Sustainable Energy Systems Theory of Regulation Lecture 2 PhD, DFA M Sustainable Energy Systems Theory of Regulation Lecture 2 PhD, DFA M. Victor M. Martins and Filomena Garcia Semester 2 2009/2010

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. 

Economists explain government policies: 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..

Theories of regulation 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 )

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

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 Diferentiated Oligopoly Few Dificult/Barriers Standardized/ Monopoly One Very difficult Unique

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.

Theories of regulation : public interest theory Perfect competion and monopoly

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

Critique of the Public Interest Theory Theories of regulation : public interest theory 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 : private interest theories B. Private Interest Theory Rational 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.

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.

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.

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.

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.

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)

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.

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.

Theories of regulation : private interest theory

Theories of regulation : private interest theory

Theories of regulation : private interest theory

Somewhere between “Y” and “X” ( slide 19 ) 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 price Implication: 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 ).

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 ).

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.

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

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

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

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.

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.

Theories of regulation : private interest theory

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).

Theories of regulation : private interest theory

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.