Economics Workshop Better Regulation Executive 2006 Sandeep Kapur

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 various 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

Objectives: Day 2 To • review the standard rationale for regulation • the basics of regulatory impact assessment • 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 Economics Some 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 ECONOMY outcome determined by private transactions in markets, based on prices, incomes, wealth

Degree of government intervention differs. . Cuba - China - Denmark - UK - USA - Hong Kong Most countries have mixed economies with both • markets, which are regulated to different extent • public production and provision

Scale of government Spending as share of national income (%) 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

The policy question Markets are generally considered to be efficient If 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 Work Demand, Supply, and Price Adjustment

Market • MARKET any arrangement in which prices adjust to reconcile buyers and sellers intentions • DEMAND quantity buyers wish to buy at each price • SUPPLY quantity producers wish to sell at each price • EQUILIBRIUM PRICE the price at which market clears (i. e. quantity demanded = quantity supplied)

Price Adjustment Supply curve price Equilibrium Price Demand curve Equilibrium Quantity quantity PRICE ADJUSTMENT Equilibrium price clears market

Price Controls Suppose government sets minimum price above market clearing price Price Supply curve Controlled price Equilibrium price Demand curve Examples include • Minimum wages • Rent control • Common Agricultural Policy excess supply Quantity

What do 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 where 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 tax 2. Taxation of petrol 3. Regulating gas prices

…Group Work 4. 5. 6. 7. 8. 9. 10. 11. 12. Regulating discharge of sewage in the Thames Legislation against insider trading Banning the use of cocaine Making primary school compulsory Regulating financial advisors Regulating length of the working week Compelling citizens to carry identity cards Minimum wage legislation 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)

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

Why Externalities Matter THE ESSENTIAL PROBLEM • Social Cost = Private Cost + Externality Social Benefit = Private benefit + Externality • Market mechanism aligns private costs and benefits; economic efficiency requires alignment of social 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

Adverse Production Externality For social optimum, we want marginal social cost = marginal social benefit At free market equilibrium E, output Q is higher than social optimum Q*

Correcting externalities 1. 2. 3. Quantitative regulation or direct government action: e. g. pollution quota [Pigou] Taxes or subsidies to correct prices e. g. pollution tax [Coase] Create markets: assign property rights and enable trade in pseudo-markets e. 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 Efficient quantity is Q*

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 nonprice controls Practical 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 Individual choices do not always result in the best collective outcomes Country 2 No nukes 8, 8 1, 12 Nukes Country 1 Nukes 12, 1 2, 2 SOLUTION: coordinate individual choices through agreements or regulation

Regulating technological 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. If so, the net effect may be to replace market failure with government failure

Well-intentioned regulation may • end up being ineffective • have perverse, unintended consequences • persist beyond its purpose • be vulnerable to regulatory creep, with high cumulative burden The scope for successful regulatory intervention is limited by • informational constraints • agency problems • lack of correction

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, including items that the market does not value properly Used for · capital projects and procurement decisions · policy proposals, including regulatory proposals environmental standards, health & safety, business regulation [Cost-effectiveness analysis when benefits are hard to quantify, or externally specified]

THE PROCESS 1. Justify action and set objectives Identify the market failure or the socially-undesirable outcome that calls for regulatory intervention. For example • • discharge of pollutants in atmosphere reduces air quality: the objective is to reduce pollutant levels by amount x 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 to change outcome (tradable permits) provide information/educate to alter behaviour (public campaign on dangers of excessive salt) no intervention

THE PROCESS 3. Identify costs and benefits of each option • Evaluate direct policy costs & administrative costs • Identify benefits and evaluate them as far as possible Include externalities (esp environmental ones), consumers’ surplus, etc. • Some benefits (e. g. prevented fatality) are hard to evaluate. Can infer prices from revealed preferences. If not, can use stated preference through contingent valuation: Willingness to Pay (WTP) or Willingness to Accept (WTA) • Identify unintended consequences and cost them too • Where relevant, identify distributional implications

What if benefits and costs are uncertain? Risk evaluation and management is important. • Identify sources of uncertainty. Not enough to look at most likely outcome: evaluate costs & benefits for entire range of scenarios. Recognise ‘optimism bias’. • Use pilot programmes to learn more about the true costs and benefits of intended regulation. • If possible at reasonable cost, transfer risk to party best placed to control it: outsourcing of technologyrelated risk to private sector.

THE PROCESS 4. Develop and implement solutions Good regulatory design must consider • regulator’s ability to monitor and verify choices • ease of ensuring compliance • setting robust targets: avoid setting targets whose achievement may run counter to objectives • proportionality, accountability, consistency

THE PROCESS 5. Evaluation • • • Review costs and benefits of regulation periodically to assess its usefulness If necessary, use sunset clauses to force evaluation at later date, in light of new information Likewise, reassess the ‘no intervention’ decision in the light of new information and developments

Green Accounting: A Case Study

Group Work: Impact Assessment For each category of regulation below, identify the social costs and benefits (including any unintended consequences). 1. Compulsory identity cards 2. Legislation to keep pubs smoke free 3. Regulating price of calling mobile phones from fixed line phones 4. Regulating the introduction of new drugs 5. Regulating the production of GM crops

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)

Information Individual choices depend on information too Two relevant aspects. Information tends to be • imperfect (we do not know everything) • de-centralised (we differ and know more about ourselves) The questions • how does information affect the case for regulation? • how does information affect scope of regulation? • how does regulation distort information and incentives?

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 work when insiders can monitor peers more easily than outsiders

Even if it does not. . Strong regulation may not be necessary. It may be easier to provide information • require product labelling (‘smoking kills’) • provide information directly (advertising)

Often markets are informationally efficient… • • • There are many contexts in which individuals or firms know more about themselves than others: information is de-centralised Markets can work with de-centralised information: individuals choices are based on private information but prices convey the essential bits of information to everyone. Regulatory control, as in a command economy, requires centralisation of information. This informational constraint makes it harder to regulate

. . . and efficient regulation is 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 regulation so that the same regulation may pose too much burden on some and not enough on others (identity cards, for instance)

and getting information is tricky • • 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 Of course, some regulatory instruments are better able to cope with informational constraints: (carbon trading arrangements, for instance).

Regulation and Incentives • • • Individuals choice also depend on incentives Markets provide sharp (‘high-powered’) incentives, both carrot and stick e. g. , profits vs. risk of bankruptcy, promotion vs. being sacked It is not easy to fine-tune the regulatory stick: road safety is only crudely regulated through speed limits 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 often has perverse effects Examples • Safety devices like seatbelts and airbags 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

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 stifles growth • price regulations inhibit investment • labour-market regulations create inflexibilities: Eurosclerosis • regulations that make it hard to set up / wind up business make the economy less responsive to change

A broad correlation. . . • High regulation, especially in developing countries, seems to stifle growth • But a cautionary note: growth is not an end in itself • if 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 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 • Social regulation is up: not surprising as 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 fastchanging technologies • Economic theory alerts us to dangers of regulation in the presence of information asymmetries

Why does regulation persist? • Some regulation corrects persistent market / information failures, so needs to persist • Political economy: those who would lose from deregulation can lobby more effectively than those who gain from deregulation (similarity with import restrictions) • In many sectors deregulation has led to a reduction in prices and profits (airlines, utilities, telecom): we should hardly expect business to support such deregulation

Looking to the future • If many of the economic inefficiencies associated with monopoly power have already been eliminated in the UK, scope for further gain may be lower • However, anything that supports innovation or labourflexibility is still worth aiming for • 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 • international coordination may be necessary

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 decisionmaking 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