Public Policy: An Economic Perspective Public Policy: An Economic Perspective prf.cuni.cz room 341, Thursday, 10-12 a.m.

Public Policy: An Economic Perspective Public Policy: An Economic Perspective urban @ prf.cuni.cz room 341, Thursday, 10-12 a.m.

The main purpose of the course  The course offers students research opportunities in a range of public policy areas  Results of this research will be shared with others through class presentations

The main requirements of the course  The main course requirements consist of a team presentation and an individual paper

The main requirements of the course  Teams (4-5) persons, ideally from different countries, will be supposed to choose a (preferably a recent and/or controversial) public policy topic, analyze the issues surrounding it and to present the analysis in class

Organization  You are required to form teams and name team leaders  Each team leader will let me know via email the team suggestion concerning its research/presentation topic

First steps  The topic you choose should cover a comparative analysis of a specific public policy area

The main requirements of the course  Each student should also summarize his/her individual part of the presentation in an individual paper, which should be about standard 8 pages in length.

The main requirements of the course  Team presentations in the class will be held for 8 weeks, from Oct. 6 till Dec. 18  Presentation time should not exceed 15 minutes

First steps/Requirements  Topics of team presentations are to be sent to me by e-mail till Oct. 23 at the latest together with suggested/preferred presentation dates  There will be 4-5 presentations per lesson

Requirements  The individual paper should be submitted until Jan. 31

First things first  What is „Public policy ?  Why „An Economic Perspective“ ?

What is public policy ?  Government decisions and actions (or inactions) intended to address a perceived public issue/problem

What are public issues/problems ?  Situations where personal choices may (positively, or negatively) affect other people or the public as a whole (rather than only the persons that make these choices)

What are public problems ?  Decision whether to buy or sell a car is a private issue because it affects you as a private individual.  Deciding what the speed limit should be on a street or a highway is a public issue because how fast a person drives can affect the safety of other persons.

What are public problems ?  Public problems (usually) occur in public settings, such as communities, rather than in private settings, such as homes

Example Allowing your dog to roam in your house is a private matter, but allowing your dog to roam in your neighborhood is a public matter

What are public problems/policies?  Situations which usually have to be regulated (solved) by the government (though some public problems can also be solved through private actions/initiatives)  Public intervention aimed at solving a public problem is called public policy

What are public problems ?  Issues involving both facts and values

What are public problems ?  People may know facts about public issues, but they still solve them on the basis of their values  When they argue about how best to solve a public problem, they are likely to select the facts that support their values

Public problem: Example  Motor vehicle crashes caused by teenagers.

Public problem. Facts:  Motor vehicle crashes are the leading cause of death for teenagers.  Sixty-five percent of teenage-passenger deaths occur when another teenager is driving.  Nearly half of the crashes involving teenage are single-vehicle crashes.  Fortyone percent of crashes involving teenagers occur between 9:00 P.M. and 6:00 A.M.

Public problem example. Policy:  Graduated licensing for younger drivers.  “Graduated licensing” means that younger drivers cannot drive alone or late at night.

Public problem example. Values: Some people object to graduated licensing as being unfair

Facts vs.Values:  If people could resolve public problems using facts alone, they probably would agree that graduated licensing is good public policy.  Treating people as a group rather than as  individuals raises, however, question („value“) of fairness.  Is it fair to treat all new teenage drivers differently from other drivers?

Public values  Public problems usually involve four principal values: - freedom (choice, individuality, etc.), - fairness (equity, justice, etc.) - safety (security, social order, etc.) - prosperity (efficiency, productivity, etc.)

Public policy infrastructure  Public policy is associated with formally approved policy goals as well as policy measures (tools), usually embedded in laws  It may be executed/implemented by state agencies (regulators)  Broader policy areas can be called policy programs

Typical broader public policy areas:  Health care  Consumer protection  Environmental policy  Social security policy  Employment (labor market) policy  Energy policy  Education policy  Public transportation

Some specific public policy issues:  Workplace safety  Immigration  Housing  Automobile safety  Smoking  Alcohol sales

Some specific public policy issues:  Gambling  Public subsidies to farmers  Policy of disposable drinks packaging deposit  Advertizing/TV commercials

More questionable public policy issues:  Bankers bonuses  Tax on financial transactions  Subsidizing corn-based ethanol production  Protecting domestic producers  Obesity (tax on fat consumption)  

Why „An Economic Perspective“?  The purpose of public policy, among other things, is to regulate society in such a way as to provide higher welfare or economic benefits

Why „An Economic Perspective“?  Public policy often includes two economic aspects - prosperity (it usually aims at increasing public welfare expressed in economic terms) - efficiency (cost/benefit ratio).

Why „An Economic Perspective“?  Public policy tries to change economic behavior of subject (individuals, firms), e.g. consumer habits, production methods etc.  Public policy tools often use economic incentives (taxes, tax reliefs, subsidies etc)

Public policy and Regulation  When applied to economic subjects/matters public policy is often also called „regulation“, „regulatory measures“ or „regulatory policy“

Some regulation examples:  Financial markets regulation  Competition policy and merger regulation  Opening of energy markets to competition  Policy of investment incentives  Ecological taxes, pollution permits (Introduction of Emissions trading scheme)

Why study public policy ?  The best way how to regulate public issues is often debatable (as is the questions who actually benefits from the policy)

The focus of the course  The course mainly focuses on public policy analysis and evaluation based on economic criteria

Policy analysis  Policy analysis is an evaluation of public policy programs and alternatives in terms of their actual impact

Scope and method of public policy analysis  The main criteria of a specific public policy analysis comprise its  goals legitimacy,  effectiveness,  efficiency (economic feasibility),  its tools,  regulatory institutions,  political feasibility etc.

olicy analysis issues P olicy analysis issues  Public policy effectiveness - its ability to reach its stated goals  Public policy efficiency - its costs, side-effects etc.  Public policy tools - possibilities of alternative tools  Public policy comparisons - in terms of its goals, tools, effectiveness and efficiency

Initial policy analysis question  Do we need public policy (public policy intervention)?  Should specific issues be considered public problems?  Do they deserve regulation ?

The Main Economic Question  From the economic perspective, the main question analyzed by the theory of public policy (i.e. Do we need public policy?) can be formulated as: - when is it best to let market forces take their natural course and when should government intervene in or regulate market activity

Examples of policy analysis results: broader conclusions  why policymakers sometimes fail to pursue socially desirable policies or policy reforms

Examples of policy analysis results: specific conclusions  which cathegories of policy tools in certain areas have been successful and which have not

Policy Distinctions two main policy cathegories  The economic approach to public policy analysis distinguishes two main policy cathegories - distributive policies - distributive policies - regulatory policies - regulatory policies

Distributive policies  The objective of distributive public policies (or social policies) is to solve social problems and/or to pursue a social goal through redistributing income from one group of citizens for the benefit of another group of citizens

Distributive policy goals  Typical distributive policy goals include reducing poverty, ensuring higher fairness (e.g. in labor markets), and providing public or merit goods—that is, goods and services that a society believes every citizen is entitled to regardless of whether he or she can afford them.

Regulatory policy  Regulatory public policies can be considered as legal restrictions imposed on economic behavior

Regulatory policy goals  Regulation attempts to produce behavior, which might not otherwise occur, or prevent behavior than would otherwise occur

Regulatory policy: Examples  Common examples of regulation include attempts to control market entries, market prices, wages, pollution effects of production or consumption, employment for certain people or in certain industries, standards of production for certain goods and services etc.

Regulatory policy can have five major legal forms (either Command-and-Control or Market- Based) Regulatory policy can have five major legal forms (either Command-and-Control or Market- Based) Command-and-Control) 1. Public standards or statements of expectations (Command-and-Control)

Regulatory policy can have five major legal forms Command-and-Control) 2. A process of registration or licensing to approve and to permit an operation, usually by a named organisation or person (Command-and-Control)

Regulatory policy can have five major legal forms Command- and-Control) 3. A process of inspection or other form of ensuring standard compliance, including reporting and management of non- compliance with these standards (Command- and-Control)

Regulatory policy can have five major legal forms Command-and-Control) 4. A process of de-licensing whereby organisation or person is judged to be operating unsafely, and is ordered to stop operating at the expense of acting unlawfully (Command-and-Control).

Regulatory policy can have five major legal forms 5. Taxes and subsidies levied on production or consumption motivating economic subject to increase or decrease their activities in certain areas (Market based)

Regulatory policy examples  Regulations imposed on the selling of (financial) products to individuals have been introduced as a protection against unscrupulous (financial) firms with better information than their customers (problem of „information asymmetry“)

Regulatory policy example (market based policy) Taxes and/or subsidies can motivate to substitute current production method polluting the environment by ecologically less harmful technologies etc.).

Some regulation has been motivated by politics rather than economics  For instance, restrictions on the number of hours people can work or the circumstances in which an employer can dismiss employees.

Regulation vs. deregulation  The last decade of the 20th century saw a wave of attempts to remove, reduce, or simplify restrictions on business and individuals with the intent of encouraging the efficient operation of markets.

Regulation vs. deregulation  The stated rationale for deregulation is often that fewer and simpler regulations will lead to lower costs, therefore higher productivity and competitiveness and lower prices und higher employment overall

Regulation vs. deregulation: Example  For example, deregulation of the air industry in Europe in 1992 gave carriers from one EU country the right to operate scheduled services between other EU states.

Regulation vs. deregulation  In addition, there have been regulatory innovations, usually suggested by economists, such as emissions trading scheme

Main Economic Reasons for Government Interventions  Market failures: situations when markets fail to be „efficient“  There are five main cathegories of such situations

Market failures: situations when markets fail to be efficient  The existence of monopolies, or excessive („dominant“) market power  „Externalities“  Provision of public (collective, merit) goods  Information failures (information asymmetry)  „Moral hazard“

Economic reasons for government interventions  Analyses of public policy/ government intervention in the economy should be looking at whether or not have market failures occured.

Economic reasons for government interventions  The occurrence of market failure usually legitimizes government intervention

Monopoly: Problem of Welfare Loss  A market with just one seller, or a few oligopolists who cooperate and behave as a monopoly, is a serious market failure justifying government intervention  Monopolies are generally inefficient: price is too high, and output is too low, to maximize net benefits in market

 Government responds to the problem of monopoly in one of three ways  Making monopolized industries more competitive.  Regulating the behaviour of monopolies.  Turning private monopolies into public enterprises. Competition policy

 Legislation designed to encourage competition and discourage/ban the use of monopoly practices (agreements or engaging in other behavior that limits competition and harms consumers  Attempts to ensure market entry and fair competition in industries with barriers to entry and anti-competitive practices Anti-trust Law

Antitrust Law Operates in three areas  Agreements among competitors —prohibits “contracts, combinations, or conspiracies” among competing firms that would harm consumers by raising prices

Antitrust Law Operates in three areas  Monopolization - it is illegal to monopolize or attempt to monopolize a market

Antitrust Law Operates in three areas  Regulation of Mergers. In a merger, two firms combine to form one new firm. The result is to increase the danger of higher prices from oligopoly or monopoly  If the competition laws are to raise social welfare, the government must determine which mergers are desirable and which are not.

Recent Antitrust Enforcement  In recent years, antitrust law has worked mainly through its deterrent effect  Many potential mergers are never even proposed because firms know the merger would not be allowed.

 A natural monopoly exists when, due to economies of scale, one firm can produce for the entire market at a lower cost per unit than can two or more firms (example: distribution networks)  When a monopoly arises as a natural monopoly, using anti-trust law to break it up or even to prevent its formation is a poor remedy Natural monopolies Natural monopolies

 Government may regulate the prices that the monopoly charges.  This is often the case with natural monopolies. Price regulation Price regulation

 regulators often depend on information obtained from monopolies  regulatory boards are often made up of individuals from the industry being regulated.  industries that could very well compete desire to be declared natural monopolies. Practical problems associated with price regulation

Anti-trust Law: not always a Remedy  Breaking up a monopoly would not make sense when the market would perform even worse with more competition  Monopolies that arise from patents and copyrights, provide an incentive for artistic creations and scientific discovery

The actions of an economic subject can have externalities  An externality is an impact or „spill-over“ (positive or negative) on any party not directly involved in an economic decision/activity

Externalities: both positive and negative  A negative externality occurs when an economic decision (concerning production or consumption) creates undeserved costs to a third party  A positive externality means undeserved benefits to a third party

 In other words, the producers or consumers in a market suffering from externalities either do not bear all of the costs or do not reap all of the benefits of their economic activity. Externalities: both positive and negative

 Manufacturing that causes polution imposes costs on others, while planting forests (rather than other agricultural activities) would improve water quality Externalities: Examples

Why market failure ?  Because costs and benefits are not fully included in prices, they do not form part of the calculations of the people deciding whether to go ahead with the economic activity

Why market failure ?  The existence of externalities means that either too much or too little of the good is produced and consumed in terms of overall cost and benefit to society

Why market failure ?  If there are external costs (negative externalities) such as pollution, the good will be overproduced by a market, as the producer does not take into account the external costs when producing the good.

Many negative externalities are related to the environmental consequences of production and use  Air and water pollution,  Industrial farm animal production, overfishing  Overconsumption of health care caused by smoking and drinking  When car owners use roads, they impose congestion costs on other users  Consumption of energy increases the nation’s dependence on foreign oil

Positive externalities: Examples  Education creates a positive externality because, among other reasons, more educated people are less likely to engage in violent crime, which makes everyone in the community better off.  Home ownership creates a positive externality in that homeowners are more likely than renters to become actively involved in the local community.

Positive externalities: Examples  Inventions and information - once an invention (or other form of practical information) is discovered or made accessible, others benefit by exploiting the invention or information  An individual buying a product that is interconnected in a network increases the value of the same product owned by others

 One potential solution of externalities is a policy of command-and-control (bans, requirements etc)  For instance, specific technologies are banned to eliminate an externality, requirement that every car be fit with a catalytic convertor, that all citizens be immunized etc. Policies correcting externalities

 Government can fight externalities also by quantity policies (specific limits are set for a particular externality such as air pollution) Policies correcting externalities

 The liability system administered by the courts also seeks to reduce the cost of externalities by encouraging firms and consumers to behave in a more socially efficient manner. Policies correcting externalities

 Market based policy dealing with externalities, when the externality is negative, is a tax on the activity or, if the externality is positive, a subsidy  Taxes and subsidies make consumers and firms account for („internalize“) the social costs or enable them to accrue the social benefits of their actions Policies correcting externalities

Externalities and public goods  Extensive positive externalities connected with providing certain goods may cause problems for the production of such goods.  Public goods - goods the free market may not produce at all

Why market failure?  The private sector may not be motivated to produce public goods  The reason is that people are not willing /cannot be forced by private companies to pay for them

Why market failure?  The free-rider problem – if produced no one can be prevented from using them  If no one can be prevented from using them, no one in willing to pay for them

Why public issue?  Public goods taken as importants for the society/economy as a whole

 Public goods are regarded as a very important example of market failure, and in most countries they are provided at least in part by government and paid for through compulsory taxation Provision of public goods

 Public safety  National Defense  Basic Research  Fighting Poverty Some Important Public Goods

 Government may decide to provide certain good/services for free or for prices below market level  Reason is it believes these goods should be available regardless of indiviuals incomes  Frequent source of misunderstanding: Public goods vs. publicly provided private goods

 These are publicly provided private goods/merit goods  Economically, these are not public goods since market can provide them (but people may not be able to buy them) Frequent source of misunderstanding: Public goods vs. publicly provided private goods

 Government may decide to provide a public/merit good if the total benefits exceed the costs. Provision of public goods: An Economic Perspective

 Cost benefit analysis refers to a study that compares the costs and benefits to society of providing a public good.  In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good. The Difficult Job of Cost- Benefit Analysis

 Government may decide to provide public good by public production or to subsidize production of a public good in the private sector  Unlike public production (direct government provision of public goods), subsidies may result in some form of a competitive market. Provision of public goods

 Informational asymmetry arises when one party to a transaction has more or better information than the other party. Market failures due to nature of exchange

 If consumers are uninformed or misinformed about the quality of a product, they may derive less utility from it than they expected.  Consumers’ choices could be distorted by false advertising, by firms’ failures to disclose relevant information about their products and services, and by a lack of information to assess accurately the safety of potentially risky products. Why market failure ?

 Similarly, workers may become injured or ill because they lack information about the health risks they may encounter in their workplace.  Another example of information asymmetry is adverse selection when people who are high risk are more likely to buy insurance Why market failure ?

 Governments attempt to minimize the welfare losses caused by imperfect information by empowering regulatory agencies to - direct firms to provide complete and accurate information about their products and workplaces - ensure that consumer products and workplaces meet reasonable safety standards. Policies to imperfect information

 Policies aimed at improving information asymmetries entail measures in - advertising regulation, - disclosure rules, - labelling, - product standards, - occupational licensing etc. Policies to imperfect information

 Moral hazard arises because an individual or an institution does not bear the full risk of its actions because it can shift at least some consequences of its risky behavior on others.  Therefore, it has a tendency to act less carefully than it otherwise would Market failures due to nature of exchange

 For instance, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company. Market failures due to nature of exchange

 Financial bail-outs of banks by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Moral hazard in financial industry

 A special case of moral hazard/asymmetric information is the principal-agent problem, where one party, called agent, acts on behalf of another party, called principal Principal-agent problem

 The agent usually has more information about his actions or intentions than the principal does, because the principal usually cannot perfectly monitor the agent. Principal-agent problem

 The agent may have an incentive to act inappropriately (from the view of the principal) if the interests of the agent and the principal are not aligned. Principal-agent problem

 There are some types of policy issues where economists believe strongly in a policy that may or may not appeal to the general public. Some Policy Recommendations

 For example, economists believe that we benefit from free trade, even though the public sometimes resents foreign imports. Some Policy Recommendations: Free Trade

 The principle of substitution says that individuals will respond to incentives by substituting low-cost methods for high-cost methods.  Example: applying taxes directly to the activity that is to be discouraged Some Policy Recommendations: Substitution

 The most ineffective policies are those that will be undermined by the principle of substitution. The principle of substitution

 Example: when a minimum wage is imposed, businesses will substitute low- skilled workers. The principle of substitution

 Lack of Information  Special Interest Effect (Lobbying, Corruption)  Rent-Seeking Behavior  Short sightness Effect: Clear Benefits, Hidden  Costs The opposite of Market Failures: Government Failures

Special Interest Effect  One that generates substantial personal benefits for a small number of subjects  Imposes a small individual cost on a large number of other persons

Special Interest Effect (cont.)  T he voters bearing the cost of special- interest legislation will often be uninformed on such an issue  It exerts only a small impact on their personal welfare and they are unable to avoid the cost and/or get more infomation

Interest Groups and Public Policy  Politicians are likely to offer policies where the costs are widely diffused, but where the benefits are more significant for a particular interest group

Interest Groups and Public Policy  Public policy makers may, therefore, have a strong incentive to favor special interests even if the corresponding action is inefficient (higher social costs than benefits).

Interest Groups and Politics  Therefore there may be bias in political decisions towards public intervention

„Rent Seeking“ u Actions by individuals and interest groups designed to (permanently) restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves.

Rent Seeking“ „Rent Seeking“ u Rent seeking occurs when an individual, organization, or firm seeks to make money by manipulating the legal environment rather than by making a profit through trade and production u

„Rent Seeking“ u The typical example of rent-seeking is the monopolist case. Firms seek government privilegies (such as barriers to entry) to secure a monopoly and therefore monopoly rents.

„Rent Seeking“ u Other examples include a farm lobby that seeks tariff protection or an entertainment lobby that seeks expansion of the scope of copyright.

„Rent Seeking“ u Other rent seeking is associated with efforts to shift the government tax burden or government spending allocation. u An example is an organization that seeks different tax liabilities for married than for unmarried couples

Results of „rent seeking“ can be considerable u If "buying" a favorable regulatory environment is cheaper than building more efficient production, a firm will choose the former option, reaping incomes entirely unrelated to any contribution to total wealth or well-being.

„Rent Seeking“ u Rent seeking moves resources away from productive activities. u The output of economies with substantial amounts of rent seeking will fall below their potential.

„Rent Seeking“ u Rent seeking may be initiated by government agents, such agents soliciting bribes or other favors from individuals or firms seeking special privileges, which opens up the possibility of exploitation of the consumer and/or taxpayer.

Interest Groups & „Rent Seeking“ u Widespread use of the taxing, spending, and regulatory powers of government that favor some at the expense of others will encourage rent seeking.

„ Regulatory capture“ u Regulatory capture is a related concept u It refers to collusion between firms and the government agencies assigned to regulate them

Regulatory capture u It is a phenomenon in which a government regulatory agency which is supposed to be acting in the public interest becomes dominated by the interests of the industry that it oversees. u

Regulatory capture example u An industry regulatory body sets prices at artificially high levels and excludes new competitors through a restrictive permitting process.

Valuable Functions of Interest Groups u Interest groups can raise awareness of public issues, or issues that concern the people at large. u Interest groups represent people who share attitudes rather than those who share geography. u Interest groups provide specialized information to government agencies and legislators.

Valuable Functions of Interest Groups u Interest groups are vehicles for political participation u Interest groups compete u Interest groups keep tabs on various public agencies and officials.

Criticisms u Some interest groups have an influence far out of proportion to their size or importance. u It can be difficult to tell who or how many people are served by a group.

Criticisms u Groups do not always represent the views of the people they claim to speak for. u In rare cases, groups use tactics such as bribery, threats, and so on.

Additional public policy phenomenon: Shortsightedness Effect u Issues that yield clearly defined current benefits at the expense of future costs that are difficult-to- identify. u

Motivation of Bureaucrats u The interests of bureaucrats are often complementary with those of interest groups they serve. u Bureaucrats can usually expand their own interests, as well as that of their constituents, by working for larger budgets and program expansion.

Lack of Incentive for Operational Efficiency u In the public sector, the absence of the profit motive reduces the incentive of producers to keep costs low. u Neither is there a bankruptcy process capable of weeding out inefficient producers. u Public-sector managers are seldom in a position to gain personally from measures that reduce costs.

Question for Thought: u Evaluate the following view: „Since government-operated firms do not have to make a profit, they can usually charge a lower price than privately owned enterprises.”

Economics of the Transfer Society u A large and growing part of government is devoted to transferring income.

Economics of the Transfer Society u Large-scale redistribution can reduce the „size of the economic pie“: u When taxes take a larger share of one’s income, the individual reward derived from work and productive service is reduced.

Economics of the Transfer Society uAs public policy redistributes a larger share of income, more resources will flow into wasteful rent seeking activities.

Four Factors that Weaken the Case for Market forces  Lack of competition  External costs and benefits  Public goods  Poor information

Four Factors that Weaken the Case for Public Solutions  The power of special interests  Rent seeking/corruption  The shortsightedness effect  Redistribution

Regulation of Financial and Capital Markets Regulation examples: Regulation of Financial and Capital Markets

What are Financial and Capital Markets? In financial markets, participants trade securities (shares, bonds, etc), money, foreign exchange, insurance, commodities etc.

What are Financial and Capital Markets?  The main types of financial markets cover:  Money Market  Capital Market (Primary and Secondary)  Insurance Market  Derivatives Market  Forex Market

What is (can be) regulated in financial markets?  Financial institutions (intermediates) – banks, investment funds, brokers, …  Flow of money  Financial risks  Information  Scope of participants  Debts The toughest regulation form - licences

Who regulates?  Supervisors of national financial markets – central banks  Supervisors of national capital and securities markets – Securities and Exchange Commissions (SEC)  EU bodies: EU Commission, European central bank (ECB), European Securities Committee (ESC), Committee of European Securities Regulators (CESR)

Regulatory bases Regulatory bases  Central banks - regulate commercial banks on the basis of Basel II Directive  A set of banking regulations issued by the Basel Committee on Bank Supervision, which regulates finance and banking internationally.

Basel II Directive The purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against financial and operational risks banks face

Basel II Directive  Basel II sets the minimum capital requirements of financial institutions with the goal of ensuring institution´s liquidity.

Basel II Instruments Basel II Instruments  Banks need to put aside capital to reduce the risks associated with its investing and lending practices  The greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold.  The goal is to ensure that capital allocation is more risk sensitive

Regulatory bases Regulatory bases  Basel III is scheduled to be introduced from 2013 until 2018. It was developed in response to the deficiencies in financial regulation revealed by the last financial crisis.  The focus of Basel III is to reduce the risk of system wide shocks.  Basel III seeks to further improve the banking sector's risk management and strengthen the banks' transparency.

“MiFID” Directive  The Markets in Financial Instruments Directive (MiFID)  MiFID is the cornerstone of the European Commission's Financial Services Action Plan

“MiFID” Directive Goals  to complete the process of creating a single EU market for financial investment services  to respond to changes and innovations which have occurred in securities markets  to protect investors by making markets deeper, more competitive and more robust against fraud and abuse

MiFID - Authorisation, regulation and passporting  Firms covered by MiFID are authorised and regulated in their "home state" (the country in which they have their registered office whereas formerly, a service was regulated by the member state in which the service took place).  Once a firm has been authorised, it can use the MiFID passport to provide services to customers in other EU member states.

MiFID – Client handling  MiFID has requirements relating to the information that needs to be captured when accepting client orders, ensuring that financial institutions are acting in a client's best interests

MiFID - Client categorisation  MiFID requires firms to categorise clients as "eligible counterparties", „professional clients“ or „retail clients“. These have increasing levels of protection.  Clear procedures must be in place to categorise clients and assess their suitability for each type of investment product.  That said, the appropriateness of any investment advice or suggested financial transaction must be verified before being given.

MiFID - Post-trade transparency  MiFID requires firms to publish the price, volume and time of all trades in listed shares, even if executed outside of a regulated market

MiFID - Best execution  MiFID requires that firms take all reasonable steps to obtain the best possible result in the execution of an order for a client.  The best possible result is not limited to execution price but also includes cost, speed, likelihood of execution and likelihood of settlement and any other factors deemed relevant.

Regulation examples: Social Regulation

Goals of Social Regulation  to ensure that the pursuit of profit does not conflict with social welfare  to gain socially desirable outcomes when competition cannot be relied upon to achieve them.

Social regulation concerns  the conditions under which goods and services are produced (working conditions, production processes firms are allowed to use)  the quality of goods and services  the side effects of production on society, mainly environmental pollution.

Regardless of industries, regulation focuses mainly on  Consumer protection  Employer-Employee relationships, e.g. working hours, equal employment opportunity, minimum wage, employees dismissal, percentage of women in management, operation of trade unions  Employees (workplace) safety  Energy use  Environmental protection

 If a product or service poses a risk to consumer safety, the most effective means of addressing the problem may be to ban the product.  This is especially so where the risk is unlikely to be mitigated through the provision of consumer information (e.g. that information is high cost, difficult to obtain or understand, or undervalued by consumers through differing perceptions of risk). Consumer protection example: Prohibitions and Bans

 Warnings retain consumer choice but do not result in the information cost problems  Consumers can then choose to seek a substitute; or to investigate the details of the risk; or to make the purchase and use it with care Consumer protection example: Labelling and Warnings

 Can be particularly effective for reducing information costs where the product has severe risks for and the intermediary knows both the risks and whether they are likely to affect a particular consumer.  This tool also sends a signal to the consumer that there may be value in searching out more precise information and not relying on general expectations of safety. Consumer protection example: Mandatory Use of Information Intermediaries

 Imposing a guarantee as to the reasonable availability of spare parts and facilities for repair reduces the need for consumers to search out that information before deciding to buy a particular product. Consumer protection example: Regulation of Terms of Agreement

 If a consumer seeks services or products from a member of a regulated profession, the cost of information is reduced because assumptions can be made as to the competence and performance of that member  However, if occupational regulation is not based on relevant quality control standards, it will not reduce information costs. Consumer protection example: Occupational Regulation

 Consumers can use indicators of compliance with a standard as an indicator of safety or quality, as appropriate  Non-compliance with standards may be subject to some form of sanction or redress due to their incorporation into regulationsame. Consumer protection example: Standards

 Where there is a consumer interest that should be protected by law, policymakers need to consider whether that interest should be protected through public enforcement and sanctions or through private claims and redress. Consumer protection: Sanctions vs. Redress Mechanisms

 The Minimum-Wage Controversy  Employment regulation and labour markets flexibility  Employment regulation in a globalized economy Main Issues of Employment regulation

Scope of social regulation  Scale and scope of regulatory activity expanded substantially in the last three decades with the emergence of environmental and consumer movements, regardless of the deregulation initiatives

Who regulates ?  Parliament  Government institutions (ministries)  Independent regulatory bodies (specialized agencies)  European Commission  Courts  Self-regulatory (private) bodies

Regulatory institutions  If regulation is implemented through independent commissions and agencies, regulatory practices can be appealed to the courts to test their constitutionality and to ensure that agencies satisfy due process in their decision making

Economics of Social regulation  A government agency has power to direct business to take specific actions  While legal procedures typically result in fines or other penalties if businesses do something wrong, regulators reach deep into the operations of business to tell them what to do

183 Economics of social regulation  Ownership of the regulated firm remains private.  Pricing and production decisions controlled by a government regulatory agency.

Economics of Social regulation  Some economists argue that the growing scope of regulation is bad.  The regulatory costs may outweigh the social benefits derived from the regulation  Regulations are often poorly written and ambiguous  Regulatory burdens may become unbearable for small firms.

Main Types of Questions in Social Regulation  What is the desired outcome of regulation (behavior of regulated subjects)?  Can we design a regulatory mechanism that induces the regulated firm to act in a way that results in the optimal outcome?  Can we balance the benefits of regulation with its costs (compliance costs) and risks, e.g. regulator’s capture?

186 Regulation in Economic Perspective  An efficient regulatory infrastructure must consider and balance benefits - safer products, reduced crime - against the costs of achieving legal and regulatory goals  A legal and regulatory system that ensured the complete elimination of crime, unsafe products, and other unwelcome activities would be less efficient than a system that tolerated some amount of these activities

What are compliance costs? Direct costs to businesses of performing tasks associated with complying with government regulation, e.g. - administrative and paperwork costs - regulatory fees - upgrading equipment / production processes - information costs - staff time, eg. training in new requirements - external expertise (e.g. lawyers, accountants).

 Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. Regulatory paradox: Price discrimination

 Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Price discrimination

 Perfect Price Discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Price discrimination

 Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. Price discrimination

 Important effects of price discrimination:  It can increase the monopolist’s profits.  It can reduce deadweight loss. Price discrimination

193 Impact of Regulations At their best: Achieve social and environmental goals Provide consumer protection I mprove economic performance by promoting competition At their worst: Create unintended, unnecessary and often unavoidable barriers to businesses and trade

194194194 Doing Business indicators – areas of business regulation Property rights Investor protection Access to credit EntryAdministrative burden Flexibility in hiring Recovery rate Reallocation of assets

Regulatory Impact Assessment (RIA)  Systematic and mandatory appraisal of how new/proposed legislation/regulation will affect certain categories of economic subjects  Often used in the pre-legislative scrutiny of legislation

Regulatory Impact Assessment (RIA)  It can be also used to - examine the effects of regulations that are currently in force, for example with the aim of eliminating some burdensome features of existing regulations (high compliance costs) - choose the most effective way to simplify regulation

197 Purpose of Regulatory Impact Assessment  Provide e mpirical data and independent oversight for regulatory decisions  Promote balanced decisions that trade off problems against wider economic and social goals

198 Purpose of Regulatory Impact Assessment  Communicate the information to decision makers  Enables policy makers to understand and take personal responsibility for regulatory decisions  Reduce the regulatory burden

Components of the RIAS  Description: defines the problem, shows why action is necessary and outlines the regulations  Alternatives: lists options beside regulation and other types of regulation  Benefits & Costs: quantifies the net impact

 Compliance and enforcement: explains the policy on conformity to the regulations and tools to ensure it is respected Components of the RIAS

Regulatory Impact Assessment can cover  firms and their types (e.g. small business)  economic sectors (e.g. their competitiveness)  industry stakeholders (employees, customers etc.)  the community  the environment

Cost-Benefit Analysis (CBA)  The main analytical tool used to assess the benefits and costs of regulation or regulatory proposals

Cost-Benefit Analysis (CBA)  Where regulation is designed to reduce the risk of physical or economic harm, a CBA should include a risk analysis detailing how the regulation will change the likelihood, frequency or consequences of an adverse event occurring

Given sufficient information, CBA can  calculate the net benefits for each proposal  rank proposals by their net benefits  recommend the proposal with the greatest net benefit  discount future costs and benefits to obtain present values  compute the net present value for each policy option 

Why is CBA useful? CBA can draw attention to equity issues  by identifying who gains and who loses from a regulatory proposal  but it is up to decision makers to decide whether distributional impacts/equity issues are important and need addressing

Cost-Benefit Analysis (CBA ) Weaknesses of CBA  Difficulty in quantification of effects, costs and benefits  Difficulty in predicting compliance behaviour  Limitations on information  The costs of analysis  The need to meet political or policy-making deadlines

207 CBA  There are significant challenges in using CBA  But even when it is difficult to measure accurately benefits and costs applying the CBA framework is important and useful  CBA can play an important role in improving the quality of regulatory proposals – even when valuation is difficult

CBA Non-monetised costs and benefits should not be excluded from consideration in CBA Impacts should be reported in CBA as follows: - monetised - quantified, but not monetised - qualitative, i.e. not quantified or monetised

Existence of non-monetised costs and benefits presents a challenge Agencies should consider non-monetised impacts adequately but not overplay them If a proposal shows large monetised ‘net’ costs the requirement on the government agency is to clearly explain why non-monetised benefits would tip the balance

Frequently used non-market values in CBA include  Value of a statistical life or life year  Value of travel time savings  Value of recreational activities  Value of nature (species or habitats)  Cost of noise pollution  Cost of air pollution

Valuing a “statistical” life (VSL)  How much would individuals pay to achieve a small reduction in the probability of death?  Revealed preference and stated preference studies can provide estimates of willingness to pay (WTP) for small changes in mortality risk

VSL is not the value of an ‘identified’ life  VSL is the aggregate amount that a group of individuals are WTP for a risk reduction  If people are WTP, on average, $12 for a risk reduction from 5 in 500,000 to 4 in 500,000  VSL = $12/0.000002 = $6 million  It does not mean that an individual would pay $6m to avoid (certain) death this year  It does imply that 500,000 similar people would together pay $6m to eliminate the risk that is expected to kill one of them randomly this year

RIA Example: biofuels  According to the Kyoto protocol of 1997, countries have commitments in relation to its C02-emissions.  The transportation sector is responsible for about one quarter of energy- related greenhouse gas emissions.  Replacement of conventional hydrocarbon based fuels with fuels made from renewable bio-sources could be one way of reducing the emissions.  Appraisal looked at a scenario where 2 % of the fuels consists of biofuels.  The main biofuels today are ethanol and biodiesel, they are usuallly imported.

Biofuels - benefits  Biofuels have a ”lower carbon footprint” than conventional fuels.  2 % biofuels content results in a reduction in total Co2 emitted amount of 160 000 tons per year.  The social cost of Co2 is set at 25 euros per ton.  Thus, the value of the annual benefit is 4 mil. euros.

Biofuels - costs  Biofuels have a lower energy content than conventional fuels.  Resource costs of biofuels passed on to consumers.  Crops that otherwise would become food might instead become fuel  Biofuel programmes could raise food prices  Higher crop prices could harm the poorest people.

Benefits and costs in summary Reduced Co2 emitted: 4 mil. euros Total additional cost (8,13+9,02) mil. euros: 17,15 mil. euros Net benefit: - 13,15 mil. euros Cost-efficiency: Reduced Co2-emissions: 160 000 tons Cost per ton of Co2 abated: 107 euros Social cost of Co2 per ton: 25 euros

Biofuels – what did the government decide? There will be a biofuel obligation where the fuel sellers have to ensure that at least 2 % of the fuel they sell for road transport is biofuel By the end of the next year least 5 % of the fuel sold for road transport shall be biofuel. In addition: Tax reliefs for biofuels and so-called flexi-fuel cars are already in place.

Public Policy: An Economic Perspective Public Policy: An Economic Perspective prf.cuni.cz room 341, Thursday, 10-12 a.m.

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Public Policy: An Economic Perspective Public Policy: An Economic Perspective prf.cuni.cz room 341, Thursday, 10-12 a.m.

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