Transcript Public Policy - Univerzita Karlova v Praze

Public Regulatory Policy:
An Economic Perspective
urban @ prf.cuni.cz
room 341, Thursday, 10-12 a.m.
First things first
 What
 Why
is „Public regulatory policy ?
„An Economic Perspective“ ?
What is public regulatory
policy ?
Government decisions and actions
(or inactions) intended to address
a perceived public issue/problem

What are public issues?
Situations or issues where personal
choices may (positively, or negatively)
affect other people or the public as a
whole (rather than only private
individuals)

What are public issues?


Decision whether to buy or sell a car is a
private problem because it affects you as a
private individual.
Deciding what the speed limit should be
on a street or a highway is a public problem
because how fast a person drives can affect the
safety of other persons.
What are public issues?

Public issues (usually) occur in public
settings, such as communities, rather than
in private settings, such as homes
What is public policy problems?
Public intervention aimed at regulating a
public issue is called public (regulatory) policy

What are public problems ?

Public issues usually involve both facts and
values
What are public issues?

People may know facts about public
issues, but they solve them on the
basis of their values

When they argue about how best to solve a
public problem, they are likely to select the
facts that support their values
Public values

Public issues usually involve four
principal values:
- freedom (choice, individuality, etc.),
- fairness (equity, justice, etc.)
- safety (security, social order, etc.)
- prosperity (efficiency, productivity, etc.)
Public policy infrastructure

Public policy is associated with formally
approved policy goals as well as policy
measures (tools), usually embedded in laws
It may be executed/implemented by state
agencies

Broader policy areas can be called policy
programs

Typical broader public policy areas:
Health care protection
 Consumer protection
 Environmental policy
 Social security policy
 Employment (labor market) policy
 Energy policy
 Education policy
 Public transportation policy etc.

Some specific public policy
issues:
Workplace safety
 Immigration
 Housing policy
 Automobile safety
 Smoking
 Renewable energy
 Gambling
 Hospitals privatization
 Public subsidies to low cost carriers
 Policy of disposable drinks packaging deposit

More questionable public
policy issues:
Bankers bonuses
 Tax on financial transactions
 Subsidizing corn-based ethanol production
 Protecting domestic producers
 Obesity (tax on fat consumption)



Why „An economic Perspective“?
 Public
policy often includes two economic
aspects
- prosperity (it usually aims at increasing
public welfare expressed in economic
terms)
- efficiency (cost/benefit ratio).
Why „An economic Perspective“?
Public policy tries to change economic
behavior of subject (individuals, firms),
e.g. consumer habits, production methods
etc.

Public policy tools often use economic
incentives (taxes, tax reliefs, subsidies etc)

Public policy and Regulation
When applied to economic subjects/matters
public policy is often also called
„regulation“, „regulatory measures“ or
„regulatory policy“

Some regulation examples:
 Financial markets regulation




Competition policy and merger regulation
Opening of energy markets to competition
Policy of investment incentives
Ecological taxes, pollution permits (Introduction
of Emissions trading scheme)
The focus of the course
The course focuses on policy analysis and
evaluation based on economic criteria

Therefore, it looks mainly at public
policy areas having a law-economics
interface

Why study public policy ?
The purpose of public policy, among
other things, is to regulate society in such a
way as to provide higher welfare
or economic benefits

Why study public policy ?
The best way how to accomplish this is,
however, often debatable (as is the questions
who actually benefits from the policy)

Policy analysis
Policy analysis is an evaluation of public
policy programs and alternatives in terms of
their actual impact, i.e. how successfully they
comply with their objectives

Scope and method of public
policy analysis
The main criteria of a specific public policy
analysis comprise its goals, effectiveness,
efficiency (economic feasibility), its tools, impact
on equity and freedom, its political feasibility etc.

Initial policy analysis question
Do we need public policy (public policy
intervention)?

Should specific issues be considered public
problems?


Do they deserve regulation ?
Further policy analysis issues
Public policy effectiveness - its ability to reach
its stated goals

Public policy tools - possibilities of alternative
tools

Public policy efficiency - its costs, side-effects
etc.

Public policy comparisons - in terms of its goals,
tools, effectiveness and efficiency

Examples of policy analysis
results: broader conclusions
why policymakers sometimes fail to pursue
socially desirable policies or policy reforms

Examples of policy analysis
results: specific conclusions
which policy tools have been successful
and which have not

The Main Economic Question
From the economic perspective, the main
question analyzed by the theory of public policy
is:

- when is it best to let market forces take their
natural course and when should government
intervene in or regulate market activity
Policy Distinctions
The economic approach to public policy
analysis distinguishes two main policy
cathegories

- distributive policies
- regulatory policies
Distributive policies
 The
objective of distributive public policies
(or social policies) is to solve social
problems and/or to pursue a social goal
through redistributing income from one
group of citizens for the benefit of another
group of citizens.
Distributive policy goals
 Typical
distributive policy goals include
reducing poverty, ensuring higher fairness
(e.g. in labor markets), and providing
public or merit goods—that is, goods and
services that a society believes every citizen
is entitled to regardless of whether he or
she can afford them.
Regulatory policy
 Regulatory
public policies can be
considered as legal restrictions imposed
on economic behavior
Regulatory policy goals
 Regulation
attempts to produce
behavior, which might not otherwise
occur, or prevent behavior than would
otherwise occur.
Regulatory policy: Examples
 Common
examples of regulation include
attempts to control market entries, market
prices, wages, pollution effects of
production or consumption, employment
for certain people or in certain industries,
standards of production for certain goods
and services etc.
Regulatory policy can have five
major legal forms (either
Command-and-Control or MarketBased)
1. Public standards or statements
of expectations (Command-and-Control)
Regulatory policy can have
five major legal forms
2. A process of registration or licensing to
approve and to permit an operation, usually
by a named organisation or person
(Command-and-Control)
Regulatory policy can have
five major legal forms
3. A process of inspection or other form of
ensuring standard compliance, including
reporting and management of noncompliance with these standards (Commandand-Control)
Regulatory policy can have
five major legal forms
4. A process of de-licensing whereby
organisation or person is judged to be
operating unsafely, and is ordered to stop
operating at the expense of acting unlawfully
(Command-and-Control) .
Regulatory policy can have
five major legal forms
5. Taxes and subsidies levied on production
or consumption motivating economic subject
to increase or decrease their activities in
certain areas (Market based)
Regulatory policy examples
Regulations imposed on the selling of
(financial) products to individuals have been
introduced as a protection against
unscrupulous (financial) firms with better
information than their customers (problem of
„information asymmetry“).

Regulatory policy example
(market based policy)
Taxes and/or subsidies can motivate
to substitute current production method
polluting the environment by ecologically
less harmful technologies etc.).
Some regulation has been
motivated by politics rather
than economics
For instance, restrictions on the number of
hours people can work or the circumstances in
which an employer can dismiss employees.

Regulation vs. deregulation
The second half of the 20th century saw a
wave of attempts to remove, reduce, or simplify
restrictions on business and individuals
with the intent of encouraging the efficient
operation of markets.

Regulation vs. deregulation
The
stated rationale for deregulation is often
that fewer and simpler regulations will lead to
lower costs, therefore higher productivity
and competitiveness and lower prices und
higher employment overall.
Regulation vs. deregulation:
Example
For example, deregulation of the air
industry in Europe in 1992 gave carriers
from one EU country the right to operate
scheduled services between other EU
states.

Regulation vs. deregulation
In addition, there have been regulatory
innovations, usually suggested by economists,
such as emissions trading scheme

Main Economic Reasons for
Government Interventions
Market failures: situations when markets
fail to be „efficient“

There are five main cathegories of such
situations

Market failures: situations when
markets fail to be efficient

The existence of monopolies, or excessive market
power

„Externalities“

Provision of public (collective, merit) goods

Information failures (information asymmetry)

„Moral hazard“
Economic reasons for
government interventions
Analyses of public policy/ government
intervention in the economy should be looking
at whether or not have market failures
occured.

Economic reasons for
government interventions
The occurrence of market failure
usually legitimizes government
intervention

Monopoly: Problem of Welfare
Loss
 In
contrast to a competitive firm, the
monopoly charges a higher price.
 From
the standpoint of consumers, this
high price makes monopoly undesirable.
Competition/Anti-trust Law
 Legislation
designed to encourage
competition and discourage/ban the use of
monopoly practices can curb the
inefficiencies resulting from market
power in general and monopoly in
particular
Price regulation
 Government
may regulate the prices that
the monopoly charges.
 This
is often the case with natural
monopolies.
Price regulation
 Practical
problem associated with price
regulation: regulators often depend on
information obtained from monopolies
The actions of an economic
subject can have externalities
An externality is an impact or „spill-over“
(positive or negative) on any party not
directly involved in an economic
decision/activity

Externalities: both positive
and negative
A negative externality occurs when an
economic decision (concerning production or
consumption) creates undeserved costs to a
third party

A positive externality means undeserved
benefits to a third party.

Externalities: both positive
and negative
In
other words, the producers or consumers
in a market suffering from externalities either
do not bear all of the costs or do not reap all of
the benefits of their economic activity.
Externalities: Examples
For example, manufacturing that causes
polution imposes costs on others, while
planting forests (rather than other
agricultural activities) would improve water
quality.

Why market failure ?
Because costs and benefits are not fully
included in prices, they do not form part of
the calculations of the people deciding
whether to go ahead with the economic
activity

Why market failure ?
The
existence of externalities means that
either too much or too little of the good is
produced and consumed in terms of overall
cost and benefit to society
Why market failure ?
If there are external costs (negative
externalities) such as pollution, the good will
be overproduced by a market, as the producer
does not take into account the external costs
when producing the good.

Many negative externalities are related to
the environmental consequences of
production and use
Air and water pollution,
 Industrial farm animal production, overfishing
 Overconsumption of health care caused by
smoking and drinking
 When car owners use roads, they impose
congestion costs on other users
 Consumption of energy increases the nation’s
dependence on foreign oil

Positive externalities: Examples
Education
creates a positive externality
because, among other reasons, more educated
people are less likely to engage in violent crime,
which makes everyone in the community better
off.
Home ownership creates a positive externality
in that homeowners are more likely than renters
to become actively involved in the local
community.

Positive externalities: Examples
Inventions and information - once an invention (or
other form of practical information) is discovered or
made accessible, others benefit by exploiting the
invention or information.

An individual buying a product that is
interconnected in a network increases the value of
the same product owned by others.

Policies correcting externalities
u
One potential solution of externalities is a
policy of command-and-control (bans,
requirements etc)
u
For instance, specific technologies are
banned to eliminate an externality,
requirement that every car be fit with
a catalytic convertor, that all citizens be
immunized etc.
Policies correcting externalities
u
Government can fight externalities also
by quantity policies (specific limits are set
for a particular externality such as air
pollution)
Policies correcting externalities
u
The liability system administered by the
courts also seeks to reduce the cost of
externalities by encouraging firms and
consumers to behave in a more socially
efficient manner.
Policies correcting externalities
u
Market based policy dealing with externalities,
when the externality is negative, is a tax on the
activity or, if the externality is positive, a
subsidy.
u
Taxes and subsidies make consumers and firms
account for („internalize“) the social costs or
enable them to accrue the social benefits of
their actions.
Externalities and public goods
uExtensive
positive externalities connected
with providing certain goods may cause
problems for the production of such goods.
Externalities and public goods
Markets, therefore, maybe be unable to
provide these goods in desired quantities
because their producers would be unable to
collect revenue from their sales.
u
uThese
issues are known as public goods
problems.
Provision of public goods
u
Public goods are regarded as a very
important example of market failure, and
in most countries they are provided at
least in part by government and paid for
through compulsory taxation
Some Important Public Goods
u
u
u
u
Public safety
National Defense
Basic Research
Fighting Poverty
Provision of public goods:
An Economic Perspective
u
Government may decide to provide a
public good if the total benefits exceed
the costs.
The Difficult Job of CostBenefit Analysis
u
Cost benefit analysis refers to a study that compares
the costs and benefits to society of providing a
public good.
u
In order to decide whether to provide a public good
or not, the total benefits of all those who use the good
must be compared to the costs of providing and
maintaining the public good.
Provision of public goods
u
Government may decide to provide public
good by public production or to subsidize
production of a public good in the private
sector
u
Unlike public production (direct
government provision of public goods),
subsidies may result in some form of a
competitive market.
Market failures due to nature
of exchange
u
Informational asymmetry arises when one
party to a transaction has more or better
information than the other party.
Why market failure ?
u
If consumers are uninformed or misinformed
about the quality of a product, they may
derive less utility from it than they expected.
u
Consumers’ choices could be distorted by
false advertising, by firms’ failures to disclose
relevant information about their products and
services, and by a lack of information to
assess accurately the safety of potentially
risky products.
Why market failure ?
u
Similarly, workers may become injured or
ill because they lack information about the
health risks they may encounter in their
workplace.
u
Another example of information asymmetry
is adverse selection when people who are
high risk are more likely to buy insurance
Policies to imperfect information
u
Governments attempt to minimize the
welfare losses caused by imperfect
information by empowering regulatory
agencies to
- direct firms to provide complete and
accurate information about their products
and workplaces
- ensure that consumer products and
workplaces meet reasonable safety
standards.
Policies to imperfect information
u
Policies aimed at improving information
asymmetries entail measures in
- advertising regulation,
- disclosure rules,
- labelling,
- product standards,
- occupational licensing etc.
Market failures due to nature
of exchange
u
Moral hazard arises because an individual
or an institution does not bear the full
risk of its actions because it can shift at
least some consequences of its risky
behavior on others.
u
Therefore, it has a tendency to act less
carefully than it otherwise would
Market failures due to nature
of exchange
u
For instance, an individual with
insurance against automobile theft may
be less vigilant about locking his car,
because the negative consequences of
automobile theft are (partially) borne by
the insurance company.
Moral hazard in financial
industry
u
Financial bail-outs of banks by
governments, central banks or other
institutions can encourage risky lending in
the future, if those that take the risks
come to believe that they will not have to
carry the full burden of losses.
Principal-agent problem
u
A special case of moral
hazard/asymmetric information is the
principal-agent problem, where one party,
called agent, acts on behalf of another
party, called principal.
Principal-agent problem
u
The agent usually has more information
about his actions or intentions than the
principal does, because the principal
usually cannot perfectly monitor the
agent.
Principal-agent problem
u
The agent may have an incentive to act
inappropriately (from the view of the
principal) if the interests of the agent and
the principal are not aligned.
Some Policy Recommendations
There are some types of policy issues
where economists believe strongly in a
policy that may or may not appeal
to the general public.
u
Some Policy Recommendations:
Free Trade
For example, economists believe that we
benefit from free trade, even though the
public sometimes resents foreign imports.
u
Some Policy Recommendations:
Substitution
The principle of substitution says that
individuals will respond to incentives by
substituting low-cost methods for high-cost
methods.
u
Example: applying taxes directly to the
activity that is to be discouraged
u
The principle of substitution
uThe
most ineffective policies are those
that will be undermined by the principle of
substitution.
The principle of substitution
Example: when a minimum wage is
imposed, businesses will substitute lowskilled workers.
u
The opposite of Market
Failures: Government Failures

Lack of Information

Special Interest Effect (Lobbying, Corruption)

Rent-Seeking Behavior

Short sightness Effect: Clear Benefits, Hidden

Costs
Special Interest Effect

One that generates substantial personal
benefits for a small number of subjects

Imposes a small individual cost on a large
number of other persons
Special Interest Effect (cont.)

The voters bearing the cost of specialinterest legislation will often be uninformed
on such an issue

It exerts only a small impact on their
personal welfare and they are unable to
avoid the cost and/or get more infomation
Interest Groups and Public Policy

Politicians are likely to offer policies
where the costs are widely diffused, but
where the benefits are more significant for
a particular interest group
Interest Groups and Public Policy

Public policy makers may, therefore,
have a strong incentive to favor special
interests even if the corresponding action
is inefficient (higher social costs than
benefits).
Interest Groups and Politics

Therefore there may be bias in political
decisions towards public intervention
„Rent Seeking“
u
Actions by individuals and interest groups
designed to (permanently) restructure public
policy in a manner that will either directly
or indirectly redistribute more income to
themselves.
„Rent Seeking“
Rent seeking occurs when an individual,
organization, or firm seeks to make
money by manipulating the legal
environment rather than by making a
profit through trade and production
„Rent Seeking“
The typical example of rent-seeking is the
monopolist case. Firms seek government
privilegies (such as barriers to entry) to
secure a monopoly and therefore monopoly
rents.
„Rent Seeking“
Other examples include a farm lobby that
seeks tariff protection or an entertainment
lobby that seeks expansion of the scope of
copyright.
„Rent Seeking“
Other rent seeking is associated with efforts
to shift the government tax burden or
government spending allocation.
An example is an organization that seeks
different tax liabilities for married than for
unmarried couples
Results of „rent seeking“
can be considerable
If "buying" a favorable regulatory
environment is cheaper than building more
efficient production, a firm will choose the
former option, reaping incomes entirely
unrelated to any contribution to total wealth
or well-being.
„Rent Seeking“
Rent seeking moves resources away
from productive activities.
The output of economies with
substantial amounts of rent seeking will
fall below their potential.
„Rent Seeking“
Rent seeking may be initiated by
government agents, such agents soliciting
bribes or other favors from individuals or
firms seeking special privileges, which opens
up the possibility of exploitation of the
consumer and/or taxpayer.
Interest Groups & „Rent
Seeking“
Widespread use of the taxing,
spending, and regulatory powers of
government that favor some at the expense
of others will encourage rent seeking.
„Regulatory capture“
Regulatory capture is a related concept
It refers to collusion between firms and
the government agencies assigned to
regulate them
Regulatory capture
It is a phenomenon in which a
government regulatory agency which is
supposed to be acting in the public
interest becomes dominated by the
interests of the industry that it oversees.
Regulatory capture example
An industry regulatory body sets prices
at artificially high levels and excludes new
competitors through a restrictive
permitting process.
Valuable Functions of Interest
Groups
Interest groups can raise awareness of
public issues, or issues that concern the
people at large.
Interest groups represent people who share
attitudes rather than those who share
geography.
Interest groups provide specialized
information to government agencies and
legislators.
Valuable Functions of Interest
Groups
Interest groups are vehicles for political
participation
Interest groups compete
Interest groups keep tabs on various
public agencies and officials.
Criticisms
Some interest groups have an influence far
out of proportion to their size or importance.
It can be difficult to tell who or how many
people are served by a group.
Criticisms
Groups do not always represent the views of
the people they claim to speak for.
In rare cases, groups use tactics such as
bribery, threats, and so on.
Additional public policy
phenomenon:
Shortsightedness Effect
Issues that yield clearly defined current
benefits at the expense of future costs
that are difficult-to- identify.
Motivation of Bureaucrats
The interests of bureaucrats are often
complementary with those of interest
groups they serve.
Bureaucrats can usually expand their
own interests, as well as that of their
constituents, by working for larger
budgets and program expansion.
Lack of Incentive for
Operational Efficiency
In the public sector, the absence of the
profit motive reduces the incentive of
producers to keep costs low.
Neither is there a bankruptcy process
capable of weeding out inefficient producers.
Public-sector managers are seldom in a
position to gain personally from measures
that reduce costs.
Question for Thought:
Evaluate the following view:
„Since government-operated firms do not
have to make a profit, they can usually
charge a lower price than privately owned
enterprises.”
Economics of the Transfer
Society
A large and growing part of
government is devoted to transferring
income.
Economics of the Transfer
Society
Large-scale redistribution can reduce the
„size of the economic pie“:
When taxes take a larger share of one’s
income, the individual reward derived from
work and productive service is reduced.
Economics of the Transfer
Society
As public policy redistributes a larger
share of income, more resources will flow
into wasteful rent seeking activities.
Four Factors that Weaken
the Case for Market forces

Lack of competition

External costs and benefits
Public goods
Poor information


Four Factors that Weaken the
Case for Public Solutions




The power of special interests
Rent seeking/corruption
The shortsightedness effect
Redistribution
Regulation examples:
Regulation of Financial
and Capital Markets
What are Financial and Capital
Markets?
In financial markets, participants trade
securities (shares, bonds, etc), money,
foreign exchange, insurance,
commodities etc.
What are Financial and Capital
Markets?

The main types of financial markets cover:





Money Market
Capital Market (Primary and Secondary)
Insurance Market
Derivatives Market
Forex Market
What is (can be) regulated in
financial markets?






Financial institutions (intermediates) – banks,
investment funds, brokers, …
Flow of money
Financial risks
Information
Scope of participants
Debts
The toughest regulation form - licences
Who regulates?

Supervisors of national financial markets – central
banks

Supervisors of national capital and securities
markets – Securities and Exchange Commissions
(SEC)

EU bodies: EU Commission, European central bank
(ECB), European Securities Committee (ESC),
Committee of European Securities Regulators
(CESR)
Regulatory bases
 Central banks - regulate commercial banks on
the basis of Basel Directive
 A set of banking regulations issued by the
Basel Committee on Bank Supervision, which
regulates finance and banking internationally.
Basel Directive
The purpose is to create an international
standard that banking regulators can use
when creating regulations about how much
capital banks need to put aside to guard
against financial and operational risks banks
face
Basel Directive
 Basel sets the minimum capital
requirements of financial
institutions with the goal of
ensuring institution´s liquidity.
Basel Instruments

Banks need to put aside capital to reduce the risks
associated with its investing and lending practices

The greater risk to which the bank is exposed, the
greater the amount of capital the bank needs to hold.

The goal is to ensure that capital allocation is more
risk sensitive
Regulatory bases
 Basel III is scheduled to be introduced from 2013 until
2018. It was developed in response to the deficiencies in
financial regulation revealed by the last financial crisis.
 The focus of Basel III is to reduce the risk of system
wide shocks.
 Basel III seeks to further improve the banking sector's
risk management and strengthen the banks'
transparency.
“MiFID” Directive

The Markets in Financial Instruments Directive
(MiFID)

MiFID is the cornerstone of the European
Commission's Financial Services Action Plan
“MiFID” Directive Goals
 to complete the process of creating a single EU
market for financial investment services
 to respond to changes and innovations which
have occurred in securities markets
 to protect investors by making markets deeper,
more competitive and more robust against
fraud and abuse
MiFID - Authorisation, regulation and
passporting

Firms covered by MiFID are authorised and
regulated in their "home state" (the country in
which they have their registered office whereas
formerly, a service was regulated by the member
state in which the service took place).

Once a firm has been authorised, it can use the
MiFID passport to provide services to customers
in other EU member states.
MiFID – Client handling

MiFID has requirements relating to the
information that needs to be captured
when accepting client orders, ensuring that
financial institutions are acting in a client's
best interests
MiFID - Client categorisation

MiFID requires firms to categorise clients as "eligible
counterparties", „professional clients“ or „retail
clients“. These have increasing levels of protection.

Clear procedures must be in place to categorise clients
and assess their suitability for each type of investment
product.

That said, the appropriateness of any investment
advice or suggested financial transaction must be
verified before being given.
MiFID - Post-trade transparency

MiFID requires firms to publish the price,
volume and time of all trades in listed
shares, even if executed outside of a
regulated market
MiFID - Best execution

MiFID requires that firms take all reasonable steps to
obtain the best possible result in the execution of an
order for a client.

The best possible result is not limited to execution
price but also includes cost, speed, likelihood of
execution and likelihood of settlement and any other
factors deemed relevant.
Regulation examples:
Social Regulation
Goals of Social Regulation
 to ensure that the pursuit of profit
does not conflict with social welfare
 to gain socially desirable outcomes when
competition cannot be relied upon to
achieve them.
Social regulation concerns



the conditions under which goods and
services are produced (working
conditions, production processes firms
are allowed to use)
the quality of goods and services
the side effects of production on society,
mainly environmental pollution.
Regardless of industries, regulation
focuses mainly on

Consumer protection

Employer-Employee relationships, e.g. working
hours, equal employment opportunity, minimum
wage, employees dismissal, percentage of women in
management, operation of trade unions

Employees (workplace) safety

Energy use

Environmental protection
Consumer protection example:
Prohibitions and Bans

If a product or service poses a risk to consumer
safety, the most effective means of addressing
the problem may be to ban the product.

This is especially so where the risk is unlikely to
be mitigated through the provision of consumer
information (e.g. that information is high cost,
difficult to obtain or understand, or
undervalued by consumers through differing
perceptions of risk).
Consumer protection example:
Labelling and Warnings

Warnings retain consumer choice but do
not result in the information cost
problems

Consumers can then choose to seek a
substitute; or to investigate the details of
the risk; or to make the purchase and
use it with care
Consumer protection example:
Mandatory Use of Information
Intermediaries

Can be particularly effective for reducing
information costs where the product has severe
risks for and the intermediary knows both the
risks and whether they are likely to affect a
particular consumer.

This tool also sends a signal to the consumer
that there may be value in searching out more
precise information and not relying on general
expectations of safety.
Consumer protection example:
Regulation of Terms of Agreement

Imposing a guarantee as to the
reasonable availability of spare parts
and facilities for repair reduces the need
for consumers to search out that
information before deciding to buy a
particular product.
Consumer protection example:
Occupational Regulation

If a consumer seeks services or products from a
member of a regulated profession, the cost of
information is reduced because assumptions
can be made as to the competence and
performance of that member

However, if occupational regulation is not based
on relevant quality control standards, it will not
reduce information costs.
Consumer protection example:
Standards

Consumers can use indicators of
compliance with a standard as an indicator
of safety or quality, as appropriate

Non-compliance with standards may be
subject to some form of sanction or redress
due to their incorporation into
regulationsame.
Consumer protection: Sanctions vs.
Redress Mechanisms

Where there is a consumer interest that
should be protected by law, policymakers need to consider whether that
interest should be protected through
public enforcement and sanctions or
through private claims and redress.
Main Issues of Employment
regulation



The Minimum-Wage Controversy
Employment regulation and labour
markets flexibility
Employment regulation in a globalized
economy
Scope of social regulation

Scale and scope of regulatory activity
expanded substantially in the last three
decades with the emergence of
environmental and consumer
movements, regardless of the
deregulation initiatives
Who regulates ?

Parliament

Government institutions (ministries)

Independent regulatory bodies (specialized
agencies)

European Commission

Courts

Self-regulatory (private) bodies
Regulatory institutions

If regulation is implemented through independent
commissions and agencies, regulatory practices
can be appealed to the courts to test their
constitutionality and to ensure that agencies
satisfy due process in their decision making
Economics of Social regulation

A government agency has power to direct business
to take specific actions

While legal procedures typically result in fines or
other penalties if businesses do something wrong,
regulators reach deep into the operations of
business to tell them what to do
Economics of social regulation
 Ownership of the regulated firm remains
private.
 Pricing and production decisions controlled by
a government regulatory agency.
15
6
Economics of Social regulation

Some economists argue that the growing
scope of regulation is bad.

The regulatory costs may outweigh the social benefits
derived from the regulation

Regulations are often poorly written and ambiguous

Regulatory burdens may become unbearable for small
firms.
Main Types of Questions in Social
Regulation
 What is the desired outcome of regulation (behavior
of regulated subjects)?
 Can we design a regulatory mechanism that induces
the regulated firm to act in a way that results in the
optimal outcome?
 Can we balance the benefits of regulation with its
costs (compliance costs) and risks, e.g. regulator’s
capture?
Regulation in Economic Perspective

An efficient regulatory infrastructure must
consider and balance benefits - safer products,
reduced crime - against the costs of achieving legal
and regulatory goals

A legal and regulatory system that ensured the
complete elimination of crime, unsafe products,
and other unwelcome activities would be less
efficient than a system that tolerated some amount
of these activities
159
What are compliance costs?
Direct costs to businesses of performing tasks
associated with complying with government
regulation, e.g.
- administrative and paperwork costs
- regulatory fees
- upgrading equipment / production processes
- information costs
- staff time, eg. training in new requirements
- external expertise (e.g. lawyers, accountants).
Regulatory paradox: Price
discrimination

Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.
Price discrimination

Price discrimination is not possible
when a good is sold in a competitive
market since there are many firms all
selling at the market price. In order to
price discriminate, the firm must have
some market power.
Price discrimination

Perfect Price Discrimination refers to the
situation when the monopolist knows exactly
the willingness to pay of each customer and
can charge each customer a different price.
Price discrimination

Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.
Price discrimination

Important effects of price discrimination:


It can increase the monopolist’s profits.
It can reduce deadweight loss.
Impact of Regulations
At their best:
Achieve social and environmental goals
Provide consumer protection
I mprove economic performance by promoting
competition
At their worst:
Create unintended, unnecessary and often unavoidable
barriers to businesses and trade
166
Doing Business indicators – areas of business regulation
Start-up
 Starting a
business
Minimum capital
requirement,
procedures, time
and cost
Expansion
Operations
 Registering property
 Dealing with
construction permits
Procedures, time and cost
Procedures, time and
cost
 Getting credit
Credit information
systems
 Paying taxes
Payments, time and Total
Tax Rate
Movable collateral laws
 Protecting investors
insolvency
(formerly
Closing a
business)
Time, cost and
recovery rate
borders
Documents, time and
cost
 Enforcing contracts
 Getting electricity
Procedures, time and cost
to resolve a commercial
dispute
Property rights
Investor protection
Access to credit
 Resolving
 Trading across
Disclosure and liability in
related party
transactions
Entry
Insolvency
Procedures, time and
cost
 Employing workers
Administrative burden
Flexibility in hiring
1
6
7
Recovery rate
Reallocation of
assets
Regulatory Impact Assessment
(RIA)

Systematic and mandatory appraisal of how
new/proposed legislation/regulation will affect
certain categories of economic subjects

Often used in the pre-legislative scrutiny of
legislation
Regulatory Impact Assessment
(RIA)

It can be also used to
- examine the effects of regulations that are
currently in force, for example with the aim of
eliminating some burdensome features of
existing regulations (high compliance costs)
- choose the most effective way to simplify
regulation
Purpose of Regulatory
Impact Assessment

Provide empirical data and independent
oversight for regulatory decisions

Promote balanced decisions that trade off
problems against wider economic and
social goals
170
Purpose of Regulatory Impact
Assessment

Communicate the information to decision
makers

Enables policy makers to understand and take
personal responsibility for regulatory decisions

Reduce the regulatory burden
171
Components of the RIAS

Description: defines the problem, shows
why action is necessary and outlines the
regulations

Alternatives: lists options beside
regulation and other types of regulation

Benefits & Costs: quantifies the net
impact
Components of the RIAS

Compliance and enforcement:
explains the policy on conformity
to the regulations and tools to
ensure it is respected
Regulatory Impact Assessment
can cover





firms and their types (e.g. small business)
economic sectors (e.g. their competitiveness)
industry stakeholders (employees, customers etc.)
the community
the environment
Cost-Benefit Analysis (CBA)

The main analytical tool used to assess the
benefits and costs of regulation or regulatory
proposals
Cost-Benefit Analysis (CBA)

Where regulation is designed to reduce the risk
of physical or economic harm, a CBA should
include a risk analysis detailing how the
regulation will change the likelihood, frequency
or consequences of an adverse event occurring
Given sufficient information, CBA can
 calculate the net benefits for each proposal
 rank proposals by their net benefits
 recommend the proposal with the greatest net
benefit
 discount future costs and benefits to obtain present
values
 compute the net present value for each policy
option
Why is CBA useful?
CBA can draw attention to equity issues
 by identifying who gains and who loses from
a regulatory proposal
 but it is up to decision makers to decide
whether distributional impacts/equity issues
are important and need addressing
Cost-Benefit Analysis (CBA)
Weaknesses of CBA





Difficulty in quantification of effects, costs and
benefits
Difficulty in predicting compliance behaviour
Limitations on information
The costs of analysis
The need to meet political or policy-making
deadlines
CBA

There are significant challenges in using CBA

But even when it is difficult to measure accurately
benefits and costs applying the CBA framework is
important and useful

CBA can play an important role in improving the
quality of regulatory proposals – even when
valuation is difficult
180
CBA
Non-monetised costs and benefits should not be
excluded from consideration in CBA
Impacts should be reported in CBA as follows:
- monetised
- quantified, but not monetised
- qualitative, i.e. not quantified or monetised
Existence of non-monetised costs and
benefits presents a challenge
Agencies should consider non-monetised impacts
adequately but not overplay them
If a proposal shows large monetised ‘net’ costs the
requirement on the government agency is to
clearly explain why non-monetised benefits would
tip the balance
Frequently used non-market values in
CBA include

Value of a statistical life or life year

Value of travel time savings

Value of recreational activities

Value of nature (species or habitats)

Cost of noise pollution

Cost of air pollution
Valuing a “statistical” life (VSL)

How much would individuals pay to achieve a
small reduction in the probability of death?

Revealed preference and stated preference studies
can provide estimates of willingness to pay (WTP)
for small changes in mortality risk
VSL is not the value of an ‘identified’
life

VSL is the aggregate amount that a group of individuals are WTP for a
risk reduction

If people are WTP, on average, $12 for a risk reduction from 5 in
500,000 to 4 in 500,000

VSL = $12/0.000002 = $6 million

It does not mean that an individual would pay $6m to avoid (certain)
death this year

It does imply that 500,000 similar people would together pay $6m to
eliminate the risk that is expected to kill one of them randomly this year
RIA Example: biofuels

According to the Kyoto protocol of 1997, countries have commitments in
relation to its C02-emissions.

The transportation sector is responsible for about one quarter of energyrelated greenhouse gas emissions.

Replacement of conventional hydrocarbon based fuels with fuels made
from renewable bio-sources could be one way of reducing the emissions.


Appraisal looked at a scenario where 2 % of the fuels consists of biofuels.
The main biofuels today are ethanol and biodiesel, they are usuallly
imported.
Biofuels - benefits


Biofuels have a ”lower carbon footprint” than conventional
fuels.
2 % biofuels content results in a reduction in total Co2
emitted amount of 160 000 tons per year.

The social cost of Co2 is set at 25 euros per ton.

Thus, the value of the annual benefit is 4 mil. euros.
Biofuels - costs
 Biofuels have a lower energy content than conventional fuels.
 Resource costs of biofuels passed on to consumers.
 Crops that otherwise would become food might instead
become fuel
 Biofuel programmes could raise food prices
 Higher crop prices could harm the poorest people.
Benefits and costs in summary
Reduced Co2 emitted:
4 mil. euros
Total additional cost
(8,13+9,02) mil. euros:
17,15 mil. euros
Net benefit:
- 13,15 mil. euros
Cost-efficiency:
Reduced Co2-emissions:
Cost per ton of Co2 abated:
Social cost of Co2 per ton:
160 000 tons
107 euros
25 euros
Biofuels – what did the
government decide?
There will be a biofuel obligation where the fuel sellers have to
ensure that at least 2 % of the fuel they sell for road transport is
biofuel
By the end of the next year least 5 % of the fuel sold for road
transport shall be biofuel.
In addition:
Tax reliefs for biofuels and so-called flexi-fuel cars are already in
place.
Regulation examples:
3. Monopoly and Monopoly Power
Monopoly and Monopoly
Power

A market with just one seller, or a few oligopolists
who cooperate and behave as a monopoly, is a serious
market failure justifying government intervention

A firm has monopoly power when it can influence the
price that it charges for its product

Monopolies (imperfectly competitive markets) are
generally inefficient: price is too high, and output is
too low, to maximize net benefits in market
192
POLICY TOWARD
MONOPOLIES

Government responds to the problem of
monopoly in one of three ways
◦ Making monopolized industries more
competitive.
◦ Regulating the behaviour of monopolies.
◦ Turning some private monopolies into
public enterprises.
Competition/Anti-trust Law
Legislation
designed to encourage
competition and discourage/ban the use of
monopoly practices can curb the
inefficiencies resulting from market
power in general and monopoly in
particular
Anti-trust legislation

To promote economic efficiency, anti-trust policy
attempts to ensure entry and fair competition in
industries with barriers to entry and anti-competitive
practices

Anti-trust policies (as with all govt regulations)
change over time and are strongly influenced by
economics and politics

Broad language of anti-trust acts leaves considerable
room for interpretation for courts/judges
195
Types of Anti-Competitive Behavior
(1)
-
-
Horizontal Restraint of Trade
a division of market, which reduces
competition and creates monopoly
a single company dominates a market
and/or industry
Types of Anti-Competitive Behavior
(2) Vertical Restraint of Trade
examples:
-
-
resale price control (manufacturer tries to
control the retail price)
a single firm controls supply chain
Types of Anti-Competitive
Practices
(3) Predatory Pricing
-
-
firms price below marginal cost until
other firms get driven out of business and
then they price and profit as a
monopolist
most relevant in industries with high
barriers to entry (e.g., airlines)
Key Issues to consider in Anti-Trust
- what is the relevant market?
- market share of competitors?
- prices, are they fair?
- barriers to entry (capital costs, distribution
chains, software platforms)?
- is there international competition?
- cost structure of industry (is it subject to
increasing returns to scale?)
- incentives to innovate ?
- the effect of tech change on relevant market?
Anti-trust Law: not always a
Remedy
Breaking up a monopoly would not make sense
when the market would perform even worse with
more competition
Monopolies that arise from patents and copyrights,
provide an incentive for artistic creations and
scientific discovery

200
Anti-trust Law: not always a
Remedy
Monopoly power that arises from network
externalities offers benefits that would be hard to
achieve under more competitive conditions

When a monopoly arises as a natural monopoly,
using anti-trust law to break it up or even to prevent
its formation is a poor remedy

The Special Case of Natural
Monopoly

A natural monopoly exists when, due to economies
of scale, one firm can produce for the entire
market at a lower cost per unit than can two or
more firms
◦ If government steps aside, such a market will naturally
evolve toward monopoly
202
The Special Case of Natural
Monopoly

If breaking up a natural monopoly is not
advisable, what can government do to bring us
closer to economic efficiency?
◦ One option is public ownership and operation
 Public takeover of private business is rare, except when certain
conditions are present
◦ That leaves one other option
 Regulation
203
Regulation of Natural
Monopoly

Under regulation, a government agency digs deep
into the operations of a business and takes some of
the firm’s decisions under its own control
◦ In the case of a natural monopoly, regulators are
interested in achieving economic efficiency, which they
do by telling the firm what price it can charge
204
Regulation of Natural
Monopoly

At first glance, you might think that natural
monopoly regulators have an easy job
 There is the matter of information:
 regulators often depend on information obtained from
monopolies
205
Regulation of Natural
Monopoly
Regulators determine a price that gives owners a
“fair rate of return” for funds they’ve put into the
monopoly
This price should give monopoly what economists
call normal profit. i.e. profit just high enough to
cover all of the owners’ opportunity costs, including
the foregone interest of their own funds
206
Price regulation problems

Price regulation is not a perfect solution
 Provides little or no incentive for the natural monopoly to
economize on capital
 Tendency of regulated natural monopolies to overinvest in
capital
 When a firm is not striving to maximize profit (in this case,
because the government is guaranteeing a specific rate of
return), it does not economize on costs. Regulated firms thus
have little incentive to hold down costs.
207
Problems with pricing
regulation include
 Regulatory
boards are often made up of individuals
from the industry being regulated.
 Industries
that could very well compete desire to be
declared natural monopolies.
Competition Law in Practice
If the competition laws are to raise social
welfare, the government must determine which
mergers are desirable and which are not.
Competition Law in Practice
The two views of competition are
judgment by performance and judgment
by structure
: 210
Competition Law in practice:
Judgment by Performance or
Structure?

Judgment by performance – we should
judge the competitiveness of markets by
the performance (behavior) of firms in
the market.
Judgement by Performance
A firm’s size within an industry is
insufficient evidence for the court to rule
against it in an antitrust suit. Issue is
behavior not size.
Evidence must show that the firm
actually used its size to violate antitrust
laws.
: 212
Competition Law in practice:
Judgment by Performance or
Structure?

Judgment by structure – we should judge the
competitiveness of markets by the structure
of the industry.
Judgment by structure
A firm’s size within an industry is
considered sufficient evidence for the
court to rule against it in an antitrust suit.
Does not differentiate between good and
bad monopolies.
: 214
Competition Law in practice
A trust or cartel is a combination of
firms in which the firms have not
actually merged, but act as a single
entity.
Competition Law in practice

A trust sets common prices and governs the
output of individual member firms.
A trust can, and often does act like a
monopolist.
Anti-trust history: The
Standard Oil and American
Tobacco Cases
In 1911, the U.S. Supreme Court
determined that both Standard Oil and
American Tobacco were structural
monopolies in that each controlled over
90 percent of their markets.
The Standard Oil and American
Tobacco Cases

In spite of this, they were not judged to
have violated the antitrust legislation
because of their structure, but because of
their “unfair business practices.”
The Standard Oil and American
Tobacco Cases

This judgment on performance, not
structure, is often called the abuse theory
since a firm is legally considered a
monopoly only if it commits monopolistic
abuses.
Judging Markets by Structure
and Performance: The Reality

Judging by structure seems inherently
unfair since the alleged wrongdoer is
doing what it is supposed to be doing—
producing the best product at the lowest
possible price.
Judging Markets by Structure
and Performance: The Reality
Supporters of this position recognize this
problem, but they nevertheless favor the
structure criterion because of its practicality.
Contextual Judgments and the
Capabilities of the Courts

Judgment by performance requires that each action
of a firm must be analyzed on a case-by-case basis.

This is enormously expensive and time-consuming.

Courts must find a way to limit the cases they look
at.
Contextual Judgments and the
Capabilities of the Courts
 Some
argue that structure is a predictor of
future performance.

A monopolist may be charging low prices
now.

Once the competition melts away, the
offending firm jacks up its prices.
Determining the Relevant
Market and Industry

The structural approach is not without
faults.

Choosing the relevant market when
evaluating competitiveness is difficult to
do.
Determining the Relevant
Market and Industry

In the du Pont case (1956), the relevant
market for cellophane was the flexiblewrap industry not the cellophane market
of which du Pont owned 100 percent.

Therefore, du Pont was not considered a
monopolist.
Determining the Relevant
Market and Industry

Both structure and performance criteria have
ambiguities, and in the real world there are no
definitive criteria for judging whether a firm
has violated the antitrust statutes.
Recent Antitrust
Enforcement

In recent years, antitrust law has worked
mainly through its deterrent effect

Many potential mergers are never even
proposed because firms know the merger
would not be allowed.
Recent Antitrust
Enforcement

Technology was changing so fast that by
the time litigation reached the courts, the
issues were no longer relevant.
Three Recent Antitrust
Cases

The modern era of antitrust policy has
been marked by important cases in the
computer and telecommunications market.
The Microsoft Case

Microsoft is the dominant player in the
software industry, controlling over 50
percent of the world market for software
and between 80 and 90 percent of the
operating systems market worldwide.
The Microsoft Case

Since all software must be compatible
with an operating system, Microsoft has
an enormous competitive advantage for
its other divisions.
The Microsoft Case

The U.S. Justice department charged
Microsoft with an antitrust violation:
Possessing monopoly power in the market for
personal computing operating systems.
Tying other Microsoft products to its Windows
operating system.
The Microsoft Case

The U.S. Justice department charged
Microsoft with an antitrust violation:
Entering into agreements that kept computer
manufacturers that install Windows, from offering
software that competes with Windows software.
Is Microsoft a Monopolist?

Monopolists need barriers to entry.

The computer software industry has two
sources of monopoly power – network
externalities and economies of scale.
Is Microsoft a Monopolist?

Network externalities exist because as the
number of applications supported by a
single platform increase, the value of the
platform also increases.
Is Microsoft a Monopolist?

Economies of scale exist because of the
cost of developing a new platform and
new software is significant while the cost
of producing it is minimal.
Is Microsoft a Monopolist?

With its stable 90 percent market share, it
certainly is a monopoly.
Is Microsoft a Predatory
Monopolist?

By directing the development of in-house
software to favor Windows, Microsoft
strengthened the barrier to entry created by
network externalities.
Is Microsoft a Predatory
Monopolist?

Microsoft also penalized computer
manufacturers that installed Windows if
they installed competing software.
Is Microsoft a Predatory
Monopolist?

Microsoft packaged Internet Explorer as part
of Windows at no additional cost to the buyer
which froze out Netscape Navigator.
Resolution of the Microsoft
Case

In late 1999, a federal judge ruled that Microsoft
violated the Sherman Act by attempting to maintain
its monopoly power by anti-competitive means.
Mergers, Acquisitions, and
Takeovers

In order to achieve economies of scope and
economies of scale, firms have been
simultaneously breaking up and merging.
Mergers, Acquisitions, and
Takeovers

The law allows firms to break up any
way they like.

Mergers, on the other hand, must fall
within the law's antitrust guidelines.
Mergers, Acquisitions, and
Takeovers

Acquisitions and takeovers both result in
the combining of firms.
Acquisitions and Takeovers

The term merger is a general term meaning
the act of combining two firms.
Mergers

There are three types of mergers:
horizontal, vertical, and conglomerate.
Mergers

A horizontal merger is the merging of two
companies in the same industry.

Most antitrust policy has centered on
horizontal mergers.
Mergers

A vertical merger is a firm merging with
the supplier of one of its inputs.
Mergers

If the merged firms are able to limit access
of other buyers or sellers to the market, the
merger would be in violation of the
antitrust law
Mergers

A conglomerate merger is the merging of
two companies in unrelated industries.
Mergers

There are five reasons why unrelated
firms would wish to merge.
To achieve economies of scope.
To get a good buy.
To diversify.
To ward off a takeover bid.
To strengthen their political-economic
influence.
Recent Merger Activity

Globalization leads to mergers because
firms can gain instant foreign distribution,
knowledge of local markets, and lower the
costs by redirecting production to low-cost
areas.

Deregulation has caused mergers to occur
among banks, electricity, and
telecommunications companies.
Recent Merger Activity and
Deacquisitions

Technological change has created takeover
targets.
If a firm wants a new technology it
could buy the firm that owns it.
Recent Merger Activity and
Deacquisitions

Regulators sometimes will not let mergers
to go through without a deacquisition
program.

Deacquisitions occur when a firm sells parts
of another company it has bought or parts
of itself.
International Competition

Antitrust policymakers now view that the
relevant market is the international market.

Some countries oppose antitrust laws
because of economies of scale, lack of a
strong ideology supporting competition, and
strong cultural ties between government
and business.
Assessment of Antitrust Policy
Competition laws have costs and benefits.
Sometimes companies merge not to reduce competition
but to lower costs through joint production.
The benefits of greater efficiencies through mergers are
called synergies.
Assessment of Antitrust
Policy

Almost all economists agree that
antitrust enforcement has not reduced
the size of firms below the minimally
efficient level, the level at which a firm
can take full advantage of economies of
scale.
Assessment of Antitrust
Policy

Performance advocates generally believe
enforcement was not needed while
structural advocates generally believe
that it was.
Assessment of Antitrust
Policy

They are also mixed on their judgment
about whether any type of antitrust
action is feasible in a rapidly changing
technological arena.