1. Theory of Regulation
Week 2

2. Historical development
Structure – Conduct - Performance paradigm
Chicago School of Political Economy
Virginia School of Public Choice
Contestable market theory
Rate of return

3. SCP paradigm
Normative theory of regulation: market fails => state interference needed
Concentrated market => suboptimal outcomes
State should attempt to lower the market concentration
Today presented by neoclassical microeconomic models
Gravelle, H. - Rees, R.: Microeconomics. Second Edition, London NewYork, Longman 1992 Kreps, David M.: A Course in Microeconomic Theory. Princeton, Princeton University Press Chapters 11 +

4. Structure-Conduct-Performance
Perfect competition
Monopoly
Oligopoly
Strategies
R&D
Prices, quantities
Profitability
Efficiency

5. Structure–Conduct–Performance (SCP)
Harvard School, 50s. and 60s
Exogenous market structure (oligopolies) determine market behavior (collusion) a it determines the performance (high profit)
Market structure : measured by concentration index
Performance: difference between MC and P
Policy implication: The concentrated market fails => scope for regulatory intervention of state

6. Monopolistic competition
Market structures
Good
Perfect competition
Monopolistic competition
Oligopoly
Duopoly
Bad
Monopoly
But practical and theoretical challenges…

7. Definition of the relevant market
Criteria
Physical characteristics of a product
Geographical parameters
Time
Measuring similarity of a product?
Cross elasticity of demand – CED = % change in quantity of x
% change in price of y
Very problematic part of regulatory policy

8. Concentration indeces
Concentration related to market share (and degree of competition
Market share = firm’s sales, output, VA, assets, # employees / market’s sales, output, VA, assets, # employees
Indeces
CRn – n firm concentration ratio
Herfindahl index
Lernerův index

9. Structure-Conduct-Performance
Mutual interaction of firms influences their behavior on the market
Product differentiation influences market structure
Structure
Conduct
Performance
Profitability of firms influences their number in the next period

10. Cournot duopoly Q2
R1(Q2) E
R2(Q1) Q1

11. Chicago School of Political Economy
Positive theory of regulation: costs determine structure, conduct determined by incentives
characteristics of the individual firm (rather than industry as a whole) are important
Literature
Stigler, G. J.: Chicago Studies in Political Economy, pp , The University of Chicago Press, Chicago and London 1988
Becker, G. S.: A Theory Of Competition Among Pressure Groups For Political Influence
Peltzman, S.: Toward a More General Theory of Regulation
Stigler, G. J.: The Theory of Economic Regulation

12. Virginia School of Public Choice
Theory of capture
Strong positive theory of regulation: the regulator has come into existence to serve interest of the captured
Weak positive theory of regulation: once regulation has come to existence (for whatever reason), it is captured by interest of the regulated
Rational choice models applied to regulators
Literature
Tollison, R.D. (1985) “Public Choice and Antirust.” Cato Journal 4: 905–16.
Buchanan‘s and Tullock‘s work

13. Contestable market theory
Concentration has little to do with industry structure
Conditions to entry and exit from the market
Natural monopoly (decreasing MC), utilities
High fixed costs
Control of key input
Administrative regulation (patents, licences, etc)
Positive theory: if free entry monopolists behave as under competition
Baumol, W.J.; Panzar, J.C.; and Willig, R.D. (eds.) (1988) Contestable Markets and the Theory of Industry Structure. San Diego, Calif.: Harcourt Brace Jovanovich/Academic Press.

14. Rate-of-return regulation
First used US, 1944 Hope Natural Gas Company
Returns should reflect the returns to investments in other industries with similar risk
Difficulties with stipulating returns
problems with benchmarking
which costs to choose: historical accounting or current market or according to the costs capital (problem with cyclicity)

15. Rate-of-return regulace
Possible input inefficiencies
Averch-Johnson efect, gold plating
Empirical findings: Courville (1974): inefficiently high capital/labour ration K/L, costs higher by 11%
Lack of incentives to buy cheapest inputs
Innefficiencies if firm produces more outputs
Decrease in innovations
Empirics: Sweney (1981)

16. Rate of Return: Calculation
Example:
Return stipulated by regulator S: 10%
Price of capital r: 8%
Allowed economic profit: 2%
Invested capital Total profit (S) Economic profit (S-R)
100 mil mil mil.
200 mil mil mil.

17. Literature
López, E.J. (2001): New Anti-merger theories: A Critique, Cato Journal, Vol. 20, Number 3 (Winter 2001) - in library