Economic Theory Of Regulation Research Paper

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Regulation is defined as ‘the act of controlling or directing by a rule, principle, [or] method’ (Webster 1989). This definition encompasses many forms of control by a variety of actors. The ensuing discussion will focus on the important form of economic regulation in which the government controls the activities of producers in order to enhance the well being of the customers they serve.

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1. Regulating With Accurate Information

When the average cost that each firm incurs in serving customers (i.e., the firm’s cost per customer) declines as the firm serves more customers, industry costs will be minimized when only one producer serves all customers. For example, the cost of providing local telephone service to a community is often lower when a single telecommunications network is constructed and operated than when multiple networks are operated. Similarly, because of declining average costs, the local distribution of electricity, water, and gas is often provided at minimum cost by a single firm. But if a single profit-maximizing firm faces no competition, consumers will have no alternative source of supply, and so an unregulated sole producer may have considerable freedom to charge high prices for its services. Regulation of the prices charged by a single (monopoly) supplier can help to protect consumers while permitting the industry configuration that minimizes the costs of serving customers.

Consumer protection can take many forms, particularly when the regulated supplier provides more than one service. To illustrate this fact, consider the mandate of the US Postal Rate Commission. When it sets the prices that the US Postal Service charges for the services it delivers, the Commission is required to ensure that the pricing structure is simple and that prices are fair and equitable. The Commission must also ensure that established prices reflect the value of the service rendered and cover the costs of providing each service (Postal Reorganization Act 1970, § 3622(b)).

To determine how a regulatory body (hereafter, a regulator) might attempt to satisfy such mandates, consider first, the case of an omniscient regulator who knows both how highly consumers value the services produced by the regulated firm and the minimum possible costs that the firm incurs in serving customers.

1.1 Linear Pricing With A Single Output

Initially suppose that the regulated firm produces only one product. Also suppose that the regulator desires to set the price for this product so as to maximize the aggregate welfare of all consumers, while delivering sufficient profit to the firm to guarantee that it will voluntarily serve customers at the established price. Consumer welfare measures the total value that consumers derive from their purchase and consumption of the product. A firm’s profit is the difference between the revenues it receives and the costs it incurs. Profit is a measure of producer welfare.

To maximize consumer welfare while delivering at least the minimum required level of producer welfare, the regulator must set the price that consumers pay for each unit of the product they purchase so as to deliver the largest possible sum of consumer and producer welfare. This welfare-maximizing price is the one that equals the extra (or marginal) cost the firm incurs in producing the last unit of the product it sells. This is because consumers will continue to buy more of the product as long as the extra value they receive from doing so exceeds the price they must pay for an additional unit of the product. Therefore, when the price reflects the producer’s marginal cost of production, consumers will purchase additional units of the product whenever the value they derive from consumption exceeds the cost of allowing that consumption. Consequently, a regulated price that reflects the producer’s marginal cost of production will ensure the level of output that maximizes the combined welfare of consumers and the firm.

However, when unit production costs decline as the firm produces more output, a price set equal to the marginal cost of producing the last unit of output will cause the firm to suffer a financial loss. For all but the last unit produced, the compensation the firm receives (i.e., the price) will be less than the incremental production cost it incurs. To ensure that the total revenue the firm receives does not fall below the total production cost it incurs, the regulator must raise the authorized price above the level of marginal cost. A price equal to the firm’s average cost of production at the prevailing level of production will deliver the highest possible level of welfare to consumers while ensuring that the regulated firm’s costs do not exceed its revenues.

1.2 Nonlinear Pricing

A regulator might contemplate implementing a pricing structure in which customers do not simply pay the same unit price for each unit of the product they purchase. For example, each customer might be charged both a fixed participation fee that does not vary with the amount of the product purchased and a constant unit price for each unit that is purchased. Under such a pricing structure, the unit price might be set equal to the regulated supplier’s marginal cost of producing the last unit of output it sells and the participation fee might be set to recover exactly the deficit the firm incurs (i.e., the difference between the total revenue it receives from sales and the total production costs it incurs) when it sells its product at the specified unit price. This pricing structure would deliver the maximum possible level of consumer welfare while ensuring non-negative profit for the firm, provided the participation fee is not so onerous as to compel some customers to terminate all purchases of the regulated product (Wilson 1993). In practice, large participation fees are often viewed as unduly onerous for consumers with limited resources. Consequently, particular concern for the well being of these consumers or general concerns with equity and fairness can limit the use of participation fees and other alternatives to constant unit prices.

1.3 Linear Pricing With Multiple Outputs

Now consider the more common setting in which the regulated firm produces multiple products (for example, both rural and urban telephone services). Also suppose the regulator chooses to implement only a constant unit price for each regulated product. Since the prices charged for different products can vary, there are many different ways in which the regulator can raise prices above marginal production costs while ensuring that revenues match total operating costs exactly. To maximize the combined welfare of all consumers, the regulator will implement proportionate mark-ups ([ pi – ci]/pi) of price ( pi) above marginal cost (ci) that vary inversely with the sensitivity of consumer demand to price (Ramsey 1927, Baumol and Bradford 1970). The regulator will set the price of a product close to its marginal cost of production when a larger price increase would cause consumers to severely curtail their purchases of the product. In contrast, the regulator will raise the price of a product well above its marginal cost of production when doing so does not cause consumers to reduce their purchases of the product significantly. This pricing policy secures the greatest combined welfare for consumers by limiting the aggregate reduction in consumption that arises as prices are raised sufficiently far above marginal production costs to generate revenues that match production costs.

1.4 Quality Deterioration And Cream Skimming

As noted above, regulators do not always seek solely to maximize the aggregate welfare of consumers. Consequently, in practice, regulated prices are not always raised above marginal costs by greater amounts the less sensitive consumer demand is to price. In fact, some prices (e.g., those for rural, residential telephone service) may be set below marginal production costs while other prices (e.g., those for telephone service to urban business customers) may be set well above marginal production costs. Such prices may arise from fairness and equity concerns, for example. Pricing patterns of this sort can introduce two important problems: quality deterioration and cream skimming.

When the price of a product is set below its marginal cost of production, each extra unit of the product that the firm sells causes its profit to decline. Consequently, the firm would secure greater profit if consumers purchased fewer units of the product. One way to induce consumers to purchase fewer units of a product is to reduce the quality of the product. Therefore, when prices are set below marginal production costs, the regulator may need to impose penalties on the firm if the level of service quality it delivers is found to be inadequate.

When prices are set above cost for some products and below cost for other products, competitors may find it profitable to supply only those products for which price exceeds cost and leave the incumbent regulated firm to supply those services for which price is set below cost. For example, unless they are prohibited from doing so, competitors may provide telecommunications service only to large businesses in urban areas. This practice is known as cream skimming. A regulator can prevent cream skimming by barring potential competitors of the incumbent regulated firm from providing services in the regulated industry. Such entry prohibitions, though, can hinder industry performance by precluding the operation of firms that have lower operating costs than the incumbent supplier and by removing the discipline that the threat of entry can impose on the incumbent firm. Furthermore, competitors are sometimes able to circumvent prohibitions on entry by developing and marketing substitute products. A regulator can limit incentives for cream skimming by setting prices that more closely reflect the incumbent firm’s operating costs. When prices reflect costs in this manner, entry will typically be encouraged only when a competitor can satisfy consumers’ needs at lower cost than the incumbent supplier can.

2. Regulating With Limited Information: Incentive Regulation

When, as presumed above, the regulator is well informed about the firm’s operating capabilities, the regulator can set prices to generate revenues that exactly match production costs when the firm operates efficiently (i.e., when it incurs only the minimum possible cost required to serve customers). When the regulator is not perfectly informed about the firm’s capabilities, the regulator cannot simply mandate that the firm operates efficiently. Instead, the regulator must induce the firm to minimize its operating costs. There are a variety of techniques the regulator can employ to do so. These techniques constitute elements of what is termed incentive regulation.

2.1 Regulatory Lag

When prices are set to match realized production costs only periodically (e.g., once every three or four years) rather than continually, the firm derives some financial benefit from reducing its operating costs. The larger the period of time before prices are reduced to match lower realized operating costs, the more pronounced is the firm’s incentive to reduce its costs. On the other hand, the longer prices are permitted to remain above operating costs, the longer consumer welfare is held below the level that could be secured given the firm’s realized costs. This tradeoff determines the optimal length of time between price revisions, i.e., the optimal regulatory lag.

2.2 Price Cap Regulation

Price cap regulation has enjoyed increasing popularity in recent years. It incorporates a form of regulatory lag while delegating some pricing discretion to the regulated firm. The typical price cap regulation plan specifies a price cap period (often four or five years) and a maximum rate at which the regulated firm’s inflation-adjusted prices can rise annually, on average, during this period (Sappington in press). The firm’s realized costs and earnings are usually reviewed at the end of the specified price cap period, and often employed to update estimates of the pricing restriction that would allow the regulated firm to secure a reasonable level of earnings in the next price cap period. When the firm’s realized performance is employed to set future standards, the firm’s incentives for exceptional performance are dulled. However, price cap regulation provides some incentives for cost reduction by instituting an explicit regulatory lag.

By controlling the rate at which regulated prices can increase on average, price cap regulation affords the firm some discretion in setting prices for individual services. This discretion can help the regulated firm to limit undesirable cream skimming by realigning prices to more closely match production costs. However, this discretion can also enable the firm to raise certain prices that the regulator prefers to remain low (e.g., the price of local telephone service to rural residential customers). To limit the firm’s ability to implement undesired pricing structures, price cap regulation plans often prohibit the firm from raising significantly the prices of certain specified products.

2.3 Earnings Sharing Regulation

By providing incentives to reduce operating costs, price cap regulation can simultaneously provide incentives to reduce service quality, since superior quality is often more costly to provide. By allowing prices to diverge from realized costs for considerable periods of time, price cap regulation can also admit earnings that depart significantly from expected levels. To mitigate these potential problems, an earnings sharing plan is sometimes appended to price cap regulation. An earnings sharing plan requires the firm to share with its customers a fraction of realized earnings above (and often below) specified thresholds. Such sharing helps to insure the firm and the regulator against extremely high (and low) earnings, but at the expense of reduced incentives for exceptional performance (Lyon 1996).

2.4 Yardstick Regulation

In certain settings, yardstick regulation can be employed to provide strong incentives for superior performance while limiting the risk of extreme earnings. Under yardstick regulation, the standards to which one firm is held are based upon the performance levels achieved by other firms. To illustrate, in the British water industry, the prices and service quality standards that are imposed on the monopoly provider in one jurisdiction are linked to the costs and service quality levels achieved by monopoly producers in other geographic regions (Cubbin and Tzanidakis 1998).

When firms face similar operating circumstances, yardstick regulation can enable the regulator to impose a reasonable but challenging performance standard on the regulated firm without basing this standard on the firm’s own historic performance. Consequently, yardstick regulation can ensure reasonable earnings for the regulated firm while providing the firm with strong incentives for superior performance. However, these desirable outcomes can only be secured via yardstick regulation if the firms are known to face similar operating circumstances or if all relevant differences in their operating circumstances are well understood (Shleifer 1985). In the absence of this knowledge, the standards imposed under yard-stick regulation can result in extreme earnings, much like under price cap regulation. Yardstick regulation may also encourage collusion among the firms that are implicitly being compared. By agreeing to reduce their performance below achievable levels, the firms can effectively relax the constraints imposed by yardstick regulation.

2.5 Franchise Bidding

Even when there is a single regulatory jurisdiction and a single producer in the industry, a regulator may still be able to harness the discipline of competition by structuring competition for the industry. The regulator may allow potential producers to bid for the right to serve as the sole producer in the industry. When the potential producers have similar abilities and similar information about operating circumstances, intense bidding competition for the market can secure for consumers the low prices and high service quality that competition among producers in the market might otherwise provide. However, successful franchise bidding requires that all relevant performance requirements be specified completely in advance, and that the regulator and firm both adhere precisely to the terms of the franchise contract once a producer has been selected. If the regulated firm can renege on its responsibilities after it is installed as the sole producer, or if the regulator can demand more services from the selected producer than it originally agreed to provide, franchise bidding can fail to deliver the maximum possible attainable level of consumer welfare (Williamson 1976).

2.6 Regulatory Options

When the regulated firm has better information than the regulator about its operating capabilities, consumers are often best served when the regulator allows the firm a choice among regulatory plans. A careful structuring of the options afforded the firm can induce it to employ its superior information to choose a plan that best serves consumers (Laffont and Tirole 1993, Armstrong and Sappington in press).

To illustrate this point, suppose that a regulator decides to impose price cap regulation on a firm rather than allow the firm to choose between price cap regulation and cost-plus regulation, whereby prices are re-set frequently to match realized production costs. To limit the likelihood of financial distress, the regulator may not insist that prices decline rapidly. In contrast, when the firm has the option to choose costplus regulation, the regulator can impose more stringent limits on price increases under price cap regulation without the fear of causing financial distress. If the firm believes that it will be unable to realize adequate earnings under the proposed price cap regime, it will choose to operate under cost-plus regulation instead. But if the regulator has not overestimated the firm’s capabilities in setting the challenging requirements of the price cap regime, the firm will choose this regime and deliver its pronounced benefits to consumers.

3. Regulation In Vertically Related Industries

Sometimes, a regulated firm may have the ability to supply both inputs and final products. Inputs are products that firms employ to make other products. Final products are those that customers consume, and that are not used to make other products. For example, a local telecommunications network operator may sell to long-distance telecommunications firms the local network access (an input) they must have to complete the long-distance messages they transport. In addition, the local network operator may have the ability to deliver long-distance telephone calls (a final product) itself. Two fundamental questions arise in such settings: (a) should the monopoly supplier of an essential input be permitted to compete downstream, i.e., against the firms to which it sells the input? (b) how should the price of the essential input be regulated?

3.1 Regulating Industry Structure

One potential benefit of allowing an input supplier to operate downstream is the additional competitive pressure that the input supplier may impose on other downstream producers. The additional competitive pressure can serve to reduce industry prices, and thereby enhance consumer welfare. An input supplier may be a particularly strong competitor when economies of scope are present. Economies of scope exist if multiple products can be supplied at lower cost when they are produced simultaneously by a single firm rather than when they are produced in isolation by distinct firms (Baumol et al. 1982 p.71).

A potential cost of authorizing downstream participation is that it may encourage the input supplier to disadvantage its downstream rivals unfairly. For example, the input supplier may intentionally reduce the quality of the essential input that it sells to its downstream competitors in order to make it more difficult for the competitors to provide high quality service at low cost. However, the input supplier may not have an unambiguous incentive to disadvantage its downstream rivals, because their demand for the essential input typically declines as the quality of the input declines. This reduced demand can reduce the profit derived from supplying the essential input (Weisman in press). The magnitude of the profit the input supplier foregoes by reducing the demand for the input it supplies is greater the higher the price the firm is permitted to charge for the input, ceteris paribus. Consequently, raising the price of an essential input above its marginal cost of production can reduce the incentive of an input supplier to disadvantage its downstream rivals.

3.2 Regulating Input Prices

Raising the price of the essential input above its marginal cost of production can also help to limit cream skimming and ensure that downstream production is carried out by the least-cost suppliers. To illustrate this point, suppose that if the input supplier operates downstream, the prices it charges there are regulated. Further suppose that the price of one downstream product (called product A) is set at a level ( pA) that exceeds the supplier’s marginal cost of production (perhaps to facilitate a price below marginal cost for another product). If the price of the essential input is set equal to its marginal cost of production in this setting, a downstream producer may be able to serve all consumer demand for product A profitably even though its marginal cost of production (cA) exceeds the corresponding cost (cA) of the input supplier. The higher-cost producer can set a price below the regulated price for product A and still secure positive profit if its cost disadvantage (cA – cA) is smaller than the regulated profit margin on product ( pA – cA ). To preclude operation by higher-cost competitors, the price of the essential input can be raised above its marginal cost of production by the amount of profit ( pA – cA ) the input supplier foregoes when it provides the input to competitors (Laffont and Tirole 1994, Baumol et al. 1997, Armstrong in press). One potential drawback to this pricing policy, though, is that it provides little incentive for the input supplier to reduce its operating costs.

4. Additional Forms Of Regulation

Regulation of producers’ activities can help to enhance consumer welfare even when industry cost minimization does not require operation by a single producer. To illustrate this fact, consider the potential value of environmental regulation and health and safety regulation.

4.1 Environmental Regulation

In certain instances, production activity can impose costs on society in addition to the direct physical costs of the inputs used in production. For example, some production processes may expel harmful pollutants into the surrounding land, water, or air. If no restrictions are placed on producers’ rights to expel pollutants into the environment, producers may produce more than the surplus-maximizing level of pollution. This is the level of pollution at which the social damage that would be caused by an additional unit of pollution is exactly equal to the social cost that must be incurred to eliminate that additional unit of pollution. Pollution in excess of the surplus-maximizing level imposes social damage that exceeds the cost of eliminating the extra pollution. In contrast, the cost of reducing pollution below the surplus-maximizing level exceeds the social benefits derived from the reduction in pollution.

Various regulatory policies can be employed to control environmental pollution. For instance, direct taxes (effluent fees) can be imposed on pollution when it is readily observed and measured. By setting the tax on pollution equal to the marginal social damage caused by the pollution, the producer can be induced to realize the surplus-maximizing level of pollution. When the level of pollution produced by a firm is difficult to measure, taxes can be imposed instead on the products whose production causes pollution, or on inputs (such as gasoline) to the activity (automobile driving) that causes pollution. The use of specific pollution abatement technologies can also be mandated.

Recently, some governments have introduced tradable pollution permits. Each permit entitles its bearer to emit one unit of pollution (e.g., one ton of sulfur dioxide). Polluting firms are able to buy and sell permits at prices determined by the available supply of and demand for these permits. A key potential benefit of tradable permits is that they promote pollution abatement at minimum cost. Producers that are able to reduce the pollutants they expel at a cost below the prevailing price of a permit will find it profitable to do so and sell any permits that they own. In contrast, producers for whom pollution abatement is more costly than the price of a permit will continue to expel pollutants but will pay for the right to do so (Schmalensee et al. 1998).

4.2 Health And Safety Regulation

Pollution abatement regulation is often intended to improve the health and well being of citizens. Other forms of health and safety regulation can serve this same purpose. The regulations come in many forms, including information requirements, standards, and prohibitions.

Regulations that require manufacturers to provide relevant product information to consumers can help consumers choose among available products. These regulations include requirements that product contents be fully specified and that the potential health risks associated with consumption be stated clearly. In contrast, direct regulation of product standards and outright prohibitions on the sale of certain products can substitute information collection and decision-making by a regulatory body for decision-making by consumers. For example, when the government imposes minimum home construction standards or when it bans certain drugs from the marketplace, the government eliminates the option a consumer might otherwise have to purchase below-standard homes or banned drugs. One rationale for such regulations is that they can implement the decisions that consumers would make if they were fully informed about all relevant benefits and costs of consumption, without requiring consumers to develop the expertise and obtain and evaluate the information required to assess the benefits and costs (Viscusi 1992).

5. Competing For Regulatory Benefits

The preceding discussion illustrates some of the ways in which government regulation of producers can be designed to benefit consumers. It is important to note, however, that regulation need not only serve this role in practice. Since regulators typically have the power to deliver benefits to some parties and impose costs on others, the affected parties will have an incentive to try to secure favorable treatment from regulators. When industry producers are better organized and have more at stake than industry consumers, regulation that benefits producers at the expense of consumers can arise (Stigler 1971, Peltzman 1989). For example, new competitors may be barred from an industry even though their entry and operation would be in the best interest of consumers. These realistic possibilities merit careful consideration when evaluating the benefits and costs of existing and proposed regulations.


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