sustainable energy systems - ulisboapascal.iseg.utl.pt/~carlosfr/ses/docs/ses_0809_ppt02.pdf ·...

Sustainable Energy Systems

Theory of Regulation

PhD, DFA

M. Victor M. Martins

Semester 22008/2009

SustainableEnergySystems


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.



Theories of regulation : normative and positive analysis, interest goup theory

Economists explain government policies:1. As an instrument to correct market failures and

improve social welfare ( normative theory )(i) optimizing, 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 ( positive theory )

Models of public choice theoryCollective action problems

3. As a mix of the approaches 1. and 2..




Theories of regulationTwo alternative approches to analyse regulation policy outcomes:

Public interest theory : regulatory intervention occurs in the interest of the public at large ( Joskov and Noll 1981 )

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

Public interest theory – PIT- ( Normative analysis)

Government regulation exists to correct some of the shortfalls of the free market economy ( market failures: monopoly power and externalities )PIT is a way to:

Insure competitionImpact externalitiesStabilize economyIntroduce social objectives in economic policies



Theories of regulation : public interest theory

Four models of Market Structure

UniqueVery difficultOneMonopoly

Standardized/Diferentiated

Dificult/BarriersFewOligopoly

DiferentiatedEasyManyMonopolistic competition

StandardizedEasyManyPerfect competition

Product typeEase of entry/exit

Nº of firms




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.




Perfect competion and monopoly

Producersurplus

Consumersurplus

D

S

Pc

Qc0 Quantity

P

CSPM

Pc

CS=>PS DWL

QM QC

P

Quantity0

P=MC MR=MC

D MC




Public interest theory- PITUnder ( 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 falure and improve social welfare



Theories of regulation : private interest theories

Rational choice paradigm vs. public choice school of thought.

Public choice models start from the premise 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 )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. E.g. the EPA and the hazardous waste industry.




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.




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 maximizepolitical 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)

0/ <∂∂ RM / 0∂ ∂ >M L




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.




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 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.




Utility rates per KWh

Pro

fit o

f the

reg

. fir

ms

L2

L1

R1 R2

M1M2

M3

X Y

Z

Iso-political support functions

M3 preferedto M2

prefered toM1

0




Pro

fit o

f the

reg

. fir

ms

M1M2

M3

Optimal regulatory policy

0

Lmax

L1

Rc R* RM Utility ratesper KWh

X

YProfit

function

L=L(R)




Pro

fit o

f the

reg

. fir

ms

Extreme outcomes

0 RM Utility ratesper KWh

Regulatorcaptured by reg.

firmsLMAX

XMF

MC

YRC

Regulatorcaptured byconsumers

Profit functionL=L(R)




• Optimal solutionSomewhere 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 most likely to be regulated ( broad sense ) are either relatively competitive ( agriculture, taxis,etc..) or relatively monopolistic ( network industries ).




Main ResultsUsually the imperfect information about the gains and losses resulting from regulation, along with organizational costs of groups looking for political favors, lead to a reduction of the winner coalition.The winner coalition will not receive a gain as big as it could be by the regulatorEven if groups organize themselves looking for their economic interests, it would be in favor of the regulator to produce a coalition that includes members of the loser group.




Main results ( cont)It is expected to observe regulation in industries that are in perfect competition (agriculture) or monopoly (electricity) but not in intermediate industries between those two points (automobiles). This hypothesis seems to be confirmed by empirical evidences.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 ).




CriticismsDespite the great appeal of the ‘capture’ theory, which prevails until today, it is possible to identify, especially in the 80s the US, new regulatory trends which could not be explained by this theory (such as social and environmental regulation) as well as a simultaneous tendency for deregulation (the most visible on commercial aviation).The challenger 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 opened question.




Criticisms ( cont.)The theory of capture 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




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




AssumptionsTaxes, subsidies, regulation etc. are used to increase the welfare of the most influential pressure groups. Groups compete to access political resources.The utility function of each person can be measured by his full income, which includes leisure and other extra market activitiesPressure depends on the number of members and the resources usedTwo 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




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 decresing 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 isassumed that 2´s wealth must be reduced by (1+x)T, where x>0. The amount xT is the wefare loss from regulationThe aggregate influence is fixed , so what is important for determining regulation ( revenu transfer between groups ) is the influence of one group relative to the influence of another goup.




Model ( cont.)Taking into account the benefits and costs of pressure one can derive the optimal strategy of group 1, p1, given any value of p2.I1 is the group´s 1 best response function; I2 is the group´s 2 best response function. They are plotted in slide 29 and e0 is the political equilibriumIf the group i =1,2 became more efficient the influence function shifted left and upwardIf the group i =1,2 became less efficient the influence function shifted right and downward

The logic behind this result is the same as for Cournot outcomein the duopoly setting



Theories of regulation : private interest theoryPr

essu

re b

y 2 I1(p1)

I1(p2)

Pressure by 1

e0

Influence curves of 1 and 2




The group that become 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.




Pressure by 1

Pre

ssu

re b

y 2 I2(p1)

I1(p2)I2(p1)

I1(p2)

p´2

p02

p´´2

p´´1p0

1 p´1




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 preferencesPro-producer tendencies are disciplined by consumer groups meaning that price is less than the monopoly levelRegulation most likely in competitive or monopoly industries as there is strong incentive for one group to lobby for regulationIn 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.

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