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Performance Measurement, Regulation and UK Productivity

A Multidisciplinary Overview of

Unintended and Indirect Effects

Ideas factory Presentation, 10 July 2006

Gerben Bakker, Stavroula Iliopoulou, Joseph Antony, Vlado Balaz, Anjula Gurtoo, Rosalind Rae, Kim Tan,

Kathryn Walsh, and Alan Williams

Essex-Leeds-Nottingham-Loughborough-Exeter

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Structure

1. Focus

2. Key characteristics

3. Background

4. Theoretical perspectives

5. Potential outputs

6. The future

7. Conclusion

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Focus:

• Regulation and performance measurement– Indirect, unforeseen and unintended effects– On UK productivity– Comparison with other countries

• Overview of literature• Overview of existing seminal cases• Detailed examination of a few cases in detail

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Key characteristics:

• Multidisciplinary

• Emphasis on the practical

• Specific cases as focal points

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Why is this research worthwhile?

• Regulation and performance measurement critical for understanding productivity performance

• At present literature is compartmentalised by discipline

• Collaborative, blue skies research– In the spirit of the Ideas Factory

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Background:

• Low-budget £50,000 multidisciplinary scoping study

• 5 investigators, each in a different discipline (pro bono)

• 5 Research Officers

• Experimental character (content as well as process)

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Structure of project:

• Two wide literature and conceptual studies– Economic and business literature on indirect effects of

regulation– Literature on indirect effects of performance

measurement (and potential relation to regulation)

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Structure of project:

• Three case-studies, each across a different empirical dimension– A specific type of regulation (environmental)– A specific industry (engineering)– A specific regulatory event (air line deregulation)

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Theories on regulation

• Normative analysis as a positive theory (NAPT)• Capture theory (CT)• The economic theory of regulation (ET)

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Normative analysis as a positive theory

• Market failure– Natural monopoly– Externalities

• Problems– Assumes market failure rather than test it– No evidence, or contrary evidence– Limited effect of regulation on monopoly pricing

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Capture theory (CT)

• Industry captures the regulatory process so that regulation favours the existing industry

• Problems:– Assumes capture rather than test it– Contrary evidence

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The economic theory of regulation (ET)

• Regulation as the outcome of competition between interest groups that all want to maximise their income

• Two major models/approaches:– Stigler/Peltzman model: regulator maximises political

support– Becker model: the relative effects of competing

interest groups

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The economic theory of regulation (ET)

• Benefits small groups with strong preferences• Regulatory outcomes are generally not profit-maximising

because of the constraining effects of consumer groups• Regulation most likely in:

– Competitive industries– Monopolistic industries

• Market failure makes regulation more likely

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Effects of regulation and the role of time

• Immediate (=direct) effects:– Static efficiency

• Allocative• Productive

• Long-run (=indirect) effects:– Dynamic efficiency

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Regulation potentially competitive markets

• Competitive model– First-best effects– Second-best effects

• Imperfectly competitive model

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Direct effects: the competitive model

• First-best effects:– Welfare loss per definition

• (price different from marginal cost)• Minimum efficient scale of firms

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Direct effects: the competitive model

• First-best effects (continued):– Effect 1: classic deadweight consumer loss– Effect 2: inefficient market structure

• Average costs per firm higher– Entry prohibition limits welfare loss– Reduction no. of firms may reduce it further

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Direct effects: the competitive model

• Second-best effects:– Theory of second-best

• Spread of regulation does not reduce welfare necessarily

• Unregulated firms can undercut regulated ones– E.g. trucks vs. railroads

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Direct effects: imperfectly competitive model

• Firms restrict supply to keep price > marginal costs• Regulation to reduce price may increase welfare• Free entry can lead to too much firms (inefficiency)

– Effects of entry/exit regulation unclear• Practical problem:

– Difficult to know right costs and prices (information; asymmetry)

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Indirect effects: price and entry regulation

• P > MC, entry prohibited

• Effect 1: excessive non-price competition– Quality (e.g. warranty, advertising, characteristics,

R&SD, service)– Dependent on:

• Available technology for differentiating products• Ease of collusion

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Indirect effects: price and entry regulation

• Effect 2: productive inefficiency:– Workers extract rents K/L higher than optimal

(substitution)– Inefficient firms are not replaced by entrants

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Indirect effects: price and exit regulation

• p < MC; exit prohibited• Effect 1: cross-subsidization

– E.g. telephone, post, airlines• Effect 2: reduced capital formation

– Higher r because of higher risk

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Dynamic effects

• The effects so far were in a static situation• Dynamic (long-run) effects can be considered indirect

per definition• They mainly concern the incentive to invest in

R&D/innovations

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Dynamic effects

• Regulation entry innovation Price p > MC too much R&D

p < MC too little R&D

non-price competition R&D, adv.

Regulatory lagsInnovation But staged (slower) adoption of innovations

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Dynamic effects

• Effect of regulation on productivity growth can be substantial:

– In US 12 – 21 percent of productivity slowdown during 1973-1977 can be attributed to regulation effects

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Methods for estimating effects of regulation:

• Intertemporal

• Intermarket

• Counterfactual

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Ref. Change details (case) Indirect Effects Unforeseen Effects

Unintended Effects

Becker & Henderson (2000)

Air Quality Regulation (US)•Stringency of equipment specifications to limit emissions from the production process

•Increase in equipment costs in nonattainment and big attainment areas

Shift in generation of New plans generated to attainment areas only

•Shift in industrial structure toward less regulated, single-plant firms, •Environmental degradation

Berman and Bui (2001)

Oil refineries of the LA Air Basin (US)•Regulation force expensive abatement activity

•Productivity enhances abatement in LA (despite costs)

Plants outside the local regulatory region may optimally choose to defer even an investment with high E(R)

•Overestimation of economic costs of environmental reg due to direct effect

Kane (1977)

Alcohol Prohibition Act & Financial Market Controls (US)

Certain political power/cost driven by voting power and associated costs

Affected effects will always seek for loopholes in regulation

•Conspiracy in rule-setting•Virtually every reg generates such effects

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Ref. Change details (case) Indirect Effects Unforeseen Effects

Unintended Effects

Caves (1964)

Theoretical Arguments

The net impact of direct regulation often differs considerably from what the regulators say that they are doing (due to Indirect & Unintended effects, which may have more economic significance than the desired direct ones)

Christainsen & Haveman (1981)

Manufacturing Sector (US)

Adoption of New pollution control equipment

Manpower required to handle new equipment, employment levels rise but NOT marketable output

Complying with reg requires info gathering, admin, legal activities that require inputs yielding no saleable output

Meeting the requirements needs time, causing delay in expansion & modernisation plans, and stretching-out of construction periods

OECD (2000)

Theoretical arguments

Proposed reforms in UK

1. Competition: Increased benefits may come at a cost

1. Risk of inconsistent application of law across industries

1. Masking of growing income inequality

2. Firms may face higher non-wage costs

1. Overinvestment

OR disincentives to grow

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Potential outputs:

• Each investigator/RA team is working on a working paper/journal article on their component

5 original papers covering the different aspects/disciplines

• At Essex we are also working on a paper on corporate governance regulation and indirect productivity effects

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Potential outputs:

• We are working on a joint project literature review for the initiative of Uwe/Ideas factory

• Possibly we will develop one other common working paper, report or edited volume

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The future

• Project still on-going (3 out of 5 RAs still working)– End date: 27 December 2006

• Next few months, as we are finishing the individual components, we will explore how the follow-up project should look like– Content– Structure/process

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The future

• Potential link to new institutions– Allan moves to senior position in two new research

centres at LMU– Gerben moves to LSE and will explore links with the

Centre for the Assessment of Risk and Regulation (CARR)

– Stavroula moves to Royal Holloway

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Conclusion:

• Substantial progress made so far

• Project has aimed to maximise the benefits from multidisciplinary background investigators

• Several potential original contributions made within and across the constituent disciplines

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Conclusion:

• Positive outlook for the future

– Given progress made so far

– New institutional dimensions/inputs

– Reinforcement link to regulation research elsewhere

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Performance Measurement, Regulation and UK Productivity

A Multidisciplinary Overview of

Unintended and Indirect Effects

Ideas factory Presentation, 10 July 2006

Gerben Bakker, Stavroula Iliopoulou, Joseph Antony, Vlado Balaz, Anjula Gurtoo, Rosalind Rae, Kim Tan,

Kathryn Walsh, and Alan Williams

Essex-Leeds-Nottingham-Loughborough-Exeter