation will not stop
neither at the point ‘X” nor at the point ‘Y’, but somewhere
in between ( slide 19 ).
Slide 22
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Criticisms
z
z
z
Despite the great appeal of the ‘capture’ theory, which
prevails until today, it is possible to identify, especially in the
80s the US, new regulatory trends which could not be
explained by this theory (such as social and environmental
regulation) as well as a simultaneous tendency for
deregulation (the most visible on commercial aviation).
The challenger provided by the environmental and social
regulation is that they tend to benefit big and diffuse groups.
Exactly the opposite of what is predicted by the theory.
The new tendency of deregulation also seems to contradicts
the basic conclusion of the theory of regulation. Although
several attempts to reconcile with these new evolutions, this
is still an opened question.
Slide 23
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Criticisms ( cont.)
z The theory of capture looks basically to the
demand side of regulation. That is, the theory
assumes that the regulator/legislator/president is
either the same person (player) or that the latter
perfectly controls the former.
z In other words, it is not taken into account the
existence of a principal-agent problem between
legislator and regulator.
z In actual life, however, there exist a strong
problem of asymmetric information
Slide 24
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Becker model
{
Becker created what he calls as “influence functions” to
demonstrate how pressures by interest-groups affect the taxes paid
and the subsidies received.
{
Competition among groups for political influence determines the
equilibrium structure of taxes, subsidies, and other political favors.
{
Regulation ( broad sense ) is used to increase the welfare of more
influential interest groups
{
Political equilibrium has the property that all groups maximize their
income
Slide 25
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Assumptions
z
z
z
z
z
Taxes, subsidies, regulation etc. are used to increase the
welfare of the most influential pressure groups. Groups
compete to access political resources.
The utility function of each person can be measured by his
full income, which includes leisure and other extra market
activities
Pressure depends on the number of members and the
resources used
Two homogeneous groups in the society “1” and “2”.
All political activities that raise the income of a group will
be considered a subsidy to that group; and all activities
that lower incomes will be considered a tax
Slide 26
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Model
z
z
z
z
I1(p1,p2 ) is the the influence function of group 1: it is
assumed that the function is increasing in the pressure of
group 1 and decresing in the pressure of group 2.
I2(p1,p2 ) is the the influence function of group 2: it is
assumed that the function is increasing in the pressure of
group 2 and decreasing in the pressure of group 1.
In order to transfer wealth , T, from group 2 to group 1 it is
assumed that 2´s wealth must be reduced by (1+x)T, where
x>0. The amount xT is the wefare loss from regulation
The aggregate influence is fixed , so what is important for
determining regulation ( revenu transfer between groups ) is
the influence of one group relative to the influence of another
goup.
Slide 27
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Model ( cont.)
Taking into account the benefits and costs of pressure one
can derive the optimal strategy of group 1, p1, given any value
of p2.
z I1 is the group´s 1 best response function; I2 is the group´s 2
best response function. They are plotted in slide 29 and e0 is
the political equilibrium
z If the group i =1,2 became more efficient the influence
function shifted left and upward
z If the group i =1,2 became less efficient the influence function
shifted right and downward
The logic behind this result is the same as for Cournot outcome
in the duopoly setting
z
Slide 28
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Influence curves of 1 and 2
Pressure by 2
I1(p2)
e0
I1(p1)
Pressure by 1
Slide 29
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
The group that become more efficient producing
political influence will be able to reduce its tax and
increase subsidies;
z
{
If both groups become more efficient pressuring, the
relative influence of each will not change much
Increase in costs of regulation increases the
influence of activity of firm 2 and reduces it for
consumer 1.
z
This is because a given wealth transfer to 2 from 1 is
more costly to firm 2 ( increased incentive to pay to avoid
it ) and is more costly to acquire for consumer 1 ( less
incentive to pay to get it.
Slide 30
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
I1(p2)
p´2
I2(p1)
I1(p2)
Pressure by 2
p02
I2(p1)
p´´2
p´´1
p01
p´1
Pressure by 1
Slide 31
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
{
Conclusions of private interest theories:
Tendency for regulation to be designed to benefit relatively
small groups with strong preferences relative to big groups
with weak preferences
z Pro-producer tendencies are disciplined by consumer groups
meaning that price is less than the monopoly level
z Regulation most likely in competitive or monopoly industries
as there is strong incentive for one group to lobby for
regulation
z In the presence of market failure regulation is likely because
of the large losses this inflicts on some interest groups
Private interest theories, in contrast to Public Interest Theories,
do not state that the regulation should only occur when there are
market failures.
z
{
Slide 32