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Economics Workshop Better Regulation Executive. Sandeep Kapur. 2006. s.kapur@bbk.ac.uk. WORKSHOP AIMS. To provide rigorous but non-mathematical training in economics, enabling BRE staff to develop a simple but reliable toolkit for economic analysis - PowerPoint PPT Presentation
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WORKSHOP AIMS
To provide rigorous but non-mathematical training in economics, enabling BRE staff to• develop a simple but reliable toolkit for economic
analysis• practise its application using concrete regulatory
problems• explore the application of simple economic theory
to their own work
Objectives: Day 1
To understand • how markets work, and their efficiency• why markets sometimes fail to be efficient and how
various regulatory instruments can improve efficiency• how regulation can improve on other aspects of market
outcomes, such as inequity• how, in practice, regulatory interventions carry the risk
of government failure
Objectives: Day 2
To • review the standard rationale for regulation• the basics of regulatory impact assessment• understand how good regulatory design can cope
with risk and uncertainty, informational imperfections, and minimise distortion of incentives
• rationale for and implementation of RPI-X regulation• the link between regulation and productivity growth
Markets vs. Command
The central questions: given existing resources• what goods and service to produce?• how to produce? • for whom?
Alternative mechanisms• COMMAND ECONOMY
direct control, as in Soviet economy, or firms’ internal decisions
• FREE MARKET ECONOMYoutcome determined by private transactions in markets, based on prices, incomes, wealth
Degree of government intervention differs..
Hong Kong- China - Denmark - UK - USA -Cuba
Most countries have mixed economies with both• markets, which are regulated to different extent• public production and provision
Scale of government
1880 1930 1960 2004
Japan 11 19 18 37
USA 8 10 28 36
UK 10 24 32 43
Germany 10 31 32 47
France 15 19 35 53
Sweden 6 8 31 57
Spending as share of national income (%)
The policy question
Markets are generally considered to be efficientIf so, why not leave things to the market?
Governments care about both equity and efficiency
• Free markets rarely deliver equitable outcomes, so some redistributive intervention is unavoidable
• Free markets do not always lead to efficient outcomes, so some interventions are motivated by efficiency considerations
To understand this, we must look at how markets work
Market
• MARKET any arrangement in which prices adjust to reconcile buyers and sellers intentions
• DEMANDquantity buyers wish to buy at each price
• SUPPLYquantity producers wish to sell at each price
• EQUILIBRIUM PRICEthe price at which market clears(i.e. quantity demanded = quantity supplied)
Price Adjustment
Demand curve
quantity
price
EquilibriumQuantity
EquilibriumPrice
PRICE ADJUSTMENT
Equilibrium price clears market
Supply curve
Price Controls
Price
Quantity
Demand curve
Supply curve
Equilibrium price
excesssupply
Suppose government sets minimum price above market clearing price
Controlled price
Examples include• Minimum wages• Rent control• Common Agricultural Policy
What does price controls do?
Price controls interfere with the adjustment process• minimum wages are good for equity: they boost the
income of some low-skill workers• But such interventions may not be good for efficiency: if
employers are unwilling to hire as many at regulated minimum wage, some potential workers are deprived of the chance to work
Economic Efficiency
An intervention is said to improve efficiency if it makes someone better off and nobody worse off
Economic efficiency: an outcome where no one can be made better off without hurting someone else
The key question: do free, unregulated markets always lead to efficient outcomes?
Markets and Choice
In markets
• consumers buy up to the point the marginal benefit equals price
• competitive firms sell as long as price covers ‘marginal cost’ of production (this is the opportunity cost of producing another unit of the good)
The Efficiency of Markets
Thus, in competitive markets
• prices align marginal benefit with marginal cost • all possible gainful exchanges are carried out• PUNCH LINE: Free, unregulated markets lead to
efficient outcomesThis is the so-called Invisible Hand Theorem
But free markets are not always efficient..
Market failure: a circumstance in which free markets fails to achieve an efficient outcome
Many interventions are designed to correct market failures, and thus to increase efficiency
In sum: why intervene?
‘Economic regulation’ • Aims to correct market failures, and make the
market outcome more efficient
(when the ‘invisible hand’ does not work, the government can provide a helping hand)
‘Social regulation’• To prevent undesirable social outcomes inherent
in market outcomes
Group Work: Efficiency and Equity
Government intervention in the economy is pervasive. For each intervention listed below identify the possible rationale. Is it primarily
a. efficiency considerations?b. equity consideration?c. something else?
1. Income tax2. Taxation of petrol3. Regulating gas prices
…Group Work
4. Regulating discharge of sewage in the Thames 5. Legislation against insider trading 6. Banning the use of cocaine 7. Making primary school compulsory 8. Regulating financial advisors9. Regulating length of the working week10. Compelling citizens to carry identity cards11. Minimum wage legislation12. Regulating taxi fares
Sources of Market Failure
• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Coordination problems
We will look at each of these in turn
MARKET FAILURE: Externalities
EXTERNALITY
• A circumstance in which an individual's choices affects others' utility or productivity
• the effect is direct (not through market or prices)
Examples
• Adverse externalities: smoking, pollution
Since costs are partly borne by others, self-interested decision-making might lead to excess
• Beneficial externalities: bees and orchards, personal hygiene
Since benefits partly accrue to others, self-interested choices lead to sub-optimal quantities
Adverse Production Externality
For social optimum, we wantmarginal social cost = marginal social benefitAt free market equilibrium E, output Q is higher than social
optimum Q*
Quantity
Demand
MPC
MSC
E
FG
QQ*
Why Externalities Matter
THE ESSENTIAL PROBLEM• Market mechanism aligns private costs and benefits • Externalities imply divergence between social and
private costs (or social and private benefit)• If divergences exist, should not expect socially efficient
allocations
Correcting externalities
1. Quantitative regulation or direct government action: e.g. pollution quota
2. [Pigou] Taxes or subsidies to correct prices e.g. pollution tax
3. [Coase] Create markets: assign property rights and enable trade in pseudo-marketse.g. carbon trading
Coasean Solution
• Assign property rights and let people trade these rights in specially-created market
• Initial assignment of rights affects distribution but get an efficient outcome regardless
• This solution does not work if there are high transactions costs Quantity
MC (for you)
QQ*
MB (to me)
Efficient quantity is Q*
MARKET FAILURE: Public Goods
Examples: defence, broadcast TV signal
Characteristics• Non-rival consumption: my consumption does not
diminish what is available for you• Non-excludability: impossible or too costly to prevent
people from consuming it
Public goods: the problem and solutions
• If you cannot exclude, people will ‘free ride’. But if no one pays, there is nothing to free-ride on (this is the paradox of free riding)
• In fact, exclusion is not efficient either In general, markets cannot provide public goods
SOLUTIONS
• public provision• compulsion Government needs to ensure right quantity, but need
not produce itself
MARKET FAILURE: Imperfect competition
The essential problem of monopoly• Firms with market power can charge prices that exceed
marginal cost • which restrains consumption below efficient level• other problems: resources wasted in securing monopoly
power (‘rent-seeking’), and in maintaining it
Solutions to monopoly problem
Solution 1. Nationalize and finance losses through taxes politically not very feasible
Solution 2. Break monopoly e.g. anti-trust legislation in US
However, no good for ‘natural monopolies’Industries with severe economies of scale, so having one producer avoids duplication of costs
And in some sectors monopoly is good for R&D, or for internal coordination
More solutions to the monopoly problem
Solution 3. Regulate Prevent abuse of monopoly power through price and non-price controlsPractical issues: when is regulation necessary? What form? How frequently?
Solution 4. Nurture competition Encourage new entrants, (but will they enter and will it only lead to cream skimming?)
Important to get the right mix of remedies
MARKET FAILURE: Imperfect information
Information in markets is imperfect. Often there is asymmetry of information between buyer and seller leading to problems of
• ‘adverse selection’: people who know themselves to be risk-prone are more likely to buy insurance
• ‘moral hazard’: once you have insurance, incentive to be careful is weakened
• these distortions may result in ‘incomplete markets’ or even ‘missing markets’: e.g. low-risk people may not find appropriate insurance
SOLUTIONS: Imperfect information
1. mitigate informational problems• mandating provision of information
(regulate financial advisors)• providing information directly
(publish league tables)
2. reduce the possibility of opportunistic behaviour • consumer protection
3. government provision of the good or service
Inefficiency due to strategic interaction
No nukes Nukes
No nukes 8, 8 1, 12
Nukes 12, 1 2, 2
SOLUTION: coordinate individual choices through agreements or regulation
Country 1
Country 2
Individual choices do not always result in the best collective outcomes
Regulating technological standards
Problem: uncertainty about new technological standards may slow down adoption
• VHS vs Betamax• Blu-Ray vs HD-DVD
Should regulation aim to guide technological choices?
• GSM in mobile telephony
Lessons for Policy Makers
• Market failures makes a potential case for corrective intervention
• However, we must beware of the possibility of government failure. If so, the net effect may be to replace market failure with government failure
Well-intentioned regulation may• end up being ineffective• have perverse, unintended consequences• persist beyond its purpose• be vulnerable to regulatory creep, with high cumulative
burden
The scope for successful regulatory intervention is limited by • informational constraints• agency problems• lack of correction
Group Work: Pollution control
As the National Rivers Regulator, you must tackle the problem of a chemical firm that is polluting the Thames
a. If everything could be quantified and valued, show in a diagram how a pollution tax can induce the firm to behave in a socially efficient manner.
Group Work: Pollution control
b. Instead of the tax you offer the firm a pollution quota (specifying the maximum pollution it can discharge in any year). Show the size of the quota in the diagram. What difference does it make to the efficient quantity of pollution?
Group Work: Pollution control
c. Now suppose information is harder to come by. As the regulator, you are not entirely certain about the firm's cost curve. Does this affect your choice between tax and quotas?
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