Transcript Slide 1

Sustainable Energy Systems
Theory of Regulation
Lecture 2
PhD, DFA
M. Victor M. Martins and Filomena Garcia
Semester 2
2009/2010
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest group theory
1.2 Theories of regulation normative and positive theory,
interest group theory and economic theory of regulation
Bibliography

VVH ( chap. 10 )

Posner , R. A. 1974 “ Theories of Regulation” , Bell Journal of Economics and
Management Science, 25 (1), Spring, pp. 335- 373.

Stigler, J. G. 1971, "The Theory of Economic Regulation," Bell Journal of
Management Science, 2 (1), Spring, pp. 3 - 21.

Peltzman, S. 1989 "The Economic Theory of Regulation after a Decade of
Deregulation," Brookings Papers on Economic Activity: Microeconomics, pp. 1 41.
Slide 2
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest group theory
Economists explain government policies:
1. As an instrument to correct market failures and
improve social welfare
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(i) optimizing and rational choice behavior
(ii) modified by incentives from various sources, and subject
to
(iii) political and other institutions.
2. As an instrument to serve the individual or group
interest
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Models of public choice theory
Collective action problems
3. As a mix of the approaches 1. and 2..
Slide 3
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest goup theory
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Theories of regulation
Two alternative approches to analyse regulation policy
outcomes:
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A. Public interest theory (normative analysis as a positive
theory): regulatory intervention occurs in the interest of the
public at large ( Joskov and Noll 1981 )
B. Private interest theory: regulatory intervention is the
result of ( individual ) powerful interest groups exerting
pressure on polititians and regulators to capture rents at the
expense of more dispersed groups ( Stigler, 1971; Peltzman,
1976; Becker, 1981 )
Slide 4
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation :public interest theory

A. Public interest theory – PIT- ( Normative
analysis as a positive theory)
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Uses normative analysis (when should regulation
occur) to generate a positive theory by saying that
regulation is supplied in response to the public’s
demand for the correction of a market failure.
PIT is a way to:
Insure competition
 Impact externalities
 Introduce social objectives in economic policies

Slide 5
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
Four models of Market Structure
Nº of firms
Ease of
entry/exit
Product type
Perfect
competition
Many
Easy
Standardized
Monopolistic
competition
Many
Easy
Diferentiated
Oligopoly
Few
Dificult/Barriers Standardized/
Diferentiated
Monopoly
One
Very difficult
Unique
Slide 6
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory

Different market structures are associated with
different levels of social welfare and deadweight loss.
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Cournot and Bertrand oligopoly are better than monopoly
and collusive oligopoly.
Firms within oligopolies can be thought of as playing games
where they attempt to maximise profits by choosing levels of
variables under there control in the light of assumed
reactions of other firms.
Economic regulation is important where monopoly
exists and conditions make sustained collusion likely
to occur and other types of market failures.
Slide 7
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory

Perfect competion and monopoly
MR=MC
P=MC
P
P
D
CS
S
Consumer
surplus
Pc
0
MC
D
PM
DWL
CS=>PS
Pc
Producer
surplus
Qc
Quantity
0
QM
QC
Quantity
Slide 8
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory
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Public interest theory- PIT
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Under ( natural ) monopoly productive efficiency suggests we
should have one firm and P=MC but this does not happen in
an unconstrained market;
This sort of market failure, along with the general need for
mechanisms of regular public disclosure by business, make
regulation critical if the public interest is to be protected.
PIT suggests that in this circunstance we should have
regulation in order to correct market failure and improve
social welfare
Slide 9
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : public interest theory

Critique of the Public Interest Theory
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Incomplete theory: states that regulation occurs when it
should occur, without stating the mechanism that allows the
public to bring this result about.
Many industries have been regulated without any efficiency
rationale (regulation in taxi cab, trucking, etc.)
Firms typically support regulation, and it is not clear why this
should be the case, if the only thing that regulation does is to
provide firms with “normal” profits.
Empirically, even for Natural Monopolies, regulation had not a
strong effect on prices as PIT would predict.
Slide 10
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theories
B. Private Interest Theory
Rational choice paradigm vs. public choice school of
thought.
 Public choice models -> that politicians have an incentive to be
re-elected and maintain power and control.
 Decisions made by a politician can be evaluated in terms of the
objective of attracting the necessary support for successful
reelection.
Stigler (1971) argued that firms will lobby legislators for
regulation when such regulation provides:
 (1) direct monetary subsidies,
 (2) constraints on substitute products or subsidies on
complementary products,
 (3) easier price-fixing/collusive atmosphere, and
 (4) incumbent firms with the ability to control entry by potential
new rivals.
Slide 11
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Capture theory ( Stigler ) – Contrasts with PIT
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Firms capture the regulatory process because each firm has a
lot at stake.
While the public as a whole has a lot at stake, any one
person has only a very small stake and so has little incentive
to invest resources in affecting the regulatory process.
There are few firms relative to the overall public decreasing
costs of organizing
Firms have the incentive and the opportunity to successfully
invest resources in lobbying for favorable regulation.
Evidence supporting the capture theory of regulation:
 revolving door deals - high-level regulators and other officials
leave government and find high-level jobs in the same
industry that they had been responsible for regulating.
Slide 12
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Critique of the Capture theory
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Lacks on the explanation on how the regulation comes to be
controlled by the industry and not by other interest groups.
Existence of many regulations which were not supported by
the industry and have resulted in lower profits.
Example:
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Oil and natural gas price regulation
Social regulation over the environment
Product safety
Worker safety etc...
Difficulty in explaining deregulation.
Slide 13
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

Economic theory of regulation: improvement of capture
theory
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Peltzman model (Peltzman. S. "Toward a More General Theory of Regulation,"
Journal of Law and Economics, August 1976:211-240. )
Various groups (e.g., consumers and regulated firms) compete
against each other in the political arena to increase their income
and wealth, or to achieve other objectives (such as
environmental cleanliness). That is, groups vie to shape
regulatory initiatives in a way that will serve their own
(sometimes narrowly-defined) interests.
Agents are rational in choosing actions that are utilitymaximizing.
Slide 14
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Basic assumption:
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Regulation is one means by which state power can be
exercised to the benefit of specific groups. Regulation is
supplied by utility-maximizing politicians and regulators
in response to the demand for regulation by interest
groups.
Those who control regulatory policy do so to maximize
political support. Political support comes in the form of
votes or campaign contributions.
Slide 15
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation: private interest theory
Model
 Let the political support function (M) be described by:
M = M(R, L)
 Where R is rates established for the regulated service
(e.g., electricity) by the regulatory authority (e.g., the
ERSE) and L is the allowed level of profit earned by
the regulated firm (e.g., REN, EDP-Distribuição).
 Notice that M is inversely related to R, ceteris paribus,
and directly related to L, ceteris paribus. That is:
M / R  0

M / L  0
Profits depend on price rates : L=L(R)
Slide 16
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

In other words:
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Regulators or politicians prefer to set low rates,
other things being equal, since this strategy will
garner political support from the customers of
regulated firms.
On the other hand, allowing the regulated firm to
earn high profits (which would mean higher rates,
by the way) puts the regulated in good stead with
business and social elites that own/control
regulated firms.
Slide 17
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Thus we have two interest groups with conflicting agendas:
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Consumers want low rates; whereas regulated firms
want high profits.
The politicians/regulators face a trade-off:
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If they allow higher profits, they gain political support from
firms that they regulate but lose support from consumers.
The reverse is also true. This trade-off is illustrated by the isopolitical support function.
The iso-political support function illustrates all
combinations of R’s and L’s that yield equal political
support.
Slide 18
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Iso-political support functions
Profit of the reg. firms
M3
L2
L1
0
M2
M1
X
Z
Y
M 3 pre fe re d
to M 2
pre fe r e d to
M1
R2
R1
Utility rate s pe r KWh
Slide 19
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Optimal regulatory policy
M3
Profit of the reg. firms
M2
M1
Y
Lm ax
X
L1
0
Profit
function
L=L(R)
Rc
R*
RM
Utility rate s
pe r KWh
Slide 20
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
LMAX
Profit of the reg. firms
Extreme outcomes
0
Re gulator
capture d by
cons um e rs
MC
MF
X
Re gulator
capture d by re g.
firm s
Profit function
L=L(R)
Y
RC
RM
Utility rate s
pe r KWh
Slide 21
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : normative and positive analysis, interest goup theory
• Optimal solution
 Somewhere between “Y” and “X” ( slide 19 )
Slope of the regulator/legislator indiference curve M is
positive ( slide 18 )
 Optimal policy is at R* ( slide 18), between a competitive
price and a monopoly price
Implication: Industries who have more to gain from
regulation:
 are either relatively competitive -> firms gain from
regulation (agriculture, taxis,etc..)
 or relatively monopolistic -> consumers gain from regulation
(network industries ).
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Slide 22
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

As the legislator/regulator takes into account the
opposition offered by the losers, he will regulate up to the
point where the obtained marginal support equals the
marginal opposition. This means that the regulation will
not stop neither at the point ‘X” nor at the point ‘Y’, but
somewhere in between ( slide 19 ).
Slide 23
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Criticisms
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Despite the great appeal of the economic theory of regulation
(such as social and environmental regulation) as well as a
simultaneous tendency for deregulation (the most visible on
commercial aviation).
The challenge provided by the environmental and social
regulation is that they tend to benefit big and diffuse groups.
Exactly the opposite of what is predicted by the theory.
The new tendency of deregulation also seems to contradicts
the basic conclusion of the theory of regulation. Although
several attempts to reconcile with these new evolutions, this
is still an open question.
Slide 24
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Criticisms ( cont.)
 The Economic theory of regulation looks basically to
the demand side of regulation. That is, the theory
assumes that the regulator/legislator/president is
either the same person (player) or that the latter
perfectly controls the former.
 In other words, it is not taken into account the
existence of a principal-agent problem between
legislator and regulator.
 In actual life, however, there exist a strong
problem of asymmetric information
Slide 25
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Becker model
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Becker created what he calls as “influence functions” to
demonstrate how pressures by interest-groups affect the taxes paid
and the subsidies received.
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Competition among groups for political influence determines the
equilibrium structure of taxes, subsidies, and other political favors.
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Regulation ( broad sense ) is used to increase the welfare of more
influential interest groups
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Political equilibrium has the property that all groups maximize their
income
Slide 26
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Assumptions
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Taxes, subsidies, regulation etc. are used to increase the
welfare of the most influential pressure groups. Groups
compete to exert more pressure on political resources.
The utility function of each person can be measured by his
full income, which includes leisure and other extra market
activities
Pressure depends on the number of members and the
resources used
Two homogeneous groups in the society “1” and “2”.
All political activities that raise the income of a group will be
considered a subsidy to that group; and all activities that
lower incomes will be considered a tax
Slide 27
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

Model
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I1(p1,p2 ) is the the influence function of group 1: it is
assumed that the function is increasing in the pressure of
group 1 and decreasing in the pressure of group 2.
I2(p1,p2 ) is the the influence function of group 2: it is
assumed that the function is increasing in the pressure of
group 2 and decreasing in the pressure of group 1.
In order to transfer wealth , T, from group 2 to group 1 it is
assumed that 2´s wealth must be reduced by (1+x)T, where
x>0. The amount xT is the wefare loss from regulation
The aggregate influence is fixed: what is important for
determining regulation ( revenue transfer between groups ) is
the influence of one group relative to the influence of another
goup.
Slide 28
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

Model ( cont.)
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Taking into account the benefits and costs of pressure we can
derive the optimal strategy of group 1, p1, given any value of
p2.
F1 is the group´s 1 best response function; F2 is the group´s
2 best response function. They are plotted in slide 30 and e0
is the political equilibrium
If x increases, more wealth is taken from group 2, which
implies that it will exert more pressure for each level of
pressure of group 1 -> F2 moves upwards.
Slide 29
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
Influence curves of 1 and 2
Pressure by 2
F1(p2)
e0
F2(p1)
Pressure by 1
Slide 30
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

The group that becomes more efficient producing
political influence will be able to reduce its tax and
increase subsidies;
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If both groups become more efficient pressuring, the
relative influence of each will not change much
Increase in costs of regulation increases the
influence of activity of firm 2 and reduces it for
consumer 1.
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This is because a given wealth transfer to 2 from 1 is
more costly to firm 2 ( increased incentive to pay to avoid
it ) and is more costly to acquire for consumer 1 ( less
incentive to pay to get it).
Slide 31
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory
F2(p1)
Pressure by 2
F1(p2)
F2(p1)
Pressure by
1
Slide 32
Theory of Regulation
Sustainable
Energy
Systems
Theories of regulation : private interest theory

Conclusions of private interest theories:
Tendency for regulation to be designed to benefit relatively
small groups with strong preferences relative to big groups
with weak preferences
 Pro-producer tendencies are disciplined by consumer groups
meaning that price is less than the monopoly level
 Regulation most likely in competitive or monopoly industries as
there is strong incentive for one group to lobby for regulation
 In the presence of market failure, regulation is likely because
of the large losses this inflicts on some interest groups
Private interest theories, in contrast to Public Interest Theories,
do not state that the regulation should only occur when there are
market failures.
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
Slide 33