Economic Regulation - Research Paper Example

? ECONOMIC REGULATION OR COMPETITION POLICY Submitted By Introduction 3 Economic Regulations 3 Background 4 Economic RegulationTheories 4 Public Interest Approach 5 Public Choice Theory 5 Tools of Economic Regulation 5 Rate of Return Regulation 6 AJ effect 7 Problems with Regulatory Policy 7 Comparing Competition policy and Economic Regulation 8 Comparing the Roles of Competitive Agencies and Economic Regulators 9 Case Study 10 Conclusion 11 Bibliography 13 Introduction In this paper I will discuss economic regulations or competition analysis. The research would be largely based on theory but I will also try to prove my point through examples and empirical evidence. I will start with the building of concept first about economic regulations and then will discuss various aspects of it in detail. This includes theories of economic regulations and Competition policy. The relationship between Competition policy and Economic regulation will also be discussed. Comparison of the two approaches and the synergies that it will bring if both are used by the same agency. We also discuss some other concepts which include AJ effect and rate of return regulation. Literature Review In this literature review we will discuss in detail various concepts related to the topic. Economic Regulations George Stigler was the pioneer of the theory of economic regulation. He suggested that as rule regulations are designed in such a way that they benefit the industry who acquire them rather than protecting or benefitting the public. (Vane) He integrated the economics of regulation and economics of politics. According to him same analysis tools should be applied to both because both of them display self interested rational behavior. Economic regulation is a form of antitrust law in traditional economics through which concentration of wealth is controlled. The major objective was that private motives of accumulation of wealth do not hurt the public interest. It was introduced to safeguard public interest. The intension was to protect public from economic abuses such as unreasonable prices, anticompetitive activities, to protect from sale of unethical products which are hazardous for health and safety of the public. The basic role of regulators was of the watchman of the public interest. In addition to that the role of regulators is of preventing monopoly and preserving competition. (Cochran) Background The regulatory scene which we witness today is significantly different from what it was in 1980’s. This phenomenon is due to massive privatization which gave birth to new regulatory apparatus. This process of privatization is now an international affair. Hence many countries and regions are now following this deregulation by trying to implement the best practices in other systems and avoiding the worst mistakes. A major problem with the deregulation is that it is based on very weak logical foundation of improving efficiency. In the absence of competition this may not be the case. (Michael A Crew) Economic Regulation Theories It is important to note that study of regulation cannot be done in isolation. It has to be studied in the social, political and economic context in which it exists. The relative powers of different interest groups play their part in formulating and shaping the regulations. Different regulatory mechanisms interact with each other and once implemented they play an important role as the motives of decision makers. A thorough understanding of regulatory process is thus not possible without considering specific institutions, political structures and actors. Two major theories of government behavior about economic regulations are public interest approach and self interest theory or public choice theory. (Jan) Public Interest Approach According to this theory government intervention or regulation is required only to in case of market failure, when market is unable to achieve a particular social objective such as equality. Government intervention is needed to correct this failure. This approach is used to justify intervention for its merits such as education and health care. Public Choice Theory According to this approach different solutions adopted to correct market failure does not arise from some abstract or monolithic public interest but the interests, cost and benefits of all the actors involved determine it. It allows the possibility that the result may not be in consistency with the government’s social objectives. This approach is criticized for the motivation of its self interest. Tools of Economic Regulation The major tool of regulatory policy is a set of devices which involves governments control and influence on the behavior of individuals and corporations. The various tools of economic regulation are (Chris J Dolan) Supervision of securities market Regulation of financial institutions Regulations on disclosure of information Procedures affecting labor relations Prohibition of activities regarded as anti competitive The two basic purposes of regulatory body are promotion of conditions essential for efficient working of market place and prevention of socially undesirable outcomes. These two purposes may not always be complementary. Rate of Return Regulation The regulator can conduct earnings audit to recalibrate price so that target rate of return can be achieved unless it is prohibited by law. (Kessides)Although Firm’s earning do not directly affect prices under pure price cap regime but the provisions are there for price adjustments if rate of return falls outside desirable range. Under this theory we can set periods between price revision which is a sort of trade off between providing incentive for efficiency and reducing excessive profits. Longer revision periods are beneficial for firms and shorter periods are beneficial for consumers. Very short periods will result in rate of return regulation. In some profit sharing mechanism organizations are allowed to keep all profit as long as rate of return falls within the specified range. Cost efficiency is stronger under rate of return regulation than price cap scheme. The decision between rate of return regulation and price cap can be empirically made. The choice between them depends on a lot of other factors and the decision is not clear cut. AJ effect AJ effect is all about cost minimization. This cost minimization is achieved through equating the marginal rate of substitution of capital for labor. (A. Mitchell Pollinsky) An AJ firm does not waste resources. Inefficiency cannot be in term of maximum utilization but inappropriate use of inputs. AJ model has many variations and its implications can be empirically tested. In the AJ type model the regulator have no knowledge of the production function, cost opportunities or realized costs or demand. The regulator just sets the allowed rate of return and the firm has to manage it. Problems with Regulatory Policy Although managing Regulatory policy seems an easier task because it seems that regulating monopoly will improve efficiency. But a critical analysis of the history of regulation reveals that regulation too has its own set of shortcomings. Some of them are discussed below. (James D Gawartney) Lack of information Cost shifting Special interest influence When we talk about ideal conditions we mean that the regulators have complete knowledge about the firm but that is usually not the case. Even the firms themselves don’t have the precise knowledge about their cost and demand curves. The actual profit cannot be easily identified because accounting profit is different from economic profit. Regulation also changes incentives hence cost estimates of the organization also changes. The regulatory agency imposes fair return rule so that when cost decreases regulatory agency will enforce price reduction and if cost increases the regulatory agency will increase price. Long run profits become independent of the efficiency of the management which results in the mismanagement of resources by managers which results in increased costs. There also exist political elements associated with the regulatory policy and it only aggravates the problem. The regulated firms want friendly and reasonable people to serve as regulators. In doing so efficiency and professionalism is ignored. Comparing Competition policy and Economic Regulation The other major and opponent approach to economic regulation is competition policy. we can understand the role of regulatory policy more effectively if we compare the two approaches and the differences between them. The differences between the two are undeniable, but the characteristic of the differences is such that is within the control of the agency and can be changed. (Medalla) If we compare the differences between competition policy and economic regulation following points are notable. 1. Competition policy reduces market power whereas Economic regulation attenuates the effects of market power. 2. Completion policy prefers structural remedies whereas Economic regulation imposes behavioral conditions. 3. Competition policy is about ex post enforcement (except mergers) whereas Economic regulation is of ex ante prescriptive approach. 4. Competition policy relies on complaints. It gathers information only when it is necessary for particular enforcement action. Economic regulation frequently intervenes. It requires continual flow of information from regulated firms. 5. Competition policy has relatively narrow range of goals that are not in conflict with each other. Economic regulation has broader range of goals which requires expertise and adeptness in deciding about tradeoffs because they are usually in conflict with each other. Comparing the Roles of Competitive Agencies and Economic Regulators Instead of treating these two theories as rivals we should use the two theories simultaneously. The desirable characteristics of competition policy and benefits of regulatory theory should not offset each other. We can compare the roles of the two as under. Competition policy not only believes in competition but also motivates to demonstrate them across many sectors. Regulatory agency uses regulations to avoid market failure. Dynamic efficiency is the ultimate goal of completion policy whereas regulatory agency desires efficiency but believes it’s impossible. Market power and market analysis is identified in completion policy while regulatory agency believes in set definition of market. Similarities and differences within industry are recognized in competition policy whereas regulatory agency treats regulated industry as unique. In completion policy price setting is not appreciated while in regulatory agency price setting is routine activity. Case Study Now we will use a case study where regulation policy was exercised and will see its effects in the real world to have the empirical data to prove our point. We will discuss the situation of USA where many industries including airline, railways and more recently Telecommunication has undergone deregulation. Economic policy in USA strongly favors competitive markets in comparison to previously regulated sectors. The basic vision of this competitive policy was to allow market to make decisions about prices and output. It was deemed that this would bring desirable results with respect to price, innovation and service and in providing benefits to both competition and consumers. It was believed that traditional regulations were inefficient and ineffective and it only protected the interests of the establishment. As expected this simplistic vision is not without its fault. Its weakness was seen when Enron (which operated in gas and electricity markets) collapsed along with many other deregulated organizations such as WorldCom going bankrupt. These deregulated organizations gave rise to many problems and generated a list of complaints which included quality and price on service of freight railroads. The unregulated model also failed miserably in the health sector where there was no control over the upward spiral of healthcare costs. Deregulation actually failed to bring any promised benefits in fact it was harmful in some cases. All this led to a debate over the appropriate policy. (Peter C Carstensen)Hence the public policy pendulum shifts back to deregulation. Meanwhile massive merger movements took place in formerly regulated industries. The transformation of formerly regulated industries to completion is closely linked to mergers. This pattern and trend was followed in almost all industries railways, banks, airlines, gas and electric utilities, healthcare and telecommunication. With these structural changes industries like telecom and healthcare experienced great technological innovations. This evolution and transformation of industries towards greater reliance on market institutions vary from industry to industry. American economy as well as many other economies of the world is moving towards greater reliance on market mechanism from the previous concept of state owned and state managed economies. Conclusion In this paper we have discussed the regulation economics its various tools and theories. We also discussed rate of return regulation and AJ effect. We analyzed various aspects of competition policy as well. None of these theories are without its set of benefits and shortcomings. We also discussed in detail the merits and demerits of each theory. A case study of USA was also discussed to develop a sound understanding of the happenings in real world. We also did comparative analysis of all these theories and tried to find the synergies between them. The conclusion I have reached after this research is that there is no one theory which is totally acceptable and applicable to all organizations and all countries. The truth is that the efficiency and effectiveness of any theory is dependent on many variables and hence varies from industry to industry and country to country. What we need to do is instead of selecting and applying any one model we should try to use the combination which best suits our needs. We should try to tap the synergies and reap the benefits of all the models. We should conduct our model in the light of experience of other organizations hence maximizing benefits and minimizing cost and risk. Complete regularization of the economy can be as damaging as leaving it completely open and competitive as we saw in the case study discussed. Government should be minimal but economy can be left unguarded and uncontrolled. The benefits of the society must be safeguarded without compromising on the efficiency of the firm. A complete and thorough analysis of all the factors and agents involved is necessary before any policy decision can be made. Bibliography A. Mitchell Pollinsky, Steven Shavell. Handbook of Law and Economics. UK: Elsevier BV, 2007. Chris J Dolan, John P Frendreis. The Presidency and Economic Policy. UK: RowMann & Littlefield Publishers, 2008. James D Gawartney, Richard L. Stroup. Economics: Private and Public Choice. USA: South Western Cengage Learning, 2009. Jan, Stephan. Economic Analysis for Management and Policy. New York: McGraw-Hill, 2006. Kessides, Ioannis Nicolaos. Reforming Infrastructure: privatization, regulation and competion. World Bank Publications, 2004. Medalla, Erlinda M. Competition Policy in East Asia. New York: Routledge, 2005. Michael A Crew, David Parker. International Handbook on Economic Regulation. Massachusetts: Edward Elgar Publishing Limited, 2006. Peter C Carstensen, Susan Beth Farmer. Competition Policy and Merger Analysis in Deregulated and newly Competitive Industries. Massachusetts: Edward Elgar Publishing Limited, 2008. Vane, Howard R. The Nobel Memorial Laureats in Economics. Massachusetts: Edward Elgar Publishing Limited, 2005. Read More