Economics Workshop
Better Regulation Executive
2006
Sandeep Kapur
s.kapur@bbk.ac.uk
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
various 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
Objectives: Day 2
To
• review the standard rationale for regulation
• the basics of regulatory impact assessment
• 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)
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*
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
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
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 technological 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. If so, the net effect may be to
replace market failure with government failure
Well-intentioned regulation may
• end up being ineffective
• have perverse, unintended consequences
• persist beyond its purpose
• be vulnerable to regulatory creep, with high cumulative
burden
The scope for successful regulatory intervention is limited by
• informational constraints
• agency problems
• lack of correction
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?