Regulation and Deregulation

Brahim Guizani

Unit 8.

Learning Objectives

What are the economic rationale for regulation of sectors such as electricity,

telecommunications, and airlines?

What motivated the recent the recent deregulations

Regulation is broadly defined to be government intervention to change market outcomes.

The intervention can directly affect market outcomes, such as prices, quality, product variety,

or the number of service providers, by changing

market institutions.

For instance, banks/insurance companies are not free to set some of their own commissions

(prices), and are not free to enter the market

without satisfying some requirements.

The Rationale for Economic Regulation

There are two explanations for the existence of regulation:

The public interest explanation is that regulation is a response to market failure.

The Economic explanations or theories of regulation are based on the premise that there is a demand for regulation from groups who could benefit from the redistribution of income and wealth resulting from regulation and that the political process provides incentives for governments and politicians to supply regulation.

Public Interest Justifications for Regulatory

Intervention

Public interest justifications are often termed normative since they are all based on the

premise that intervention is justified because it

leads to an improvement in social welfare.

Regulation in this view is a legitimate response to market failure: Markets fail when the

market outcome is inefficient.

Sometimes when markets are left to themselves, total surplus is not maximized.

The characteristics of an efficient outcome

1. Allocative efficiency: results when an efficient level of

output is produced. It is measured by total surplus. The

maximum is achieved at the point where marginal cost

equals willingness to pay (Perfect competition

equilibrium). Failure to achieve allocative efficiency is

usually due to either market power or externalities.

2. Rationing efficiency: it occurs when a (fixed) level of

output is distributed to those with the greatest

willingness to pay.

3. Cost efficiency: output is produced at minimum

opportunity cost.

4. Efficient product selection: refers both to the number

and location of differentiated products. Efficient

location of differentiated products refers to the correct

set of products. For a fixed number of products, the set

is efficient if it provides the best match between

consumers preferences and product availability.

5. Efficient cost reduction occurs when the marginal cost

and marginal benefits of investments in cost reduction

are equal.

The usual market failure suspect that justify

price and entry regulation is:

Natural monopoly.

Natural Monopoly

Natural Monopoly

In natural monopolies one firm can serve the market more efficiently than more than one firm.

DD is the market demand curve. It is clear that in such a market, competition will not be sustainable, even if the market initially has many firms. Price taking would result in negative profits, since for all levels of output AC(Q) > P = MC(Q).

Moreover, each firm has an incentive to expand production since MC is declining. The industry would be characterized by a period of consolidation and rationalization involving exit and merger until the remaining firms had enough market power to raise price at least up to average cost.

Natural Monopoly and Regulation

If at the relevant levels of market demand, production costs are minimized when there is a single firm, there is some justification to regulate with price and entry controls. Restricting entry keeps competitors out of the industry, providing for the possibility that industry costs will be minimized. If the industry is a natural monopoly, entry by more than one firm will be inefficient. The imposition of entry controls needs to be complemented with the addition of price controls since the imposition of entry controls creates a monopoly. Price regulation is required to avoid the allocative inefficiency associated with monopoly pricing.

Natural monopoly creates a rationale for regulation

The Economic Theories of Regulation

Fundamental to economic explanations for the existence of regulation is the assumption that all economic actors are self-interested utility maximizers.

The seminal contribution is Stigler (1971). The political process provides incentives for the

government to supply regulation. Politicians are willing to supply regulation in return for help in attaining and maintaining political power. In return for using regulation to restrict competition and deter entry, firms provide politicians and political parties with what they need to win elections: money and votes.

Stigler observed that this process workseven though it leads to an inefficient allocation of resourcesbecause the benefits are concentrated and significant, but the costs are small and their distribution diffuse. It is inefficient because the benefits to the few are less than the costs to the many.

Stiglers analysis provides theoretical underpinnings for the notion that regulators are captured by the very firms they are supposed to control. In return for votes, financial resources, or the promise of future employment, regulators use their power to serve the interests of firms.

The following figure shows the distributional and efficiency implications of regulation, which effectively monopolizes a perfectly competitive industry. Regulation in this case raises price from pc to pm and reduces output from Qc to Qm. The firms in the industry gain by the amount m. However, the loss to consumers is this amount, plus the deadweight loss triangle of DWL.

The analysis of Stigler was extended by Posner (1971). Posner observes that regulation is also used by

politicians to redistribute income. Regulatory pricing structures, Posner observes, often involve cross-subsidies. Some groups of customers pay more than the cost of providing them with service in order that other consumer classes can pay less than their cost of service. More generally, regulation is used not only by politicians to win votes by creating and distributing economic rents to firms, but it is also used to gain the support of other groups with influence, including some consumer groups and some factors of production. Traditionally, telecommunications pricing in many countries appears to fit this pattern.

In telecommunications, there are, typically at least five cross-subsidies. One is from long

distance to local; the second is from local

business users to local residential users; the

third is from enhanced or special services to

basic local; the fourth from light users to heavy

users of local service; and the fifth is from low-

cost urban centers to high-cost rural areas.

From Regulation to Deregulation: e.g.

Financial Markets The financial system is among the most heavily

regulated sectors in most countries even though this sector has been increasingly deregulated since the 70s in many developed countries.

Regulatory agencies:

The USA: (1) the Securities and Exchange Commission (SEC), (2) the Commodity Futures Trading Commission (CFTC), (3) the Federal Deposit Insurance Corporation (FDIC) and (4) the Federal Reserve System.

Tunisia: Le Conseil du Marche Financier (CMF) and la Banque Centrale de Tunisie (BCT)

The financial crisis of 2007 2009 made clear the process does not always work well.

The rationale for regulating financial markets:

1. Asymmetric information:

Information is asymmetric if one party that is

involved in the transaction has less information

than other parties. This lack of information

increases the difficulty of making accurate

decisions about the transaction.

Example: a banks depositors are unable to evaluate fully if bank managers are taking too

much risk or even making fraudulent decisions.

Thus in the absence of any kind of regulation of the banking system, depositors would be

reluctant to put any funds into a bank.

A lack of information can also lead to bank panics as happened in the US in 1819, 1837, 1857, 1873,

1884, 1893, 1907, and 1930 1933.

2. Adverse selection and moral hazard:

Adverse selection occurs prior to a transaction and refers to the fact that borrowers most eager to seek out a loan are the potential bad credit risk just as the people most likely to buy health insurance are those who expect to experience health problems. It leads lenders to be more reluctant to make loans even though the lenders know that there are good credit risk as well as bad ones in the market.

Moral hazard occurs after a transaction has taken place. In financial markets, moral hazard is the risk that a borrower, having received the funds, may make decisions that decrease the probability that the loan will be repaid.

In an attempt to mitigate these problems, governments around the world have enacted different forms of regulations in the financial markets such as: government safety net, restrictions on assets holdings, capital requirements, prompt corrective actions, chartering and examination assessment of risk management, disclosure requirements, consumer protection and restrictions on competitions.