Regulation
1. General
2. Second Best
3. Industry Capture
Traditional View
• Departures from marginal cost. all about
It’s
• Key idea is that MC = MB QUANTITY!
• Mathematically:
Benefits = W(Q) = Willingness to pay for Q.
Costs = C(Q) = Cost of producing Q.
• Maximize U = (Benefits - Costs):
U = W(Q) - C(Q)
dU/dQ = W - C = 0
Mgl WTP = Mgl Cost
Departures
• If the price of a good
equals someone's
willingness to pay, then if MR Demand
we price at marginal cost, P
then we should move to
an optimum.
• All of us are aware of the MC
standard monopoly model
that shows departure
from optimum.
• We have the WRONG
quantity
Q
Although you have excess
profit, the welfare loss has
Departuresto do with the wrong
QUANTITY
• This is a fairly standard
diagram. The efficient A
choice of production is at P1 MR Demand
point C. P
Because the firm has
monopoly power, it C
produces output Q1 and MC
sells for price P1.
At this point, the
willingness to pay is P1 >
MC.
If we could get the
producer to increase Q1
production, well-being Q
would be improved.
Departures
In this type of situation, regulator
could come in, and force A
monopolist to price at P2 rather P1 MR Demand
than P1. P D
This makes for a horizontal MR P2
curve up to where it intercepts
the demand curve. Monopolist pink MC
will produce at D, rather than at
A, and will reduce welfare loss
triangle from gold to pink.
Key feature here is the sense of
knowing what the marginal cost
is. There are some fairly tricky
information problems here as Q1 Q
well.
Second Best
• One of the arguments against
regulation has to do with so-
Demand
called "second best
MSC
considerations." Says that if MR
you have more than one P
imperfection, moving toward
MC, MAY not improve
welfare. Here's an example. MC
• Suppose we have a
monopolist who is also a
polluter. The pollution
imposes social costs on
society, although the
monopolist does not see them.
Q
• We get a diagram that shows
the problems
Second Best
• Suppose that the monopolist Demand
faces constant marginal MSC
PMON MR
production cost, but that the
more he produces, the P
incremental amount of pollution
increases.
• The monopolist does not face MC
these costs, but society does. We
can calculate the amount of
output, and the implied amount
of pollution that the monopolist
comes up with.
QMKT
•Now, suppose the regulator comes in and, QMON QOPT
•again, imposes marginal cost pricing. Q
Second Best
Demand
• This increases both the amount MSC
of output and the amount of PMON MR
pollution. P
?
MC
• The general sense of the theory
of the second best, then, is that
when there are many
imperfections, addressing one of
them does not necessarily
improve well-being.
QMON QOPT QMKT
Q
Industry Capture
• Are the regulators beneficent?
• What if the industry “captures” the
regulatory process?
• There are lots of trade associations; for
example, American Medical Association,
American Hospital Association.
Peltzman on Regulation - Capture
Starting premise: Regulatory process constitutes a
transfer of wealth. Treats the process as if taxing
power rests on direct voting.
Regulator seeks “votes”, in particular a majority, M.
(1) M = nf - (N - n) h
n = # of potential voters in beneficiary groupget
Seek to
majority
f = probability that beneficiary will grant support
N = total number of potential voters n/N.
h = probability that (non-n) opposes
(1) M = nf - (N - n) h Seek to get
majority
Peltzman on Regulation (2)
n/N.
(2) f = f (g)
g = per capita net benefit
(3) g = [T - K - C(n)]/n
T = total transferred to beneficiary group
K = $ spent by beneficiaries to mitigate opposition
C(n) = cost of organizing direct support of beneficiaries
and efforts to mitigate opposition
T = transfer
K = $ to mitigate opp.
z = K/(N – n)
Seek to get
majority
Peltzman on Regulation (3)
n/N.
Assume that K and T are chosen. What is optimal tax rate t?
T is raised by taxing the “others.”
(4) T = t B(t) (N - n) t = T/[B(t) (N - n)]
B = wealth
Opposition is generated by tax rate, and mitigated by
education expenditures per capita z, so:
(5) h = h (t, z)
(6) z = K/(N - n)
(7) fg > 0; fgg 0 K = $ to mitigate opp.
(9) ht > 0; htt a
Denominator falls, you’re subtracting a larger number
and (n/N)
So, there is an optimal fraction, and it is less than 1.
As n/N , there is a bigger majority, BUT less to tax, and
more opposition if you raise the tax.
Peltzman on Regulation (7)
M/T = f - ht [1/(B+tBt)] = 0 (11)
Let’s rearrange:
f (B+tBt) = ht (11)
[Mgl [Mgl prod. = [Mgl opp.
in prob. raising from
of revenues taxes]
support] from losers] T = transfer
K = $ to mitigate opp.
z = K/(N – n)
Peltzman on Regulation (7)
(B+tBt) ht /f
(B+tBt) = Rt = ht /f
$ or R
If you tax to maximize
revenue (tmax), you compromise
your majority by mobilizing
opposition.
T = transfer tmax
K = $ to mitigate opp.
ta
z = K/(N – n) tax rate t