sustainable energy systems theory of regulation lecture 2 phd, dfa m. victor m. martins and filomena...
TRANSCRIPT
Sustainable Energy Systems
Theory of RegulationLecture 2
PhD, DFA
M. Victor M. Martins and Filomena Garcia
Semester 22009/2010
SustainableEnergySystems
Theory of Regulation
Slide 2
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.
SustainableEnergySystems
Theory of Regulation
Slide 3
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 (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 Models of public choice theory Collective action problems
3. As a mix of the approaches 1. and 2..
SustainableEnergySystems
Theory of Regulation
Slide 4
Theories of regulation : normative and positive analysis, interest goup theory
Theories of regulation Two alternative approches to analyse regulation
policy outcomes: 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 )
SustainableEnergySystems
Theory of Regulation
Slide 5
Theories of regulation :public interest theory
A. Public interest theory – PIT- ( Normative analysis as a positive theory) 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
SustainableEnergySystems
Theory of Regulation
Slide 6
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
SustainableEnergySystems
Theory of Regulation
Slide 7
Theories of regulation : public interest theory
Different market structures are associated with different levels of social welfare and deadweight loss. 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.
SustainableEnergySystems
Theory of Regulation
Slide 8
Theories of regulation : public interest theory
Perfect competion and monopoly
Producersurplus
Consumersurplus
D
S
P c
Q c0 Quantity
P
CSP M
P c
CS =>PS DWL
Q M Q C
P
Quantity0
P=MC MR=MC
D MC
SustainableEnergySystems
Theory of Regulation
Slide 9
Theories of regulation : public interest theory
Public interest theory- PIT 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
SustainableEnergySystems
Theory of Regulation
Slide 10
Critique of the Public Interest Theory 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.
Theories of regulation : public interest theory
SustainableEnergySystems
Theory of Regulation
Slide 11
Theories of regulation : private interest theories
B. Private Interest TheoryRational 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.
SustainableEnergySystems
Theory of Regulation
Slide 12
Theories of regulation : private interest theory
Capture theory ( Stigler ) – Contrasts with PIT
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.
SustainableEnergySystems
Theory of Regulation
Slide 13
Theories of regulation : private interest theory
Critique of the Capture theory
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: Oil and natural gas price regulation Social regulation over the environment Product safety Worker safety etc...
Difficulty in explaining deregulation.
SustainableEnergySystems
Theory of Regulation
Slide 14
Theories of regulation : private interest theory
Economic theory of regulation: improvement of capture theory 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 utility-maximizing.
SustainableEnergySystems
Theory of Regulation
Slide 15
Theories of regulation : private interest theory
Basic assumption:
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.
SustainableEnergySystems
Theory of Regulation
Slide 16
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:
Profits depend on price rates : L=L(R)
0/ RM / 0 M L
SustainableEnergySystems
Theory of Regulation
Slide 17
Theories of regulation : private interest theory
In other words: 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.
SustainableEnergySystems
Theory of Regulation
Slide 18
Theories of regulation : private interest theory
Thus we have two interest groups with conflicting agendas:
Consumers want low rates; whereas regulated firms want high profits.
The politicians/regulators face a trade-off: 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 iso-political support function.
The iso-political support function illustrates all combinations of R’s and L’s that yield equal political support.
SustainableEnergySystems
Theory of Regulation
Slide 19
Theories of regulation : private interest theory
Utility rates per KWh
L2
L1
R1 R2
M1M2
M3
X Y
Z
Iso-political support functions
M3 preferedto M2
prefered toM1
0
SustainableEnergySystems
Theory of Regulation
Slide 20
Theories of regulation : private interest theory
M1M2
M3
Optimal regulatory policy
0
Lmax
L1
Rc R* RM Utility ratesper KWh
X
YProfit
function
L=L(R)
SustainableEnergySystems
Theory of Regulation
Slide 21
Theories of regulation : private interest theory
Extreme outcomes
0RM Utility rates
per KWh
Regulatorcaptured by reg.
firmsLMAX
XM F
M C
YRC
Regulatorcaptured byconsumers
Profit function
L=L(R)
SustainableEnergySystems
Theory of Regulation
Slide 22
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 priceImplication: 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 ).
SustainableEnergySystems
Theory of Regulation
Slide 23
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 ).
SustainableEnergySystems
Theory of Regulation
Slide 24
Theories of regulation : private interest theory
Criticisms 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.
SustainableEnergySystems
Theory of Regulation
Slide 25
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
SustainableEnergySystems
Theory of Regulation
Slide 26
Theories of regulation : private interest theory
Becker model
Becker created what he calls as “influence functions” to demonstrate how pressures by interest-groups affect the taxes paid and the subsidies received.
Competition among groups for political influence determines the equilibrium structure of taxes, subsidies, and other political favors.
Regulation ( broad sense ) is used to increase the welfare of more influential interest groups
Political equilibrium has the property that all groups maximize their income
SustainableEnergySystems
Theory of Regulation
Slide 27
Theories of regulation : private interest theory
Assumptions 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
SustainableEnergySystems
Theory of Regulation
Slide 28
Theories of regulation : private interest theory
Model 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.
SustainableEnergySystems
Theory of Regulation
Slide 29
Theories of regulation : private interest theory
Model ( cont.)
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.
SustainableEnergySystems
Theory of Regulation
Slide 30
Theories of regulation : private interest theoryP
ress
ure
by
2 F2(p1)
F1(p2)
Pressure by 1
e0
Influence curves of 1 and 2
SustainableEnergySystems
Theory of Regulation
Slide 31
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; 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. 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).
SustainableEnergySystems
Theory of Regulation
Slide 32
Theories of regulation : private interest theory
Pressure by 1
Pre
ssu
re b
y 2 F2(p1)
F1(p2)
F2(p1)
SustainableEnergySystems
Theory of Regulation
Slide 33
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.