Western European Economics Research Paper

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1.    Background

In  many  respects,  economic  Western  Europe  looks very different  today  from  what  it  was in  the  Cold War  years of the early 1980s. In these two eventful decades, the Western  European economy underwent radical transformations, with deep structural changes and   complex   institutional   reforms   affecting   the working of both  markets  and policy authorities.

Since the  second  half  of  the  1980s, after  a  long period of sclerosis, an ambitious  process of economic integration was launched  and successfully implemented. It first took  the form  of market  enlargement  in real and financial assets aiming at the perfect mobility of goods and productive  factors.  The idea of a single European market  was significantly reinforced  by the decision  to  introduce   a  common   currency  and  to design   a   new   set   of   European  institutions  and procedures.    Consequently,    economic   convergence within  the  area  increased  while,  following  German reunification,  integration   with   Eastern    European countries   also   proceeded   at   a   very   rapid   pace. Projects  for  a  further   widening  and  deepening  of European integration, ranging from a more complete economic   and   political   union   to   the   Eastward enlargement  of membership,  are now in an advanced stage of elaboration or just about  to be implemented.

The decisive steps toward  greater  integration  were taken under the influence (which occasionally became a   threat)   of  world   trade   globalization,  the   new technological  revolution,  and the generalized liberalization  of capital  movements.  In  Europe,  accepting these  external  challenges  brought   about   a  decisive retreat  of the nation-state from  the effective control of  a  series of  domestic  policy  instruments   and  the public ownership  of industrial  concerns.  Traditional theories on market failure were replaced by a number of  alternative   approaches based  on  incentives  and mechanism   design.   State-owned    enterprises   have been  affected  by  a  massive  wave  of  privatizations, while new  procedures   to  deal  with  anticompetitive behaviors  were elaborated by the  European Union. The  European  Commission   has  now  acquired   increasing powers in this respect and some commentators have argued that  latecomer  Western Europe  has one  of the  most  developed  antitrust policies in the world.

In this process, regulation  was critically scrutinized as  a  source   of  market   inefficiency  and   systemic degeneration. Politicians and academic scholars often wondered   whether   Government  intervention    had become  a  powerful   obstacle   to   employment   and economic  growth.   The  pressure   to  have  common labor   legislation   and   economic   regulations   going from a harmonization of tax rules to the redefinition of social benefits  opened  new fields of investigation on the traditional theme  of the optimal  relationship between markets  and authorities.

Major transformation processes such as these often impose heavy adjustment costs on societies or specific groups. Western Europe was no exception to this rule of history.  It would probably  be an exaggeration  to talk of a long recession of the European economy in the  1990s, but  it remains  true  that,  in comparative terms,  the century  closed with a long series of weak economic  performances  that  have not  been reversed by   the   introduction  of   the   new   currency.   The unwelcome   consequence   of   this   rapid   transition toward  a more integrated  and competitive  economic system  was  the  upward  convergence  of  unemployment  rates  and  the  increase  of  social  inequalities. Double-digit figures were a permanent  feature of the European labor  market  in the  1990s, and  remained quite unaffected  from  cyclical fluctuations in output and investment.

Quite understandably, integration, unemployment, and regulation  were among  the economic issues that attracted   a   great    deal   of   intellectual    energies. Although  the richness  of Western  European studies in  economics  is obviously  far  greater,  considerable work  was  done  on  these  general  topics,  and  this explains  the  decision  to  restrict  this  discussion  to them.

2.    Integration

Generally  speaking,  integration in  Western  Europe has  been  interpreted  as  the  outcome   of  sovereign actions  of politicians  and bureaucrats, rather  than  a market-induced process  (Streit  and  Mussler  1994). Ever since the Treaty of Rome (1957), a long series of ‘interventions    from   above’   produced    substantial results  in the  fields of trade  policy,  agriculture,  the monetary  system, competition, industrial  policy, and social cohesion. The Maastricht Treaty (1992) strictly followed   this   functional   approach,  extending   the Community   powers  over  new  sectors  and  policies, and establishing a rigid set of criteria for the creation of a monetary  union.  Policies for redistribution and compensation within the area  were also significantly reinforced    after   Maastricht.   Many    more   recent features  (like  Sweden’s  large  majority   rejection  of the monetary  union in September 2003 that strengthened the anti-Euro sentiments  of the Northern fringe of Scandinavian countries  and  Britain)  corroborates the view that European integration is an elitist project with rather  limited popular  support.

Before  the  approval  of the  Delors  report  (1986), agriculture  and  exchange  rates  dominated  the agenda. The Community  Agriculture  Policy turned  out to be a ‘subsidized folly’ (Petersmann  1993), burdening the European taxpayer  and consumer with extremely high  costs.  It  still absorbs  most  of the  Community (modest)  financial  resources  and  instead  of winning approval  it provoked  loud  protests  even among  its beneficiaries. It turned  out to be a permanent  source of conflict, both  within and outside  the Community, and   was   particularly   detrimental   to   new   trade creation  and  growth  opportunities with Less Developed and Eastern  European Countries  in transition.

The European Monetary System (EMS) worked as an  exchange  rate  mechanism,  which  was  built  on fixed  but   frequently   adjustable   parities,   enhanced central  banks  cooperation, and  an  anti-inflationary bias. Flexibility, new financial facilities, and a strong dollar  were the  main  factors  for  its  first  successful stage  (1979–87),  while  rigidities,  frictions,   a  weak dollar, and the economic consequences of German reunification marked  its  tumultuous end  (1992). In terms of a monetary  union,  the EMS was unsuccessful  and  steps  in  that   direction   (the  creation   of  a European monetary  fund and the issue of a ‘parallel’ currency) did not evolve.

However,  the  actual  working  of the  EMS  stimulated   fresh   analysis   on   the   interaction    between monetary  arrangements on the one hand and the functioning  of real markets  and the efficacy of policy decisions on the other.  European economists  refined such concepts  as credibility,  reputation, time consistency, or the games between governments  and central banks, and applied them as analytical tools to explain the new road  to integration. They also showed  that asymmetries  and  rigidities  were the  result  of choice rather   than   constriction.   New  theoretical   models were framed to speculate on the advantages  of ‘tying one’s hands’ in the conduct of domestic monetary policy: the EMS,  so it was argued,  allowed member states to import  credibility and acquire stability from the  core  country   (i.e.,  Germany)   and   its  central monetary   authority. Therefore,   by  the  end  of  the 1980s, the loss of monetary  independence was almost complete,    thus   easing   the   way   toward    greater monetary  integration (Giavazzi and Pagano  1988).

The EMS collapsed due to its incapacity  to target simultaneously fixed exchange rates  and  use interest rate  policy  in  pursuit  of  other  domestic  economic objectives  (i.e.,  employment   growth).  While  this  is possible when capital movements are prohibited, in a global  financial  market  the  ‘trinity’ becomes  inconsistent.   Thus,   a   monetary   union   or,   conversely, flexible   exchange    rates,    remained    the   alternate options  to  overcome  the  ‘open economy  trilemma,’ given  the   freedom   of  capital   flows.   After   some discussion and popular  reactions,  Western European countries   decided   for   the   former   (Giavazzi   and Giovannini 1989).

The  European Monetary Union  (EMU)  remains the  world’s  most  advanced   experiment  in  moving beyond  national   economic  sovereignty.  The  transition  to  monetary  union  was accompanied by wide- spread     skepticism     and     criticism.     Particularly, American  observers  thought that  the  likely  effects of monetary  union  on macroeconomic fundamentals would  be adverse  even though  they might  be somewhat  compensated by closer political  ties (Feldstein 1997).

Debates  on  EMU  focused  on  what  prerequisites real markets  of goods  and  productive  factors  ought to  possess for  monetary  integration to  generate  net welfare gains. The Maastricht schedule of events and convergence criteria, relying on arbitrary quantitative ratios, was attacked  for having nothing to do with the economics  of optimal  currency  areas.  Requisites  for the ‘sustainability’  of EMU  were strongly  influenced by the prevailing  German  view and  were defined  in terms   of   nominal    convergence   of   inflation    and interest   rates,   monetary   independence,   and   fiscal policy restraints.

Economists  emphasized that the real properties  for monetary  integration simply did not exist in Western Europe:  local  markets  were not  efficient  enough  to guarantee  low adjustment costs and offset the loss of exchange   rate   changes.   Mobility,   flexibility,   and social  integration  were  other  indispensable   factors that   Western   Europe   did   not   possess.   Common monetary  policies with no exchange rate adjustments rendered   the   absorption  of   asymmetrical   shocks more difficult.  The inclusion  of restrictions  on fiscal policy in a treaty  that  set the timetable  for monetary union  was a further  source  of considerable  debate. Many   felt  that   the  road   to  monetary   unification needed  to  be supplemented  by some forms  of fiscal coordination  in  order   to   absorb   country-specific shocks and  avoid  migration  of taxpayers.  However, while   nation-states   were   all   quite   reluctant    to surrender  or harmonize  their fiscal stance, Germany imposed  stringent  rules  in  order  to  discipline  high deficit  countries  and  avoid  negative  spillovers  that would  threaten   the  dogma   of  price  stability   and interest  rate convergence. The economic rationale  of this ‘stability pact,’ however, was thought to be very weak, particularly if rigidly applied over the business cycle.

On  the  whole,  the  (almost)   unanimous  verdict was   that   Europe   did   not   constitute    a   ‘natural’ monetary   union,   and  that   imposing  a  new  single currency  would  be  detrimental  mainly  for  cyclical unemployment. On  the  positive  side of the  balance sheet,  the  European countries’  significant  degree of openness  to  mutual  trade  remained,  mainly  intraindustry.   This  feature   rendered   adjustment through exchange  rates   less  effective  and   less  compelling. Moreover,  a single currency  was thought to provide further    expansion    to   intra-European   trade    and investment,  because  of lower  transaction costs,  less discrimination, and  no  currency  risks.  The  ensuing regionalization   of   the   European   economy    was expected to reduce the likelihood  of country-specific asymmetric  shocks.

Therefore,  within the economics profession,  EMU is   still   receiving   favorable    support,    despite   the difficult  start   of  its  new  currency  and  widespread manifestations of anti-Euro public opinions.  On the one   hand,   it   created   a   safety   net   against   such outcomes  as  trade  wars,  competitive  devaluations, and discriminatory practices that  are always likely to be   implemented   as   it   was   experimented   in   the aftermath of the 1992 EMS crisis. On the other, dynamic efficiency gains might be obtained  by integration in terms of more perfect competition, economies of scale, productivity  growth,  and a more efficient allocation  of loanable  funds.

Building up on these advantages,  new studies show that  currency  integration is indeed  a  very dynamic process that cannot be (exclusively) predetermined by some set of exogeneous  criteria  (whether  the Maastricht  ones or other  more  theoretically  sound  ones). In  Europe,  the  lack  of mobility  and  flexibility is a regional,  not national, phenomenon, and there is no reason why monetary  integration should make things worse.  The  classic Mundell  criteria  have  thus  been substantially revised. Research  efforts  have  recently been   directed   to   the   study   of  the   intertemporal balancing  of the  benefits  against  the  costs  (Padoan 2000). Monetary integration must then be analyzed in an endogeneous  growth model. In the process toward more  complete  integration, public  confidence  in the system  may  grow,  some  new  benefits  may  emerge, and existing benefits may rise; alternatively,  expected costs and  the occurrence  of asymmetric  shocks may diminish as integration proceeds.

Recent   manifestations  of   anti-Euro   sentiments have  been  sustained  by bad  economic  performance in the Euro  area.  At the current  stage of European monetary  integration, Europe  oddly  resembles more a multi (rather  than  an optimal)  currency area, while economists  have  raised  serious  doubts   on  whether European policy rules have been efficiently designed and properly  managed.

Finally, empirical research has shown that  Eastern and  Western  Europe  have  integrated  faster  than  it was commonly  expected. Eastern  European firms are now  participating in Western  Europe-centered production   hubs,   and   have  actively  organized   cross- bordered   corporate  networks.   Intraindustry  trade and  input  sourcing  boomed   together   with  foreign direct  investments,  just  showing  the  growing  complexity and maturity  of economic integration between the European Union  and the transition economies.

3.    Unemployment

Western    European   unemployment  has   increased dramatically since the  early  1970s, moving  up  from 2% to more than 10%. Compared to other countries, European  unemployment  is  suffering  from   higher duration rates (relating to those who are unemployed for one year or more), higher rates of open unemployment   (which   considers   discouraged   workers   and involuntary  part-time   jobs),  and  low  participation rates among  particular classes of individuals,  such as prime-age men, married women, and the elderly. Economists   often  talk  of  the  existence  of  a  ‘dual’ labor market  in Western Europe,  one formed by very protected  (male) workers (the so-called ‘insiders’), the other  by an  army  of unemployed  for  which market mechanisms and incentives no longer seem to be functioning  (the ‘outsiders’).

Debates  on  rising  European  unemployment have focused on three main issues: (i) the effects of globalization with  growing  imports  from  low-wage countries;   (ii)  the  effects  of  the  German   way  to monetary  union; and (iii) the effects of a rigidly constrained labor market  structure.  According  to the former,   increased   international  trade   from   LDCs may have something to do with European unemployment. Although analysts often disagree of the real magnitude   of  these  effects,  demand   for  unskilled labor has been dramatically  reduced in developed countries   as  a  consequence   of  globalization, and changes  in the  structure  of foreign  trade  provide  a plausible explanation (Davis 1998). As to the second argument,  meeting the Maastricht criteria  for EMU membership  has led in some countries  to substantial short-term increases in unemployment. This reflected the  contraction of  aggregate  demand   due  to  tight monetary and fiscal policies that all countries implemented in order to meet the deadline. However, the greatest  attention has been devoted by far to the study of the labor market, which has been mainly developed   in  comparative   terms.   Particularly,  the North America versus Europe dichotomy has been featured  in a variety of works (Siebert 1997, Nickell 1997, Layard  et al. 1991).

Conventional  wisdom  states  that   European  un- employment  is now comparatively  higher because of the more  powerful  interactions between local factor market   institutions  and  global  goods  markets.   In other   words,   greater   openness   of   the   European economy  to  trade  and  external  competition   in  the goods  market  was unaccompanied by greater  open-ness and competition  in the factor markets, where the downward   wage   rigidity   is  the   main   source   of unemployment. Local  institutional features  (such as the  minimum   wage,  workers   immobility,   or  high firing costs) introduced  important asymmetries  that affect the level of wages and have a negative impact on labor  demand  and supply.

The contrast  between Western  Europe  and  North America  is more  complex  than  this stylized picture. Economists,  for instance, have begun to question  the description  of America  as a flexible wage economy and  of  Europe  as  a  rigidly  constrained and  overly institutionalized economy.  Furthermore, it  is quite inconvenient  to talk of Western European unemployment  since the  structure  of labor  markets  is hardly homogeneous,  while their performance is even more markedly  different  (Siebert 1997). European rates of job turnover  are quite satisfactory  while overall wage flexibility  is  not   dramatically   lower  compared   to North  American standards (Nickell 1997). Consequently, economic analysts have been trying to disaggregate  the European labor  market  in order  to understand as to what are its main structural weaknesses  that  generate  high unemployment rates. One  of  the  more  challenging  questions  is  whether there  are  any  specific institutional features  that  are more responsible than others and what practical remedies can be introduced.

The  review of  the  empirical  evidence shows  that Western Europe has strong legislation both on employment  protection (relating  to  the legal frame-work  governing  hiring and  firing) and  other  aspects of the labor market (from working time to fixed-term contracts    and   minimum    wages).   Unemployment benefits are also fairly generous even though,  beyond the short  term, they tend to adjust  toward  the lower North  American  coverage. While extremely variable across  countries,   nonwage   labor   costs  (which  are mainly   responsible   for   the   so-called   tax   wedge) appear  extremely burdensome. Hence labor  productivity   is  financing   social   insurance   benefits   to   a greater  extent  than  in other  labor  markets.  Finally, in  most  European countries,  trade  unions  play  an important role in wage determination and even when union density is quite low the coverage rate is always substantial. One  possible  generalization   from  these institutional features  is that,  in Western  Europe,  the wage elasticity of labor needs more time to determine the  necessary   quantitative  adjustments,  while  the long-term   response  of  wages  to  unemployment  is satisfactory  and  even higher  than  in other  contexts (Siebert 1997).

Among  the  remedies,  together  with  greater  wage flexibility, the high fiscal wedge is considered to be the most   important  single   explanation  to   European unemployment, regardless  of how the tax burden  is redistributed.  Extension   of  social  insurance   is  the main reason  for the increase in the overall marginal tax   wedge,  which   has   particularly   depressed   the demand   for  labor.   Lowering   payroll   and   income taxes has thus  become a very popular  recommendation  for  reducing  unemployment.  Moreover,   there seems   to   be   an   increasing   awareness   that    job protection rules must be softened in order to increase firms’ incentives  to  create  new labor  opportunities. Serious  implications  are  also associated  with unemployment   benefits,  especially  if  they  have  no  time limit and  are combined  with a decreased  willingness to   search   for   a   new   occupation.  The   so-called ‘reservation wage’ (which guarantees  minimum social welfare and unemployment benefits) needs to become more  negotiable,   thus  reducing   distortions   in  the market mechanism that are familiarly indicated under the  heading  ‘unemployment  traps.’  As far  as  trade unions are concerned, centralization of wage bargaining is thought to increase efficiency if the process is coordinated with  strong  employer  associations  and negotiated within the more general macroeconomic compatibilities  imposed  by policy authorities. However, centralization leads, almost by definition, to less wage   differentiation:   in   Western   Europe,    equity reasons have again prevailed to market clearing equilibrium, mainly at the expense of low-skilled workers. Finally, increasing investments in education are generally recommended as a remedy against structural unemployment.

4.    Regulation

The great claim for perfect competition  is that it leads to  efficient  results  in  the  allocation   of  resources. From  the production side of the economy, a perfectly competitive market solves two problems. First, production is allocated  in  such  a  way  that  desired output is produced  at a minimum  cost (i.e., efficient cost structure).  Second, given that prices are equal to marginal   costs,   desired   output  is  supplied   by  a sufficient number  of (viable) firms (i.e., efficient price structure).  Thus,  production efficiency is a desirable objective of public policy.

Unfortunately, the competitive  model  may fail to be  satisfied  in  the  sense  that   markets   are  neither always complete (some may even be missing) nor are all  markets   perfectly   competitive.   The   theory   of market failures and the rationale for government intervention  have been pioneered  by such European economists as Lindahl (1919), Pigou (1920), and Wicksell  (1896).  Then,   starting   in  the   1930s,  in Western Europe the question of how deeply the government   should   be   involved   in   the   national economy has strongly  been debated  with economists divided   between   advocates   (Robinson  1933)  and critics  (Hayek   1944)  of  government   intervention. After  World  War  II,  market  failures  together  with the difficulties of price controls,  subsidies,  taxation, and  nonprice  regulation   were the  major  considerations  that,  with  slight  differences  across  countries, turned  out  the answer in favor  of regulation  and/or granting governments ownership and operation of selected activities. Some have argued  that  the role of government   should  have  been  that  of  acting  as  a ‘welfare state’ and thus modifying  the actions  of the market   that   would  not   produce   vital  (or  public) goods  and  services  at  an  acceptable   cost  (Briggs 1961). In this vein, most Western European countries adopted  the so-called  public interest  view of regulation  in which positive theories  are based  on normative considerations: to improve (maximize) social welfare the government  needs to respond  to market imperfections,  and the extent of its action,  subjected to  various  constraints, varies  accordingly  with  the extent of those imperfections.  Moreover,  abstracting both from positive and normative rationales, state ownership  of certain  ‘strategic’ industries  like steel, defense,  airlines,  automobiles, and  banks  has  been perceived as necessary to promote  economic growth. However, this interpretation is perhaps  too idealistic. As  we  shall  see  later,  it  is  often  inappropriate to assume that a benevolent government would make decisions solely in the interests  of citizens.

From  the 1980s, the very idea of a single European market  has shifted  policy from  using regulation  and state-owned  enterprises  (SOEs) to  a greater  reliance on the market mechanism and on incentive systems to improve consumer welfare as well as pursue industrial and  employment  goals.  The  promotion of competition  has  been  one  of  the  pillars  of  the  European Union since the treaty of Rome, and governing bodies of the Union  have acquired  increasing powers to deal with noncompetitive behavior,  both  by private  firms and   public  agencies,  that   distort   competition   and inhibit integration of markets  across Europe.  Empirical analysis raised concerns about  the cost, price, and quality performance of regulated firms, and the policy arena  became increasingly aware of the possibility of regulatory     failures.    Theory     advancements    also showed how, although market failures remain an argument  for government  intervention, the ‘unnecessary’ and/or  the ‘wrong’ intervention  may worsen the situation.

The existence of market  failures, however, is not a sufficient reason to grant  government  intervention  in markets.  This  insight  was  provided  some  20 years before by Ronald  Coase, a British economist working in  the  US.  In  the  seminal  paper  ‘The  Problem  of Social Cost,’ he paved the way for the economic profession  to realize that  some market  failures  may be solved by redefining  property  rights  and  creating markets.  Moreover,   in  choosing  regulatory   policies one should  take  into  account  the fact that  informational limitations  may raise the possibility of strategic behavior   both   by  the  regulated   firm  and   of  the regulator  itself. Thus, rather  than  on command-and-control  provisions,  regulatory  enforcement  should be based on incentive mechanisms.  This was made clear by   a   French   economist,   Dupuit    (1844).   In   his pioneering  contribution on marginal  cost pricing, he was perhaps  the first to take up the problem  of how to design incentive-compatible regulatory  mechanisms. These issues, which were largely absent  in the traditional regulatory  theory,  have been brought  up by developments in the literature on game theory, principal-agent, information economics, and the new institutional economics.  The  introduction of  informational   and  institutional constraints showed  how second-best optimization of social welfare is not straightforward while the  set  of  feasible  regulatory instruments  is rather  limited (an excellent account  of most of the issues of the ‘new regulatory  economics’ is provided  by Laffont  and Tirole 1993).

In  the  last  two  decades,  European Union  public policy reform has been mainly concerned with liberalizing  prices  and  access  to  restricted  markets as  well as  transferring SOEs  to  the  private  sector, and/or   contracting  out   activities   previously   run directly by governments (i.e., privatization). These phenomena have been reinforced  by developments  in the product  and capital markets,  changes in the level and structure  of demands,  and a sharp  decline in the cost of certain  products  and  services. Although  the pace and extent of liberalization have been quite different across countries,  the policy objectives of the European Union  can be summarized  as follows:

* setting   rules   that    make   access   to   industries possible for a plurality  of efficient providers,

* unbundling vertically integrated  monopolies,  thus creating  new markets  to replace transactions that previously took  place within firms,

* restructuring tariff  structures  in ways that  reflect underlying  costs,

* ensuring that  noneconomic  public interest may be attained  in a competitive  environment,

* designing  regulatory  mechanisms  that  reflect  the possibility of ‘capture’ by regulated  firms or other interest  groups,

* replacing   regulation   through   public   ownership with arm’s length regulation,

* ensuring  independence  of the  regulator  from  the executive branch  of the government,  and

* imposing constraints on regulator’s  discretion.

Looking  at selected industries, such as services and utilities,  makes  it possible  to  highlight  some  of the features of the reform  process.

Regulation of network industries, such as the local loop  in telecommunications, electricity  distribution, water pipelines, and rail track, has been based on two kinds   of  market   failures:   natural  monopoly   and externalities.  In a natural monopoly  a single supplier could serve the entire market at a unit cost lower than any  industry  configuration with  two  or  more  firms (Baumol  et  al.  1982).  Hence,  the  case  for  natural monopoly   is  based  on  the  fixed  and  costly  infra- structures    needed   to   deliver   services   to   users. Externalities  are  effects of  jointness  of  production/ consumption   not   priced   by   the   market.    Here, externalities  are  mainly  related  to  network  effects: the demand  for the product  or service increases with the increase in the size of the network,  since there are benefits in being connected  to a larger network.

Restricted   entry   and   extended   price  regulation have  been  sought   to  prevent:   (a)  that   the  single unregulated  firm  would   not   produce   the   desired output level,  making  impossible  the  fulfillment  of social  or  universal  service, (b)  unstable  prices,  and (c) excessive investments.  However,  as Coase  (1960) put it, ‘all solutions have costs, and there is no reason to suppose that  governmental  regulation  is called for simply because the problem is not handled well by the market  or  the firm.’ Take,  for  example,  the case of telecommunications. Here, the existence of both scale and scope economies has been used to justify vertical integration of the provider of the local service (a true natural  monopolist)    with   potentially    competitive activities such as long distance and mobile services. In these  multiproduct  industries   socially  optimal   second-best (Ramsey) prices, which permit a natural monopoly  to break  even, resulted in cross-subsidization.  In other  words,  prices of competitive  activities (i.e., long-distance  calls) higher than  those based  on ‘stand-alone’  costs  subsidized  the  costs  of noncompetitive   activities   (i.e.,  local  access).  Hence,   high prices in potentially  competitive services prevented consumers   from   reaping   the  benefits  of  technical progress.

Increasingly  aware  of these pitfalls,  the European Union moved toward regulatory  reform that involved the privatization of state monopolies,  the elimination of entry  restrictions,  and  the adoption of incentive- based  regulatory  techniques.  An  example  is the  so-called   ‘Full  competition’   directive   (96/19),  which required   the   elimination    of   all   remaining    legal barriers  to  entry  in telecommunications markets  by January  1, 1998.

Where competition  within the market is not feasible an  alternative  competition  for the  market  has  been introduced   (Demsetz  1968).  For  example,  auctions for   the   franchise   right   to   operate    the   mobile telecommunication  services  have  been  used  in  the United  Kingdom,  Germany,  Italy,  and  the  Nether- lands.   Provided   that   (a)   inputs   are   competitive available  to all bidders,  and (b) there is no collusion among bidders, auctions  compel prospective entrants to  reveal private  information on their  services, thus reducing  the  agency  problem  that  characterizes  the relationship  between  the  government  and  the  regulated   firm.   Regulated    firms   almost   always   have superior  information concerning  costs, demand  conditions,  products  quality,  and  technological  possibilities  than   the  regulator.  Indeed,   this  asymmetric information   plagues   the   whole   (multi)principal– (multi)agent  relationship  of the regulatory  problem. Informational constraints limit  both  the  control  of the  regulator   over  the  firm  and  the  set  of  feasible instruments  to exert such control.

In  traditional rate-of-return regulation, prices are set so that the regulated firm can cover its costs plus a reasonable   rate   of  return   for   capital.   Here,   the regulator  suffers heavily for informational limitations on costs and demands.  Thus, where possible, rate-of- return  regulation  has been displaced by more fruitful incentive-based  techniques.  For  example, to increase the  available  information, the  regulator   may  make use of external information, such as the performance of  other  firms  as  a  benchmark by  which  to  compare  the performance of the regulated  firm (Shleifer 1985). Yardstick  competition is increasingly  used by European  agencies  in   assessing  efficiency  and/or evaluating  performance. It has strongly  been recommended   by   the   European  Commission    for   the regulation  of interconnections prices  in telecommunications.   Another   type  of  incentive-price   regulation—one    that    avoids   continuous   and    detailed information on costs and demands—is price–cap regulation. In price–cap regulation, the regulator  fixes caps  on  the  prices  that  firms  can  charge  for  their products  (or basket of products)  for a given period of time. Then, firms choose to price at or below the caps—that  are reviewed over time. Since firms have the incentive to minimize costs, price–cap regulation induces price structures  to be more in line with underlying  costs than  rate-of-return regulation.

Traditionally,  in  Europe,   regulatory   objectives such   as   quality   of   service,   price   control,    and universal   service  obligations   were  thought   to   be more  easily implemented  by state-owned  firms than through  regulatory  schemes.  However,  several European  governments—most notably  Britain, France, Germany, Italy, and Spain—have launched large  privatization  programs   in  the  1990s,  which have been widely used to raise revenue and to reduce public debt without raising taxes or cutting other government   services.  Nevertheless,  in  some  industries, state control  through  share ownership  remains widespread and the dominant role of incumbents (former monopolists)  is still an obstacle to full competition.

Positive theory  suggests that  politicians  are reluctant  to  privatizations because  they  have  to  give up their  ability  to  operate  SOEs  in  ways that  provide economic  benefits  for  their  political  constituencies (Shleifer  and   Vishny  1994).  Regulators  have   the power   to   generate   and   redistribute  rents   across interest  groups  and/or may  use this  power  to  gain, or  maintain,  support  from  their  political  principals. At the same time, regulated  firms have incentives to ‘capture’  regulators   and   influence  regulatory   out- comes  (Stigler  1971). Indeed,  the  European Union has strongly criticized regulatory  agencies of member states  for  delaying  the  implementation of its directives aimed at liberalizing markets.

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