Economics Workshop

 Better Regulation Executive

Sandeep Kapur

2006

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 EconomicsSome 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 ECONOMYoutcome determined by private transactions in markets, based on prices, incomes, wealth

Degree of government intervention differs..

Hong Kong- China - Denmark - UK - USA -Cuba

Most countries have mixed economies with both• markets, which are regulated to different extent• public production and provision

Scale of government

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

Spending as share of national income (%)

The policy question

Markets are generally considered to be efficientIf 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 WorkDemand, Supply, and Price Adjustment

Market

• MARKET any arrangement in which prices adjust to reconcile buyers and sellers intentions

• DEMANDquantity buyers wish to buy at each price

• SUPPLYquantity producers wish to sell at each price

• EQUILIBRIUM PRICEthe price at which market clears(i.e. quantity demanded = quantity supplied)

Price Adjustment

Demand curve

quantity

price

EquilibriumQuantity

EquilibriumPrice

PRICE ADJUSTMENT

Equilibrium price clears market

Supply curve

Price Controls

Price

Quantity

Demand curve

Supply curve

Equilibrium price

excesssupply

Suppose government sets minimum price above market clearing price

Controlled price

Examples include• Minimum wages• Rent control• Common Agricultural Policy

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 tax2. Taxation of petrol3. Regulating gas prices

…Group Work

4. Regulating discharge of sewage in the Thames 5. Legislation against insider trading 6. Banning the use of cocaine 7. Making primary school compulsory 8. Regulating financial advisors9. Regulating length of the working week10. Compelling citizens to carry identity cards11. Minimum wage legislation12. 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

For social optimum, we wantmarginal social cost = marginal social benefitAt free market equilibrium E, output Q is higher than social

optimum Q*

Quantity

Demand

MPC

MSC

E

FG

QQ*

Correcting externalities

1. Quantitative regulation or direct government action: e.g. pollution quota

2. [Pigou] Taxes or subsidies to correct prices e.g. pollution tax

3. [Coase] Create markets: assign property rights and enable trade in pseudo-marketse.g. carbon trading

Coasean Solution

• 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 Quantity

MC (for you)

QQ*

MB (to me)

Efficient quantity is Q*

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 non-price controlsPractical 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

No nukes Nukes

No nukes 8, 8 1, 12

Nukes 12, 1 2, 2

SOLUTION: coordinate individual choices through agreements or regulation

Country 1

Country 2

Individual choices do not always result in the best collective outcomes

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 analysisIf benefits are hard to quantify, compare costs of achieving

some target level of benefits

THE PROCESS

1. Justify action and set objectives2. Identify all options

incl ‘do minimum’ and politically infeasible ones3. Identify costs and benefits of each option, including non-

market costs or benefits4. Other considerations

a) risk and optimismb) distributional impact

5. Choose the best option6. Develop and implement solutions7. 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

1985 1986 1987 1988 1989 1990

Children's health 223 600 547 502 453 414Adult blood pressure 1724 5897 5675 5447 5187 4966Other pollutants 0 222 222 224 226 230Maintenance 102 914 859 818 788 767Fuel economy 35 187 170 113 134 139Total benefits 2084 7821 7474 7105 6788 6517-Refining costs -96 -608 -558 -532 -504 -471Net Benefits 1988 7213 6916 6573 6284 6045

Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars

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 mnLow 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. Taxation of cigarettes2. Legislation to keep pubs smoke free3. Regulating taxi fares and quality4. Regulating price of calling mobile phones from

fixed line phones5. Regulating the introduction of new drugs6. 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 designSteps 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: Euro-

sclerosis• 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 fast-

changing 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 labour-

flexibility 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 decision-making 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