Understanding Regulation

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					   Research Review Seminar - I

Understanding Regulation

                   Jogendra Behera
                       Dec 12, 2007
What is a Market
   "A market is a social arrangement that allows
    buyers and sellers to discover information and carry
    out a voluntary exchange of goods or services.

   An arrangement wherein buyers and sellers can
    exchange resources, goods, and services. A market
    may be a physical place such as a store or an
    auction gallery, or it may occur through other
    arrangements such as a telephone and Internet
    transactions; a market is said to exist whenever or
    wherever a buyer and seller enter into an
   Is “a situation in a market in which firms or sellers independently
    strive for the buyers’ patronage in order to achieve a particular
    business objective for example, profits, sales or market share”
    (World Bank, 1999)

    A market in which rival sellers are trying to gain extra business
     at one another's expense and thus are forced both to be as
     efficient as possible and to hold their prices down as much as
     possible. Competition is thus a sophisticated yet uncoordinated
     mechanism that sorts out the actions of millions of buyers and
     sellers and uses the resulting pattern of supply and demand to
     determine what shall be produced, in what quantities, and at
     what price.
    Adam Smith stated in 1776, “ …while he intends only his own
     gain…he is …led by an invisible hand to promote an end
     which was no part of his intention…” – that is to maximize the
     wealth of the nation

    The competitive market guides and controls the self seeking
     activities of each individual to maximize the wealth of the

     “Our mission is to deliver a competitive framework for the
     growth of successful businesses and a fair deal for
     consumers. We want to help consumers and businesses
     enjoy more choice, better service, safer products and
     competitive prices.”
    Adam Smith, The Wealth of Nations (1776),
    (References from other sources)

   The competition in the market will:
       Promote efficiency – ensure best possible utilization
        of resources (productive and allocative efficiency)
       Encourage Innovation
       Ensure abundant availability of goods and services of
        acceptable quality at affordable price
       Offer wide choice to consumers

    Inference from general readings – Kahn, CRC articles, Wikipedia,
    Internet articles etc.)
Different views of
   Behavioral Approach
       It emerged during the classical period of economics
       Competition was considered to be a process of rivalry
        between participants in the market
       The participants would compete by changing prices in
        response to market conditions, thereby eliminating
        excessive profits and unsatisfied demand.

   Structural Approach
       The neo-classical approach generated the view that a
        market could be defined as competitive when there was a
        significantly large number of sellers of homogenous
       so that no sellers had enough of a market share to enable
        them to influence the product price by changing the
        quantity that they put into the market.
    Different views of
   Structural Approach
       The structural approach has survived as the
        standard model for analysis – profound influence on
        policy making
       Emphasis on market structure  structure, conduct,
        performance approach (SCP approach) towards the
        competition policy

    (Competition, regulation and regulatory governance: an overview – Cook,
    Kirkpatrick, Minogue, Parker, 2004
    SCP, NIEO and Beyond – Cassey Lee, 2007)
Economic Policy/Reforms
   There is a long history of competition and regulation
    in developed country
       Canada enacted its first Competition Law in 1889.
       In the 1890s, many of the states of USA enacted
        Competition Laws. The Federal Government of USA
        enacted the (Sherman Anti-trust Act [1890]), Clayton Act
        (1914) and Fair Trade Commission Act (1914).
       In the 1980s, under the Government of Margaret Thatcher,
        most state-owned enterprises in the industrial and service
        sectors, which since the 1940s had been nationalised, were

   Cycle of regulation and deregulation
       In U.S market with limited regulation prior to 1930; Industry
        wide regulation after Great Depression – 1930 - 1970;
        Deregulation after 1970 after the onset of Stagflation
    Economic Policy/Reforms
   In the past most developing countries were
    characterized by significant government involvement
    in their economies marked by dominance of large
    state owned enterprises.

   Economic reforms were undertaken such as trade
    liberalization, opening up of economy, promoting FDI,
    and facilitating private sector participation.

   The poor performance of State Owned Enterprises
    and consequent pressure on budgets forced
    governments to reduce support to SOEs and move
    towards privatizing them or restructuring them.
Shift in Public Policy

   The thrust of economic reforms has
    been to allow for more competition.
   The underlying rationale is that
    competitive markets ensure efficiency
    resulting in best choice of quality,
    lowest prices and adequate supplies to
    (References – General Readings – Competition and
    Regulation reports of CUTS)
Shift in Public Policy
   “…The shift in the public policy over the last two
    decades away from state ownership and state
    responsibility for the provision of services, to private
    ownership and private provision with enhanced
    state regulation is sometimes described as the rise
    of regulatory state…” (Majone, 1997)

   Alternatively it has been referred to in terms of the
    invisible hand of the market being supplemented by
    the visible hand of the regulators (Jackson and
    Price, 1994) In this regime the state ceases to be
    directly concerned with the provision of goods and
    services and instead concentrates on regulating
    private markets to promote economic and social
    (References – from other sources; Competition, regulation and regulatory
    governance: an overview – Cook, Kirkpatrick, Minogue, Parker, 2004 )
Market Failures

   Significant Externalities
   Nature of Goods – Public goods, merit or
    demerit goods
   Information asymmetry
   Incomplete market
   Monopoly
   Inequality
    (Economic Regulation – A Preliminary literature review and summary
    of research questions – Parker)
   The possibility of market failure underpin the
    economic rationale for state regulation of market
   Regulations can take different forms with different
       Health, safety regulations and environmental regulations
        can be rationalized on the basis of imperfect information
        and externalities
       Economic regulation of public utilities can be explained by
        economies of scale and scope and need to protect the
        consumers from monopoly exploitation
       Aspects of fiscal policy can be rationalized on the basis in
        terms of wealth and income redistribution
       Regulatory intervention for universal service obligations
   Regulation cannot be limited to economic issues –
    means to ultimately achieve non-economic ends
   Intentions and outcomes are therefore defined by a
    combination of economic, social, political and
    bureaucratic factors and cannot be attributed to one
    set of factors alone
   Involvement of disciplines other than economics
    (law, political science, sociology etc.)
   Broad definition – “ the use of public authority to set
    and apply rules and standards” (Hood et al, 1999)
    (Economic Regulation – A Preliminary literature review and summary of
    research questions – Parker)
   As an effort by the state “to address social risk,
    market failure or equity concerns through rule
    based direction of individual and society” (Planning
    Commission consultation paper on Regulation)
   Regulation is a complex balancing act between advancing the
    interests of consumers, competitors and investors, while
    promoting a wider, „public interest‟ agenda.
       minimum prices to benefit the consumer (maximize consumer
       ensure adequate profits are earned to finance the proper
        investment needs of the industry (earn at least a normal rate of
        return on capital employed);
       provide an environment conducive for new firms to enter the
        industry and expand competition (police anti-competitive
        behavior by the dominant supplier);
       preserve or improve the quality of service (ensure higher
        profitability is not achieved by cutting services to reduce costs);
       identify those parts of the business which are naturally
        monopolistic (statutory monopolies that are not necessarily
        justified in terms of either economies of scale or scope);
       take into consideration social and environmental issues (e.g.
        when removing cross subsidization of services).
    (Minogue, 2000)
    Brief History
   Origin in progressive era of U.S economy

   Early scholarly contributions that evaluated the new regulatory institutions and
    political economy of the American regulatory state (Cushman 1941; Bernstein
    1955; Mitnick 1980).

   Next chapter in regulatory studies opened in the 1960s and 1970s, when the USA
    and other developed nations experienced a burst of new forms of consumer, civil
    rights, health and safety, and environmental regulation, and with these changes
    came renewed interest in regulation (Wilson 1980; Bardach & Kagan 1982).

   More recently, there has been a move away from treating the USA as the main
    arena for regulatory studies, especially as the European Union has become an
    important trendsetter in both risk regulation and regulation for competition (Majone
    1994, 1997; Moran 2003; Vogel 2003).

   An important strand of regulatory studies emerged out of corporate crime
    research. Especially after the Watergate scandal in the early 1970s, this field has
    attracted many of the brightest and best postwar criminologists. Later on these
    experts got interested in regulation. Many criminologists studying regulation, in
    turn, became engaged in sociology.
Brief History
   Initially the regulation study was based upon Law
    and Sociology and later on the importance was
    given to Law and economics
   Regulation had long been an important topic in
    mainstream economics. Nobel Prizes were won for
    work on regulation, including a cluster awarded to
    economists from the University of Chicago who
    were critics of certain kinds of regulation.
   The spread of privatization around the world has
    created the renewed interest in regulation
Natural Monopoly &
Economic Regulation

   Natural Monopoly
       Multiple firms providing a good or service is less
        efficient (more costly to a nation or economy)
        than would be the case if a single firm provided
        a good or service.
       industries where fixed costs predominate,
        creating economies of scale which are large in
        relation to the size of the market
       Examples – Electricity, telecommunications,
        Railways, Water Services etc.
Natural Monopoly &
Economic Regulation
   In case of other sectors (other than natural
    monopolies) – Regulation operate
    essentially at the periphery of the markets

   The role of regulation is generally conceived
    as one of the maintaining the institution
    within whose framework the free market can
    continue to function, of enforcing,
    supplementing and removing the
    imperfections of competition
    Natural Monopoly &
    Economic Regulation
   In the case of Natural Monopoly the essence of regulation is the
    explicit replacement of competition with governmental orders with
    principal institutional device for assuring good performance.

   In the case of natural monopoly the primary guarantor of
    acceptable performance is conceived to be not competition or self
    restraint but direct governmental prescription of major aspects of
    their structure and economic

   There are four principal components of this regulation that in
    combination distinguish the public utility from other sectors of the
    economy: control of entry, price fixing, prescription of quality and
    conditions of service, and an imposition of an obligation to serve
    all applicants under reasonable conditions.
    (The principles of economic regulation, A.E.Kahn)
    Traditional way of regulating
    public utilities
   Firms can be regulated in terms of their profits
    or prices, as well as their quality of service.
    The three general forms of regulatory
    instruments are:
       Cost of Service Regulations
           Regulator agreeing the level of operating costs and the
            capital costs
           Added a profit or agreed rate of return based upon firm‟s
            cost of capital on the asset base
           This method is associated with cost padding up and over
            investment (Averch and Jhonson, 1962, A-J-W effect)
Traditional way of regulating
public utilities
   Price Cap Regulations
       Profits are not determined by regulator but are a residual
       Regulator agrees the forecast operating and capital costs
        and applies a efficiency gain factor X – benchmarked with
        other firms
       Price cap – CPI +/- X – Incentive to the firm to outperform
        in terms of reducing costs or attracting customers, leading
        to higher profit
   Sliding Scale Regulations
       Combination of the price cap and cost of service regime
       Price cap operate upto a given level of reported profit
       Beyond that, the prices are reduced to consumers thus
        sharing the efficiency gains with consumers
    (Competition, regulation and regulatory governance – Cook et al.)
Competition Policy &
Sectoral Regulation
   Competition policy is essentially understood to refer
    to those governmental measures that directly affect
    the behavior of firms and the structure of the
    industry -- “those government measures that
    directly affect behavior of enterprises and structure
    of industry.” (Khemani and Mark Dutz 1996)

       Economic policies adopted by Government, that enhance
        competition in local and national markets (such as, policy
        of economic de-regulation and privatization etc.); and
       Competition law designed to stop anti-competitive
        business practices by
Competition Policy &
Sectoral Regulation

   Competition Authority – A separate agency
    to implement the competition law
    (Competition Commission of India in the
    case of India)
   Sectoral Regulations – This is in addition to
    the Competition authority – in the sectors
    where there is a natural monopoly
   “In market regulator” vis- a – vis “off market
         Competition Policy &
         Sectoral Regulation
   Competition Authority                      Sectoral Regulation
         Off market regulator                     In market regulator
         Prevents market failure                  Sets rule of the game –
          through law enforcement                   entry condition, technical
         Three basic elements of a                 details, tariff, safety
          modern competition law –                  standards, access etc.
          anti-competitive agreements,             Direct control –
          abuse of dominant position                price/quantity/quality
          and combinations
         Applies competition law
          across all sectors
        Issue of overlapping and conflict between Competition Authority &
        Sectoral Regulators
Regulation in Developing
   Lack of regulatory commitment: political expediency and
    the limits of independence
       Political expediency can undermine regulatory independence
   Lack of transparency, participation, and accountability
   Institutional fragility
       Challenge in developing new public institutions in developing
   Regulatory substance compromised: lack of capacity and
       Quality, credibility and impact of regulatory decisions
       Lack of specialized skills in utility regulation
   Regulatory contracts also under stress
       Obsolescence of long term contracts is frequent
    (Infrastructure Regulation in Developing Countries – Anton Eberhard, PPIAF)
Efficiency and Effectiveness
of Regulation
   Regulatory Costs
       Direct Costs
           Budget of regulatory departments
       Indirect Cost/Compliance Cost
           Imposed on remainder of the economy in terms of complying
            with the regulations
           Usually hidden from the view Efficiency of Regulation –
            Administrative and compliance cots of regulation should be
            compared to the benefit accruing from the regulation
   Regulatory Impact Assessment (RIA) –
    Systematically assessing the benefits and costs of a
    new or existing regulation
    (Kirkpatrick & Parker, 2002)
Efficiency and Effectiveness
of Regulation
   Five principles to determine the relevance and
    effectiveness of regulations (Haskins, 2000)
Different levels of regulation
   Schema for assessing different regulatory and governance structures
    (Parker, 1999)
Some examples – Role of
Thank You