GtdMktGovernments and Marketsfaculty.arts.ubc.ca/ftrebbi/590_lectures/trebbi_lecture...that allows entry of other firms). This seems to be the case even for energy markets. 2. Monopoly

G t d M k tGovernments and Markets

Topic 3Topic 3

Goals of the Lecture

1) Regulation and Markets

2) Procurement

3) Antitrust

4) Theoretical analysis (cost reimbursement, yardstick competition, regulated prices, etc.)

Suggested readings: Ch.9, 10, 11 Baron (2007).

Political Economy - Trebbi2

Regulation


Regulation

Regulation is government intervention in economic activity using commands, controls, and incentives.

Regulation is not only an economic instrument (say, aiming at solving market failures), but is also a political instrument (social regulation, say, rent controls, or health and

i t l t ti )environmental protection).

Regulation is implemented by independent commissions and agencies of the executive branch In contrast to antitrust regulation is usually not implemented through judicialbranch. In contrast to antitrust, regulation is usually not implemented through judicial institutions.

Participating in regulatory rule making is considered as important as lobbying Congress byParticipating in regulatory rule making is considered as important as lobbying Congress by 2/3 of special interests groups (Kerwin, 1994).

Can you give me some examples?


y g p

Typical Regulatory Interventions

1. Price controls (e.g. crops, minimum wages, local telephone service, electricity)2. Controlling number of market participants (e.g. broadcast or taxi licenses, )3. Ensuring equal opportunity (e.g. banning discrimination in employment)4. Providing for solvency (e.g. pensions plans, financial institutions, insurance)5. Specifying qualifications (e.g. occupational licensure)6. Requiring pre-marketing approval, testing, labeling, product safety (e.g.

pharmaceuticals, toxic chemicals, cars)7. Allocating scarce public resources (e.g. spectrum allocation, fisheries)8. Controlling toxic emissions and other pollutants (e.g. CO2, sulfur dioxide, emissions

trading)9. Controlling unfair international trade practices (e.g. antidumping)10. Specifying industry boundaries (insurance, investment and commercial banking, stock

brokerage)11. Mandating information disclosure (publicly trade firms accounting and statements)12 Li iti hi ( di i li )


12. Limiting ownership (media, airlines)

Foundations

In the early 1100s the English monarchy started contracting with private parties for the provision of public goods and services. In common law the contractual agreements between the Crown and a firm provided the legal foundations for regulation.

Early examples: the King allocated rights-of-way to stage lines in exchange of the authority to regulate prices and services.


Foundations (cont.)

Abuses were common.

Shleifer and Vishny (QJE 1993) report that:

In 1400 there were 60 independently run tolls along the Rhine.

There were so many tolls along the Seine that 20 miles of transportation had a cost equal to the price of the good.

England was free of such tollbooths.

So large differences in early examples of government interventions in markets.


Legal Foundations

In US common law regulatory jurisdiction is very broad:

“[when] affected with a public interest, [private property] ceases to be juris privati only…When, therefore, one devotes his property to a use in which the public has an interest, he, in effect, grants to the public an interest in that use, and must submit to be controlled by the public for the common good…” Munn v. Illinois (1877)

H “Wh t i titl d t k i f i t th l f th t hi h itHowever, “What a company is entitled to ask is a fair return upon the value of that which it employs for the public convenience.” Smith v. Ames (1898)

This is the basis for cost-of-service regulation in the 1960s and 1970s for instance.


Regulatory agencies

Two forms:

1) Executive branch agencies;

2) Independent commissions.

Executive branch agencies are direct emissions of the executive, they are directly linked to cabinet departments, and tend to be more partisan.

Independent commissions’ members are usually appointed by the executive but have to be confirmed by the Senate. Tend to be non-partisan (in fact, terms in office are longer than a standard legislature between 7 and 14 years).


Some Examples

Independent Commissions (Year Est) Agencies (Year, Department)

Federal Reserve System (1913) Food and Drug Administration (1931, HHS)HHS)

Federal Trade Commission (1914) Federal Aviation Administration (1948, DOT)

International Trade Commission (1916) National Highway Traffic Safety Administration (1970, DOT)

Federal Energy Regulatory Commission (1916)

Occupational Safety and Health Administration (1973, DOL)

Securities and Exchange Commission Environmental Protection Agency g(1934)

g y(1970 – no cabinet dept.)

Federal Communications Commission (1934)

National labor Relations Board (1935)National labor Relations Board (1935)

Federal Maritime Commission (1961)

Equal Employment Opportunity Commission (1965)


Nuclear Regulatory Commission (1975)

Regulatory rule-making

All agencies’ main task is regulatory rule-making, a process under the Administrative Procedure Act (1946). Formal or informal.

Informal rule making requires publishing on the Federal Register a Notice of Proposed Rule Making (NPRM) and a request for the submission of comments. Once all comments are collected the rule is revised and published as final on the Register effective at least 30collected, the rule is revised and published as final on the Register effective at least 30 days in the future.

Formal rule making is a quasi-judicial process that requires hearings conducted by an g q j p q g yadministrative law judge, presentation of evidence, witness testimony and cross-examination. The record offers the basis for the regulatory rule and it follows procedural due process.

Parties can sue for judicial review under the APA. Both rule making processes are subject to review by the courts, that assess whether an action exceeds the scope of the mandate of the regulatory agency (substantive due process) or does not follow protocol (procedural


the regulatory agency (substantive due process) or does not follow protocol (procedural due process).

Regulatory Agency Influences (Checks and Balances)

Special Interests influence the Regulators directly through their testimonies, petitions, and lobbying. Indirectly through lawsuits.

Congress influences the Regulators directly through the definition of mandate and oversightand indirectly through appropriating the Agency Budget.

The President influences the Regulators directly through appointing their heads and steering their policy goals.

Th C t i fl th R l t th h j di i l i f d ( d l dThe Courts influence the Regulators through judicial reviews of due process (procedural and substantive) and Constitutionality.


Industry LobbyingLobbying on Nov. 3, 2010 at the Commodity Futures Exchange Commission – New regulator for over‐the‐counter derivatives

Time Organization(s) Rulemaking TopicInternational Banking Institutions II. Definitions, such as Swap Dealer, Major Swap Participant, Security‐Based Swap Dealer,

and Major Security‐Based Swap Participant, to be Written Jointly with SEC7:15 PM EDTSkadden Arps Slate Meagher & Flom II. Definitions, such as Swap Dealer, Major Swap Participant, Security‐Based Swap Dealer,

and Major Security‐Based Swap Participant, to be Written Jointly with SEC6:50 PM EDT j y p p yBGC Partners XIII. SEF Registration Requirements and Core Principle Rulemaking, Interpretation &

Guidance5:00 PM EDT ICAP plcGFI Group Inc.Tradition (North America) IncTullet Prebon LtdPatton Boggs LLPNidera II. Definitions, such as Swap Dealer, Major Swap Participant, Security‐Based Swap Dealer,

and Major Security‐Based Swap Participant, to be Written Jointly with SEC

2:30 PM EDT National Grain and Feed Assn XIX. Agricultural SwapsAdvance Trading XXVI. Position Limits, including Large Trader Reporting, Bona Fide Hedging Definition &

Aggregate LimitsAdvanced Market ConceptsUniversity of IllinoisKansas Farm BureauKansas State UniversityShay GrainKansas City Board of Trade Wheat Cash CommitteeHaviland CoopK G i d F d A i tiKansas Grain and Feed Association

Illinois Farm BureauChicago Bar Association II. Definitions, such as Swap Dealer, Major Swap Participant, Security‐Based Swap Dealer,

and Major Security‐Based Swap Participant, to be Written Jointly with SEC

12:00 PM EDT V. Capital & Margin for Non‐banksPatton Boggs LLP XIII. SEF Registration Requirements and Core Principle Rulemaking, Interpretation & Guid.


Patton oggs P XIII. S F Registration Requirements and Core Principle Rulemaking, Interpretation & Guid.10:00 AM EDT ICAP XVIII. Real Time Reporting10:00 AM EDT Independent Community Bankers Association XI. End‐user Exception

Why do we need regulation?

Answer 1: To correct market imperfection (e.g. negative externalities, asymmetric information, etc.).

Answer 2: We do not. In fact, rent seeking drives regulatory agencies who skim/gain from restricting entry or redistributing gains from trade.


Typical Market Imperfections

Let’s consider typical situations were government intervention may be useful to solve market imperfections.

1. Natural monopoly – A local energy market where the efficient power plant size is so large that one firm can produce a given amount at lower cost than can any larger

b f finumber of firms.

2. Asymmetric information. Adverse selection – Private health insurance market

3. Asymmetric Moral Hazard – Car insurance market. Banking.

4 E t liti CO2 i i4. Externalities – CO2 emissions

5. Public goods – Broadcast licenses


Natural Monopoly

A natural monopoly arises in presence of economies of scale (marginal/average costs are decreasing in the scale of output). Inefficiently low output (at MC=MR there are

illi b h d i b i l ) d i h lconsumers willing to buy the good at a price above marginal cost) – Deadweight loss.

p

p2

Demand

Marginal Cost

MarginalR

DWLp0

The government will usually try to lower the price toward p0.

Revenue

q


Natural Monopoly (cont.)

It will not be sufficient to lower the price by mandate, because the firm will not be able to recover all its costs at that price (average cost > p0). Hence the government will need to

id b id h d ll f f i f h fi ’provide a subsidy to cover the costs and allow for a fair rate of return on the firm’s assets.

p

p2

Average Costp1

Demand

Marginal Cost

MarginalR

p0

Average Costp1

Revenue

qq0



It will not be sufficient to lower the price by mandate, because the firm will not be able to recover all its costs at that price (average cost > p0). Hence the government will need to

id b id h d ll f f i f h fi ’provide a subsidy to cover the costs and allow for a fair rate of return on the firm’s assets.

p

p2

Average Costp1

Demand

Marginal Cost

MarginalR

p0

Average Costp1

Th t ill ith t t l th i t fi d h ( thl

Revenue

qq0


The government will either try to lower the price to p1 or use fixed charges (e.g. monthly fixed charges).


Example: Under a cost of service regulation consumers pay monthly charges to cover the fixed costs of electric power plants, including a fair rate of return on capital.

Example: Local telephone companies also are allowed to charge fixed amounts for the same reason.

Also notice:

1. Economies of scale ∫ Natural Monopoly (economies of scale may exhaust at a scale that allows entry of other firms). This seems to be the case even for energy markets.

2. Monopoly may be not so inefficient when there is an entry threat. If the market is contested by potential entrants the incumbent may leave the price as low as to makecontested by potential entrants the incumbent may leave the price as low as to make entry just about inefficient (this means it will increase output and the inefficiency will be low). Also monopolies use nonlinear prices, that decrease the DWL

3. Monopolies are of the natural type also when large fixed costs would be inefficiently


p yp g yduplicated (local telecommunication systems or power grids).

Adverse Selection & Regulation

Akerlof’s (1970) market for lemons problem.

Suppose I know the value of my used car is x and the distribution of used car values on the market is F(x), with mean xm. Also assume there is a buyer for every car. However, if the car type is difficult to assess for a buyer, a buyer will be willing to pay no more than xxm.

So if x > xm, I will not put my car on the market. This means that the pool of available cars will be even worse, and people will be willing to pay even less, because quality is , p p g p y , q ylower on average. The market will fully unravel.

Example: Consider now a health care system that is voluntary. Only patients with bad health will self-select in. Healthy patients will not be willing to pay higher premia than it is actuarially fair for them. So the good types will be crowded out. Rationale for Hillary Clinton’s 2008 presidential platform on health care reform. Universal and Compulsory => increases patients’ pool quality Barak Obama’s proposal was Universal and


=> increases patients pool quality. Barak Obama s proposal was Universal and Voluntary.

Moral Hazard & Regulation

If individuals do not bear the full consequence of their actions, because of an asymmetric information issue (say, I cannot observe if a bad outcome is the result of your lack of care or just bad luck – i.e. the action is unobservable or cannot be contracted upon), care or just bad luck i.e. the action is unobservable or cannot be contracted upon), then you will have a condition of moral hazard.

Typical problem in banking sector regulation. yp p g g

A bank can take on a very risky project in the hope it turns out well or a safe project, but with a lower expected payoff. If the bank knows it will be bearing the full cost of the risky project even in the bad state, the decision will be first best.

However, if there is the possibility of being bailed out by the government in the bad t i ( b th t t tl th diffoutcome scenario (say because the government cannot exactly assess the difference

between the two projects), and no punishment attached to it, then the bank will take that risky action too often.

Example: Savings and Loans crisis of 1988 Savings and Loans institutions privatizing


Example: Savings and Loans crisis of 1988. Savings and Loans institutions privatizing profits and passing losses to FDIC.

Externalities may require regulation

Of course almost every action of an economic agent affects other economic agents. If I open up a plant in a city and labor supply is not infinitely elastic, I will raise real wages.

However, demand and supply will be in equilibrium and my marginal cost (the real wage) will equalize the marginal benefit (the worker’s productivity).

The indication of an externality requiring regulation is that the private benefit and costs are different from the social benefits and costs.

Coase’s theorem tells us that if property rights are well defined and transaction costs are null, then there is no need for regulation (i.e. markets will achieve the socially optimal outcomes).

Since such assumptions are not true, governments intervene to make private costs and social costs coincide. This is why we tax polluting firms or we impose environmental


standards on cars (Pigouvian taxes).

Public Goods & Regulation

Public good = consumption by one individual does not reduce its availability for others.

Example: National defense, radio broadcast.

Either supplied by the government directly or by private firms, which are then regulated. The reason why regulation is necessary is that the optimal amount of public good provision is under-funded if left to private parties (Bergstrom, Blume,Varian, JPubE 1986 “On the private provision of public goods”).

Free-rider problem.


Political Economy Rationale

The Chicago school of Stigler (1971), Peltzman (1976) and Posner (1974). Two different views, both positive, not normative.

A. CaptureRegulation soon forgets the goal of economic efficiency. Regulation evolves over time to

serve the interests of the regulated firms who profit from entry barriers The regulatedserve the interests of the regulated firms, who profit from entry barriers. The regulated “capture” the regulator.

Example: Mortgage Brokers and Bankers Industry captured the FHA (Federal Housing Administration) and HUD (Dept. Housing and Urban Development) during the sub-) ( p g p ) gprime mortgage expansion of 2000-2006.

B. Rent seeking/Tollbooth Regulation arises in industries where rents accrue copiously. Regulation is supplied through

the political process and benefits politicians that use it to extract rents. Example: Railroads in the 19th century sought regulation to enforce their cartel agreements


that were plagued by defections and cheating. Politicians gladly obliged obtaining rents

Evidence: Regulation of Entry

Djankov, La Porta, Lopez-de-Silanes and Shleifer (QJE 2002) paper.

Regulation of entry of new firms in a cross-section of 85 countries.

The authors look at:i. Number of Proceduresii. Official Timeiii. Official Cost

Evidence favors the public choice view (Stigler, 1971, Peltzman, 1976) that entry regulation benefits politicians and bureaucrats.

a. Heavier regulation is positively correlated with higher corruption.b. Heavier regulation is not correlated with better public goods or more competition.c. More autocratic regimes have heavier regulation (even controlling for GDP per capita).


See the following four figures from the paper.

0

1

2

3

4

5

1 2 3

Tim

e (b

usin

ess

days

)

0

0.1

0.2

0.3

0.4

0.5

0.6

Cost

/GDP

per

cap

ita (%

)

Procedures

Time(left axis)

Cost(right axis)

1. Check name for uniqueness

2. Apply for registration

3. Register for taxes

Start up Procedures in New Zealand. Procedures are lined up sequentially on the horizontal axis and described in thetext box. The time required to complete each procedure is described by the height of the bar and measured against the leftscale. Cumulative costs (as a percentage of per capita GDP) are plotted using a line and measured against the right scale.

Figure I

0

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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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8.00

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/GDP

per

Cap

ita (%

)

Procedures

Time(left axis)

Cost(right axis)

1. Check name for uniqueness

2. Obtain Mayor’s authorization for home office

3. Obtain proof of no criminal record

4. Obtain a certificate of marriage

5. Obtain power of attorney and sign it

6. Open a bank account

7. Draw articles of incorporation

8. Publish a business location notice

9. Register copies of articles of association

10. File a request for a company’s registration

11. Designate a bondsman

12. Inform the post office of address

13. Unblock capital

14. Have all ledgers initialed

15. Send a recruiting declaration

Start up Procedures in France. Procedures are lined up sequentially on the horizontal axis and described in the text box.The time required to complete each procedure is described by the height of the bar and measured against the left scale.Cumulative costs (as a percentage of per capita GDP) are plotted using a line and measured against the right scale.

Figure II

Figure III

Corruption and number of procedures. The scatter plot shows the values of the corruption index against the (log) number ofprocedures for the 78 countries in our sample with non-missing data on corruption.

Cor

rupt

ion

Inde

x

Ln (Number of Procedures).5 1 1.5 2.5 3

0

1

2

3

4

5

6

7

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Arg

Arm

Aus

Aut

Bel

Bol

Bra

Bul

Can

Chl

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ColHrv

Cze

Dnk

Ecu

Egy

Fin

Fra

Geo

Ger

Gha

Gre

Hon

Hun

Ind

Idn

Ire

Isr

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Jam

Jpn

Jor

KazKen

Kor

Kgz

LvaLtu

Mwi

Mys

Mex

MngMar

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NldNzl

Nig

Nor

Pak

Per

Phi

Pol

Por

Rom

Rus

Sen

Sin

Svk

S v n

Zaf

Spa

Swe

Swi

Twn

Tza

Tha

Tun

Tur

UgaUkr

Gbr

USA

Ury

Ven Vnm

Zmb

Zwe

Figure IV

Autocracy and number of procedures. The scatter plot shows the values of the (log) number of procedures against the autocracyscore (higher values for more autocratic systems) for the 84 countries in our sample with non-missing data for the autocracy score.

Ln (

Num

ber

of P

roce

dure

s)

Autocracy Score1 2 3 4 5 6 7 8

.5

1

1.5

2

2.5

3

Arg

Arm

Aus

Aut

Bel

Bol

Bra

Bul

B f a

Can

Chl

Chn

Col

Hrv

Cze

Dnk

Dom

Ecu

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Fin

Fra

Geo

Ger Gha

Gre

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Jpn

Jor

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Kor

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LebLtu

Mdg

Mwi

Mys

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Mar

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Nld

Nzl

Nig

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Pak

Pan

Per

Phi

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Rom

Rus

Sen

Sin

Svk

S v nZaf

Spa

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Swe

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USA

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Ven

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(Bad) Examples: Cost-of-Service Regulation

This form of regulation was common in the airline and trucking industry in the 1970s.

Entry was controlled and industry-wide prices were set, with cost increases passed on to consumers in the form of higher prices.

Industry-wide wage increases were passed directly into prices, so weak incentives to resist labor demands. However, this left many firms substantially disadvantaged when markets got deregulated and inefficiently high labor costs started to induce competitive disadvantagesdisadvantages.

Cost of service regulation was also used in the telecom business. Since in this sector it is extremely difficult to evaluate the cost structure, regulators allowed firms to simplyextremely difficult to evaluate the cost structure, regulators allowed firms to simply extract a “fair rate of return” computed on the asset base of the firm. Obviously, telecom firms had an incentive to increase their asset base enormously, with excess capacity and over-investment in inefficient technologies.


(Bad) Examples: The 3G Telecom Auctions in Europe

The 2000-01 European telecom auctions for third generation (UMTS) licenses were the largest in history. See Klemperer (2002, EER)

Roughly the same per capita value across Western Europe, but differences in auction design and regulatory failure brought in revenues of 20 Euros per capita in Switzerland and 45 i B l i d G t 650 E it i th UK d 615 E i Gin Belgium and Greece to 650 Euros per capita in the UK and 615 Euros in Germany.

300-400 Euros per capita was the estimated revenue. Why these disparities?

Not all auctions were well designed and attracted sufficient entry (especially by non-2G incumbents) or prevented collusions.

Most were ascending auctions (subsequent bid higher than the previous bid) where the number of licenses was equal to the number of (large) incumbents. Entrants were put off. Incumbents ended up having a license each (so no need to compete and bid up).


p g ( p p)

The Mother of Bad Examples: Financial Markets and Regulation

Financial sector regulation is dual: g

1. Banking regulation deals with systemic risk: Cross-bank spillovers and interdependencies.

2. Financial securities and commodity regulators focuses on investor protection (so does micro-prudential credit market regulation, prudential regulation, capital requirements, leverage, etc.).

Hellman, Murdock and Stiglitz (2000)Morrison and White (2005)Dewatripont and Tirole (1994)


Deregulators: OTS, OCC, FDIC, NCUA…

“In the summer of 2003, leaders of the four federal agencies that oversee the banking industry gathered to highlight the Bush administration's commitment to reducing regulation. They posed for photographers behind a stack of papers wrapped in red tape. The others held garden shears Gilleran who succeeded Seidman as OTS director in late 2001 hefted a


garden shears. Gilleran, who succeeded Seidman as OTS director in late 2001, hefted a chain saw.” Source: Washington Post.

Deregulation in US Financial Markets

US Financial Deregulation0

1n

Inde

x-1

al D

ereg

ulat

ion

3-2

Fina

nci a

-3

1900 1920 1940 1960 1980 2000 2020year

Note: Replication of Philippon and Reshef (2008) Black and Strahan (2001) Intrastate branching via M&A


Re-Regulations

Financial regulation and delegation often reactive.

Regulatory patch after the crisis:

• Glass-Steagall Act of 1932 after the onset of Great Depression and 19291929.

• Financial Institutions Reform, Recovery and Enforcement Act of 1989 after S&L crisis of 1988.

• Serbanes-Oxley Act of 2002 after the Enron scandal.

Incremental process. Now:

• Dodd-Frank Law of 2010.


Open Questions

1. Study congressional voting patterns on regulatory and deregulatory bills.

W ld lik k h i fl d i d h ( i ib i l bb iWe would like to know who influenced it and how (campaign contributions, lobbying over time).

2. “Divide et Impera” strategy of regulatory fragmentation.

Do we really need an additional regulatory body on top of:

Federal Deposit Insurance Corporation (FDIC)Federal Reserve System (FED)Office of the Comptroller of the Currency (OCC)Office of Thrift Supervision (OTS)State Banking RegulatorsS e g egu o sNational Credit Union Administration (NCUA) U.S. Securities and Exchange Commission (SEC)Commodity Futures Trading Commission (CFTC)


and most importantly: What are the consequences of this alphabet soup?

WaMu 5 year CDS Spread

Inconsistent Regulators: Evidence from Banking

1400

1600“Jamie deal”

If not, would have wiped $45 billion Deposit Insurance

Fund.[“J i ” CEO f JP

1000

1200

bp

)

[“Jamie”: CEO of JP Morgan]

600

800

Spre

ad (b

Reid: “Cannot believe audacity

OTS gives a CAMELS rating of

2

Draws fees of $30 mill/year (15%)

200

400believe audacity of this woman

[Bair]”

mill/year (15%)

0

FDIC asks OTS to downgrade CAMELS to 3.

OTS downgrades CAMELS to 3

FDIC asks OTS to downgrade to

4. OTS disagrees

Reid (OTS): “You [Bair, FDIC] are

not a super-regulator”

FDIC downgrades to 4. OTS follows.

Motivation

WaMu is a (costly) anecdote.

Is this behavior systematic?

Within the context of US banking, we ask: Do different regulators implement same rules differently? What are the consequences of inconsistent oversight? What are the consequences of inconsistent oversight?

34

Empirical Complications

Establishing systematic differences in regulatory and supervisory behavior i h dis hard

Heterogeneity of regulator actions and responsibilities FRB: Macro-prudential regulation, Risk Assessments, LOLR,… State Regulators: Micro-prudential regulation, Supervision,…

Heterogeneity of financial firms regulated Financial firms complex and differ substantially S l i f b k i l i Selection of banks into regulatory environments

35

Dual Banking System

36


Selection of banks into regulatory environments not just a theoretical ibilipossibility

Negatively: Competition for laxity (Chairman Burns, 1974)

“Ability of financial companies to shop for the regulator of their choice weakened their oversight prior to the crisis”

President Obama 2009President Obama, 2009

“When Countrywide Financial felt pressured by federal agenciesWhen Countrywide Financial felt pressured by federal agencies charged with overseeing it, executives at the giant mortgage lender

simply switched regulator to OTS in the spring of 2007” Washington Post, 2008

37


Selection of banks into regulatory environments not just a theoretical ibilipossibility

… or positively: “Checks and balances of a system of more than one regulatory authority” (Chairman Greenspan, 1993 )

“Charter switching enhances adaptability of the banking system and allows for more innovation”

American Bankers AssociationAmerican Bankers Association, 2009

“State regulators are cheaper….State regulators also advertise their ibilit d th b tt d t d l l diti daccessibility and say they better understand local conditions and

concerns. ”

Washington Post, 2009

38

What We Do

Heterogeneity of regulator actions: Focus on prudential supervision On-site exams: one of two pillars US banking supervision Culminate in a “CAMELS” rating From 1 [safe] to 5 [failing][ ] [ g]

Important rating for several reasons Comparable across regulators Comparable across regulators

39

What We Do

Heterogeneity of banks: Exploit legally-determined policy Assigns federal and state supervisors to same bank at exogenously

pre-determined time interval

40

What We Do

Legally-determined rotation policy circumvents bank self-selection Riegle Act of 1994: federal agencies required to use state reports as

substitute in alternate 12-month (18-month for small banks) cycles Between State Regulator and FRB for SMBs Between State Regulator and FDIC for NMBs

~80% US commercial Banks covered (30% by assets)

Can track Different regulators behavior when dealing with same bank Bank behavioral response to differential regulator behaviorp g

41

Main Findings

Inconsistent regulatory behavior when dealing with same bank Federal agencies twice as likely to issue a downgrade in ratings

Banks respond to differential regulatory behaviorp g y Induces variability in operations Federal regulators induce readjustments of capital ratios, NPLs, and

delinquencies implying lower ROAdelinquencies, implying lower ROA

Why do these differences exist? S ti id C t b l t d tit t d i t d Suggestive evidence: Capture by regulated constituents and resources invested

in supervision

42

CAMELS Downgrades

SMBs, FRB-STATE rotating

Drop in CAMELS Increase in CAMELS Freq. Percent Freq. Percent

FRB 284 42.84 741 76.08STATE 379 57.16 233 23.92Total 663 100 974 100

Mean SD Mean SD

∆CAMELS -1.017 0.139 1.093 0.318

NMBs, FDIC-STATE rotating

Drop in CAMELS Increase in CAMELS Freq. Percent Freq. PercentFreq. Percent Freq. Percent

FDIC 2,737 57.63 3,393 65.05STATE 2,012 42.37 1,823 34.95Total 4,749 100 5,216 100

43

Mean SD Mean SD

∆CAMELS -1.109 0.364 1.125 0.377

CAMELS Upgrades

SMBs, FRB-STATE rotating

Drop in CAMELS Increase in CAMELS Freq. Percent Freq. Percent

FRB 284 42.84 741 76.08STATE 379 57.16 233 23.92Total 663 100 974 100

Mean SD Mean SD

∆CAMELS -1.017 0.139 1.093 0.318

NMBs, FDIC-STATE rotating

Drop in CAMELS Increase in CAMELS Freq. Percent Freq. PercentFreq. Percent Freq. Percent

FDIC 2,737 57.63 3,393 65.05STATE 2,012 42.37 1,823 34.95Total 4,749 100 5,216 100

44

Mean SD Mean SD

∆CAMELS -1.109 0.364 1.125 0.377

(Bad) Examples: Deregulation in the (California) Energy market

The energy industry is massive (3% of GDP = telecom+airlines combined).

L diff i i f kil tt h t t (9 3 t i C lif i 4Large differences in average prices of kilowatt hour across states (9.3 cents in California v. 4 cents in Idaho in 1999). This is due to local supply differences, differentials in environmental regulation, and difficulty of energy transmission (electricity cannot be stored and depletes with distance). The industry was initially regulated on a cost-of-p ) y y gservice basis.

However, with the help of new technologies, a wholesale market for electricity slowly developed over time. California-based Enron was one of the first companies to operate on the energy spot market (one traded unit is a 15 minutes energy block).

Th i t f thi k t l d t d l ti I l di i C lif iThe existence of this market lead to deregulation. Including in California.

This left many energy plants in California at a huge cost disadvantage, because they were not as economical to operate (for instance because of tougher environmental


not as economical to operate (for instance, because of tougher environmental regulation).


The stranded investment in these plants got warranted by the government . Government agencies issued bonds to pay off part of the stranded investment of local power suppliers. suppliers.

Price went down in California at the end of the 1990s. Also the government imposed a price freeze until 2002.

This led to an increase in demand. However, no additional power plants were built to meet demand (nonmarket pressures played a role) and when a drought in the Northwest reduced the supply of hydroelectric power and increase wholesale prices substantially, Californian utilities could not pass the increase onto consumers (reducing demand).

N t ll tiliti ld ff d t t th l t i it bill d h t d Th h d tNot all utilities could afford to meet the electricity bills and shut down. The governor had to bail some of them out in 2001 and signed a secret $43 billion long-term electric power contracts. The following year prices went down but the government got stuck with the bill.


This almost bankrupted the Californian government and the governor was recalled in 2003.


A failed deregulation:1. Bad assessment of supply volatility (i.e. Northwestern drought).

2. Environmental restrictions stifled deployment of new capacity (constraining supply).

3. Price caps and refusal by the California Public Utility Commission to raise retail prices did not allow demand to adjust and the market to clear.

4. Passing all the risk on public utilities was short-sighted, since they had to be bailed out as soon as they became insolvent.

5. Did not allow utilities to sign long-term contracts with wholesale suppliers (only buy on the spot market). No hedging.

Th l i k t i C lif i h d i


The rules governing energy markets in California changed since.

Antitrust


Antitrust Legislation: The origins

Farmers and commodity producers (i.e. oil producers) concerned with monopoly of railroad cartels (the “Robber Barons”). See Josephson (1934).

The Interstate Commerce Act of 1887: First Act of Federal Regulation of Interstate Commerce.

The Sherman Act of 1890: First Antitrust Statute. Focuses of unreasonable restraints on trade and the creation of monopolies. Section 1 covers joint anticompetitive behavior of firms Section2 individual firm behaviorfirms. Section2 individual firm behavior.

The logic of early legislation was that the economic power also requires checks and balances (just like political power).


(just like political power).

Sherman Act of 1890

Section 1. Every contract, combination in the form of trust or otherwise, or conspiracy, in restraints of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal… Every person who shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felonyfelony…

Section 2. Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons , to monopolize any part of the trade orconspire with any other person or persons , to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony…


Antitrust Legislation: The beginning (cont.)

The Clayton Act of 1914. Monopolization and potentially anticompetitive actions are further specified. Provides for private lawsuits.

The Federal Trade Commission Act of 1914: Prohibits deceiving or unfair methods of competition. Institutes the Federal Trade Commission (FTC) as a main antitrust enforcement and supervisory body.

Note: These Acts are broadly worded and not very specific (“unfair practices”, “restraints on trade”, etc.).

Armies of jurists and economists have helped out designing specific theories to interpret/integrate such wording. Interpretive activity on the parts of the Judiciary has been central in early evolution of precedent. New IO theories have gained weight over


y p g gtime.

Clayton Act of 1914

Section 2. (a) That it shall be unlawful for any person engaged in commerce…to discriminate in the price between different purchasers…where the effect of such d b b ll l d ldiscrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy, or prevent competition…nothing herein contained shall prevent differentials, which make only due allowance for differences in the cost of manufacture, sale or delivery… f f , y

Section 3. That it shall be illegal for any person [to enter an arrangement] …on the condition… that the lessee or the purchaser thereof shall not use or deal in the goods…of a competitor or competitors, where the effect…may be to substantially lessen the competition or tend to create a monopoly in any line of commerce.

Section 7. That no corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the stock or other share capital…where in any line of commerce in any section of the country the effect of such acquisition may be substantially to lessenany section of the country, the effect of such acquisition may be substantially to lessen competition or tend to create a monopoly.

(as amended by the Celler-Kefeauver Act of 1950)


(as amended by the Celler Kefeauver Act of 1950)

Federal Trade Commission Act of 1914

Section 5. (a)(1) Unfair methods of competition in commerce, and unfair or deceptive acts or practices in commerce, are hereby declared unlawful.

(as amended by the Wheeler-Lea Act of 1938)


Antitrust Legislation: The beginning (cont.)

The Clayton Act of 1914. Monopolization and potentially anticompetitive actions are further specified. Provides for private lawsuits.

The Federal Trade Commission Act of 1914: Prohibits deceiving or unfair methods of competition. Institutes the Federal Trade Commission (FTC) as a main antitrust enforcement and supervisory body.

Note: These Acts are broadly worded and not very specific (“unfair practices”, “restraints on trade”, etc.).

Armies of jurists and economists have helped out designing specific theories to interpret/integrate such wording. Interpretive activity on the parts of the Judiciary has been central in early evolution of precedent. New IO theories have gained weight over


y p g gtime.

Antitrust Legislation Around the World

Political Economy - Trebbi55Source: Josh Wright, GMU

Government Enforcement: FTC & DOJ

The Federal Trade Commission (FTC). Enforces the Sherman Act, the Clayton Act and the FTC Act. 5 members appointed by President for 7-years terms.

The Antitrust Division of the Department of Justice (DOJ). Enforces the Sherman Act and the Clayton Act.

Goal: they issue guidelines (e.g. on mergers, on vertical restraints of trade, etc.) and also i iti t liti ti ( ll b i d t f t ) O l DOJ b i i i linitiate litigation (usually by industry of competence). Only DOJ brings criminal charges (requiring higher standards of proof).


Government Enforcement: Criminal and Civil Charges

Criminal charges imply available penalties such as fines and imprisonment.

Civil charges imply contract dissolution, injunctive relief, business units ordered divested.

Example: in 1996 the FTC seeks injunction in federal courts to block the proposed merger between Office Depot and Staples.

Out-of-court settlements between litigants are very common and usually are implemented through Consent Decrees (to remedy antitrust violations and supervised by the court, but do not change precedent because extra-judicial).

C t d b lift d E l i 1956 IBM li t d l dConsent decrees can be lifted. Example: in 1956 IBM was a monopolist and some sales and services practices for its mainframes were restricted by consent decree. In 1997 a federal court lifted the consent decree as IBM market share “has substantially diminished”.


Typical Horizontal Antitrust Practices

Increasing market power within the same industry fl higher prices & lower competition.

1. Monopolization;

2. Horizontal Mergers;

3. Predatory pricing;

4. Price fixing;

5. Bid rigging;gg g

6. Allocation of customers;


Examples of Horizontal Antitrust Practices: Early cases

The 1911 case of Standard Oil Co. v. United States broke up the oil industry monopoly. It generated Mobil, Exxon, etc.

The 1911 case of United States v. American Tobacco Co. broke up the tobacco industrymonopoly.

The 1945 case of United States v. Aluminum Co. of America

In this last case the two-step procedure for trial of monopoly was developed by Judge Learned Hand:

Fi t t h th l i t First, necessary to prove whether monopoly exists; Second, necessary to prove that anticompetitive or willful practices used to obtain or

maintain monopoly (and not that monopoly exists by superior performance or market characteristics, say Ebay or Ipod).


characteristics, say Ebay or Ipod).

Examples of Horizontal Antitrust Practices: AT&T

Founded 1877.

In 1934 a regulated monopoly under the supervision of the Federal Communication Commission. Consent decree in 1956. A de facto monopolist until the mid-1970s

A lawsuit alleging illegal practices by the Bell System finalized at stifling competition in the telecommunication industry was initially filed by the Department Of Justice in 1974 and settled on January 1982.

In 1984 The Bell System was divested.

Th B ll S t lit i 1984 i t 7 i l i l id l AT&TThe Bell System split in 1984 into 7 regional companies plus a residual AT&T company.Verizon is a holding company stemming from Bell Atlantic; AT&T is a holding company

from the long-distance division; QWEST traces back to the Pacific Northwest Bell and Northwestern Bell.


Northwestern Bell.

Examples of Horizontal Antitrust Practices: Microsoft

The Microsoft Antitrust case where the DOJ alleged that Microsoft used anti competitive practices to maintain monopoly of PC Operating System.

Marketing agreements between PC manufacturers and Microsoft restricting the use, licensing, or distribution of non-Microsoft products.

Also DOJ alleged that Microsoft attempted to monopolize the Internet browser market by tying Internet Explorer for free to its Windows OS to put Netscape out of business. Microsoft had initiated a “browser war” and issued “polluted” versions of Java that would only work on Explorer.

Consent Decree (extra judicial agreement validated by the Courts) already in 1995. Lawsuit b DOJ i 1998 B d k t h Mi ft l d i l t d CDby DOJ in 1998. Based on market share Microsoft was a monopoly and violated CD.

In 2000 Judge Jackson concluded Microsoft had violated the Sherman Act. Certain practices when used by a monopolists (like forcing Compaq not to distribute


practices, when used by a monopolists, (like forcing Compaq not to distribute Netscape) were unreasonable restrictions of competition. Appealed.

Fines and Damages Paid by Microsoft ($6.83 billion up to 2006)

Owner of Netscape Æ

Political Economy - Trebbi62Source: Todd Bishop, Seattle Post Intelligencer

Example of Criteria Triggering Enforcement Agencies

Example of how the FTC or DOJ would operate in case of a merger.

Define a measure of market concentration such as the Herfindahl Index

HI ∑i1n si

2

Where n is the number of firms and si is the market share of firm i.

A di t l t ti d t f G il K i d B k (2004)

∑i1 i

According to regulatory action data from Gavil, Kovacic, and Baker (2004):

1996-2003 Mergers Increase in HI < 300 Increase in HI > 300Post-merger HI <2400 Action taken: 0 Action taken: 3g

No Action: 6 No Action: 16Post-merger HI >2400 Action taken: 2 Action taken: 183

N A ti 7 N A ti 45


No Action: 7 No Action: 45

Examples of Horizontal Antitrust Practices: American Airlines

A DOJ’s1999 complaint against American Airlines alleged that American had violated Section 2 of the Sherman Act by engaging in successful predation that involved adding money losing capacity to drive lower cost carriers out of four of American's Dallas Fortmoney-losing capacity to drive lower-cost carriers out of four of American s Dallas-Fort Worth Airport routes.

Where low-cost entrants threatened significant expansion of low-cost service, American flooded the routes with additional capacity – more flights, bigger planes, or both. p y g , gg p ,

Former CEO Bob Crandall had stated, “If you're not going to get them out then [there is] no point to diminish profit.”

DOJ alleged [ ] it made no business sense except for the fact that American stood to gainDOJ alleged […] it made no business sense except for the fact that American stood to gain much more in the long run by eliminating competition and then elevating prices once competition was driven away.

American's conduct made sense only as what Judge Bork has called “an investment in future y gmonopoly profits”.

Source: http://www justice gov/atr/public/speeches/201167 htm


Source: http://www.justice.gov/atr/public/speeches/201167.htm

Typical Vertical Antitrust Practices

Supply arrangements or distribution channels across sectors:1. Refusal to deal; Group boycotts;

2. Vertical Mergers;

3. Exclusive territory; Allocation of territories;

4. Exclusive dealing arrangements;

5. Bundling (Tying);g ( y g)

6. Retail price maintenance;


7. Reciprocal arrangements.

Examples of Vertical Antitrust Practices: Visa&MasterCard

Wal-Mart filed an antitrust lawsuit against Visa and MasterCard in 1996.

Visa and MasterCard had imposed a “honor-all-calls” policy on merchants requiring them to accept debit cards if they accepted credit cards.

Increased the number of transactions over which Visa and MasterCard collected charges.

Wal-Mart alleged illegal tying under Section 1 of Sherman Act. Moreover, attempt to monopolize the debit card market by Visa and MasterCard was a Section2 violation.

Settlement in 2003, Visa paid $2 billion, MasterCard $1 billion to merchants. Revised policy and reduced charges for debit cards.


Examples of Vertical Antitrust Practices: Mercedes-Benz Parts

DOJ antitrust lawsuit against Mercedes-Benz for requiring its dealers to carry only original Mercedes-Benz auto parts.

Tying.

DOJ later dropped the case because a tying arrangement can only be anticompetitive if based on horizontal market power – if it had restricted competition in the auto parts market (the tied product market), which it did not (the fact that you can only buy Mercedes-Benz parts at a Mercedes-Benz dealer does not mean you cannot buy otherMercedes-Benz parts at a Mercedes-Benz dealer does not mean you cannot buy other parts somewhere else.)

Notice that tying may also aim at maintaining monopoly in the tying market (i.e. autoNotice that tying may also aim at maintaining monopoly in the tying market (i.e. auto market). Again obviously not the case here.

Intra-brand (dealers selling the same product from the same firm) vs. Inter-brand (dealers


( g p ) (selling products from different firms) competition.

Examples of Vertical Antitrust Practices: Visa&MasterCard (2)

In 1998 DOJ filed an antitrust case against Visa and MasterCard for exclusionary restrictions. The two companies contractually prevented banks from issuing other credit cards, such as American Express or Morgan Stanley’s Discovery Card.

The district court found against Visa and MasterCard, imposing them to allow commercial banks to issue other cards.

Th l d b t th l t d i i h ld b th C t f A lThey appealed, but the lower court decision was upheld by the Court of Appeals.

Visa and MasterCard also appealed to the Supreme Court and lost.


Private Enforcement: Courts

The Courts are the main venue of antitrust activity (570 cases in 1997). Viscusi, Vernon and Harrington (2000): 90% of lawsuits were private over the 1970-1990 period.

Antitrust litigation (initiated by private firms against other private firms) is and has been relevant for shaping antitrust law through the role of legal precedent.

The treble (i.e. triple) damages clause under the Clayton Act provides strong incentive to file a lawsuit.

Usually cases are filed for violations under the Sherman Act. More frequently for vertical antitrust practices than for horizontal. Only 5.4 percent cases go to trial (most settle). Only 30% in favor of plaintiff Precedents following lawsuits has been fundamental inOnly 30% in favor of plaintiff. Precedents following lawsuits has been fundamental in shaping juridical interpretation.

New economic theories are quickly picked up in courts where both plaintiff and defendants


q y p p phave incentives to make the best case possible.

Per Se Violation & Rule of Reason in Antitrust

The courts employ a distinction in analyzing antitrust practices:

1 Th ti d i tit t i l ti b th ff t1. There are actions producing per se antitrust violation because they affect unambiguously structure of market power, the conduct of market participants, and the resulting performance of those markets. The only defense is that the defendant did not commit the act.

Example: Price fixing, output restraints, minimum resale price maintenance, the allocation of customers among competitors are all per se violations of antitrust law.

2. Rule of reason. There are actions producing antitrust violations when the restraint on trade is unreasonable, that is the same action may be reasonable and not deleterious of

titi d diff t i t Th t d f th t th d f d t didcompetition under different circumstances. The two defenses are that the defendant did not commit the act or that the act is a reasonable restriction to competition.

Example: When a manufacturer sets a maximum price that retailers may charge (maximum


Example: When a manufacturer sets a maximum price that retailers may charge (maximum price resale maintenance) is not per se illegal.

Examples of Vertical Antitrust Practices & Rule of Reason

Exclusive territorial restrictions were considered per se violations before Continental TV v. GTE Sylvania in 1977

Sylvania (in an effort to revive its market share) had eliminated distributors in the early 1960s and started selling only through franchised retailers in an attempt to have dealers

ti t l it TV t S l i t t it i l lipromoting more strongly its TV sets. Sylvania gave out territorial licenses.

Continental TV was agent for San Francisco but wanted to sell in Sacramento. Sylvania refused Continental sold anyways Sylvania stopped selling its TV sets to Continentalrefused. Continental sold anyways. Sylvania stopped selling its TV sets to Continental, which sued.

The vertical agreement produced a verdict to the plaintiff. Sylvania appealed and it wasThe vertical agreement produced a verdict to the plaintiff. Sylvania appealed and it was reversed on the grounds that this particular vertical restriction was finalized at increasing Sylvania competitiveness, not reducing competition in the TVs market.


Rule of reason was applied. The restriction was not an unreasonable restriction to trade.

The Theories Influencing the Judiciary

Early decisions emphasized how the structure of markets (market share, concentration, etc.) were the parameter of reference to investigate the presence of antitrust practice ( )(structural approach).

However, after the 1970s this (simplistic) approach got replaced by more emphasis on the ff t f tit t ti i F i t titi b i ieffect of antitrust practice on prices. For instance, competition may be vigorous in a

market even in presence of oligopoly (think of Bertrand duopoly or a theory of contested monopoly). Also most vertical arrangements seem to foster competition more than stifling it, because they mostly modify intra-brand competition. Some scholars (Baron, 2007) call this the “Chicago School” approach.

Finally, judges started to consider dynamic efficiency implications from new IO, not just static efficiency implications. Think about collusion through repeated interaction. Think about signaling games among competitors (e.g. incumbent versus potential entrants, signaling their cost structure/type). Or network externalities arising from standards of adoption (e.g. Microsoft OS or the “polluted” Java version running only on


standards of adoption (e.g. Microsoft OS or the polluted Java version running only on Windows).

Contrasting The Theories Influencing the Judiciary (1)

Is predatory pricing (pricing below marginal cost, incurring short term losses to rip the benefit of lower future competition) bad?

Structural approach: definitely, as it reduces the number of firms in a sector and then must reduce competition.

The “Chicago School” approach: Suppose firm A engages in predatory pricing and drives out firm B and then raises prices back up. What does prevent firm C from entering then? Nothing, if there are no barriers to entry. Well, suppose barriers to entry due to sunk costs exist. Even then it is not clear firm C will not enter. It depends for how long firm A could sustain a new price war. So it’s hard ex ante to pin a price cut as “predatory” –most likely the result of healthy competition Antitrust should not stifle.

New IO: Marginal costs are unknown to firms. Asymmetric information about firm A’s costs may induce it to costly signal its type. The price war could be a signal aimed at deterring entrance, even when run by high-costs types trying to mimic efficient


g , y g yp y gproducers. In addition, signaling in one market could “protect” other markets.

Contrasting The Theories Influencing the Judiciary (2)

Should price fixing be a major concern for Antitrust?

Structural approach: definitely, firms will collude whenever possible to decrease competition.

The “Chicago School” approach: Unlikely, suppose firms collude, firms have incentives to undercut each other. Cartels will break down and prices will revert to competitive levels.

New IO: Price fixing is not a one-shot prisoner dilemma. The stage game is repeated over time and, if the players are patient enough, clearly equilibria with collusion (price fixing) are very much possible.


Special Interests and Antitrust

P f l i l i t t lik i i i d f ti i dPowerful special interests like unions, insurance companies, and farmer cooperatives gained statutory exemption from specific antitrust provisions early on.

For Agricultural cooperatives with the Capper-Volstad Act of 1922.

For Unions the Norris LaGuardia Act of 1932For Unions the Norris-LaGuardia Act of 1932,

For Insurance companies the McCarron-Ferguson Act of 1945,


Special Interests and Antitrust (cont.)

An egregious example of recent lobbying is the Soft Drink Interbrand Competition Act of 1980 It is a de jure exemption from the Clayton Act for soft drink manufacturers1980. It is a de jure exemption from the Clayton Act for soft drink manufacturers (Coca-Cola, PepsiCo, Canada Dry).

They produce syrup to be sold to bottlers, who are allowed to sell only in specificThey produce syrup to be sold to bottlers, who are allowed to sell only in specific geographic areas. Exclusive territorial distributorships were deemed anticompetitive in 1978 by the FTC.

Congress was heavily lobbied and passed the act.

The rationale was that there was substantial competition in the soft drink market.

Direct legislative exceptions like this are rare, though.


Some Theoretical Formalization


Models of Regulation of a Natural Monopolist

1. Cost Reimbursement of a Monopolist.

2. Yardstick Competition.

3. Regulation of Pricing By A Monopolist.

Note: The best reference for a theoretical treatment of regulation of procurement is “A f f f g f pTheory of Procurement and Regulation” (MIT Press, 1993) By Jean-Jacques Laffontand Jean Tirole. What follows is based on Ch.1 and Ch. 2.


1. A Simple Model of Cost Reimbursement of a Natural Monopolist

A regulator R is concerned with protecting consumer’s welfare.

R is attempting to force a natural monopolist M to produce a certain good at the lowest cost for taxpayers.

Problem: The regulator does not have specific information about M’s cost structure θ.

Consider the case of two (discrete) states θ = θH with probability 1-β or θL with probability β, and θH > θL > 0. Such distribution is common knowledge.

Define Δθ = θH - θL


Cost Reimbursement: Setup

M’s overall cost of producing the good isM s overall cost of producing the good isc = θ – e

where e is the effort level in cost cutting technology by the monopolist c is observable butwhere e is the effort level in cost-cutting technology by the monopolist. c is observable, but not its components θ and e.

M’s effort is exerted at a (convex and increasing) costM s effort is exerted at a (convex and increasing) cost

ψ(e)=(max{0,e})²/2


Incentives

wants the good to be produced at the lowest payment P inclusive of subsidies s:

P = s + c

The payoff for the monopolist firm M is:

P – c – ψ(e) = s – ψ(e)

and if M does not produce its outside utility is 0.


Timing of the game

Sequential structure:

1. State of θ is realized and Monopolist learns it.

2. Regulator offers a menu of contracts for the Monopolist to pick.

3. Monopolist exerts effort e.

4. c is observed.

5. Payoffs realize.


First Best: Observable Costs

The problem would go away if the asymmetric information about θ were absent.

Then R’s problem would be:

min{P} = min{s + c} = min{s + θ – e}

Subject to the constraint of having M not suffer losses (Participation Constraint)

s - (max{0,e})²/2 ≥ 0

The solution clearly would induce to minimize payments to M, so the participation y p y p pconstraint binds s = (max{0,e})²/2, transforming R’s problem in

min{(max{0,e})²/2 + θ – e}


which is solved at e* = 1 and s* = ½.

First Best: Observable Costs (cont.)

Marginal cost savings equalized to marginal disutility of effort.

The solution e* = 1 and s* = ½ is true for any cost structure θ.

So the regulator offers a contingent total payment Pi = ½ + θi – 1 for i=L,H.

This is called a PRICE CAP SCHEME (you make the monopolist the residual claimant of the cost-saving effort).


Second Best: Unobservable Costs

Asymmetric information about θ.

Call (sH, cH) the contract that will be chosen by type θH and call (sL, cL) the contract that will be chosen by type θL

We need to find the optimal contracts (sH, cH) and (sL, cL) in the sense of solving R’s problem:

L L H Hmin{E(P)} = min{β (sL + cL) + (1-β) (sH + cH)} = min{β (sL - eL) + (1-β) (sH – eH)} + βθL+(1-β)θH (1)

Subject to the constraint of having M not suffering losses by participating (Participation Constraints)

si - (max{0,ei})²/2 ≥ 0 for i=L,H (2)


Second Best: Incentive Constraints

And subject to the constraint of having M behaving appropriately depending on the state of the world (Incentive Constraints)

a. In state θ = θL the utility from exercising eL obtaining cL and receiving sL (i.e. obtaining contract (sL, cL) ) must be above the utility from getting contract (sH, cH), hence

i i H Δθ i d t bt i Hexercising eH - Δθ in order to obtain cH:

sL - (max{0,eL})²/2 ≥ sH - (max{0,eH - Δθ})²/2 (3)

Note that a credible lie in this case still needs to generate observable costs cH = θL - e

Al th diti H θH H d t h ld b d fi iti If t th tAlso the condition cH = θH - eH needs to hold by definition. If you equate the two you see:θL - e = θH - eH

t H θH + θL H Δθ [Y ’d H b i i l ff ]


or, as we wrote, e = eH - θH + θL = eH – Δθ [You’d get sH but exercising lower effort]

Second Best: Incentive Constraints

b. In state θ = θH the utility from exercising eH and receiving sH must be above the utility from exercising effort eL+Δθ, obtaining cL and receiving sL

sH - (max{0,eH})²/2 ≥ sL - (max{0,eL + Δθ})²/2 (4)

Note: To avoid corner solutions also assume Δθ < θH – cH

Political Economy - Trebbi87 Political Economy - Trebbi87

Second Best: Cost Reimbursement Solution

This is not an easy problem to solve, unless you start reducing the number of inequality constraints, looking at which constraints are binding and which are slack.

The relevant Participation Constraint for the high-cost type (2) becomes:sH - (eH)²/2 = 0 (PC)

The equality follows because: i. one PC has to be binding (otherwise R is not saving as much money as possible) and ii. the PC for the low-cost type must be slack because

IC L t t PC Hi h t tsL - (max{0,eL})²/2 ≥ sH - (max{0,eH - Δθ})²/2 > sH - (max{0,eH})²/2 ≥ 0 (5)

so

IC Low-cost type PC High-cost type


sL - (max{0,eL})²/2 > 0

Second Best: Solution (cont.)

But if (PC) is true, this also implies by (4) that the IC for the high-cost type:

0 ≥ sL - (max{0,eL + Δθ})²/2

In case θ = θH the monopolist would lose to act like a low-cost type.

However, if θ = θL the monopolist could still gain to act like a high-cost type by equation (5).

Hence, we let the Incentive Constraint for the low-cost type be binding and hold with equality in order to keep the monopolist in check (exert eL effort) at the minimum cost

iblpossible.

Then (3) becomes:L ( L)²/2 H ( H Δθ)²/2 (IC)


sL - (eL)²/2 = sH - (eH - Δθ)²/2 (IC)


Then, by substitution of the (PC) and (IC) equalities (expliciting sH, sL) into the objective function (1), R’s problem becomes:

min{E(P)} = min{β (sL + cL) + (1-β) (sH + cH)}

= min{β (sL - eL) + (1-β) (sH – eH)} + βθL+(1-β)θH

= min{β ((eL)²/2 + (eH)²/2 - (eH - Δθ)²/2 - eL) + (1-β) ((eH)²/2 – eH)} + βθL+(1-β)θH

which can be solved for the optimal eH and eL.which can be solved for the optimal e and e .



The solution eL* = 1 and eH* = 1- Δθ β/(1-β).

Also sL* and sH* follow from PC and IC equations.

The regulator offers a menu of contracts:

(sH*, cH*) = (sH*, θH -eH* ), (sL*, cL*) = (sL*, θL -eL* ) .

Note: i. There is under-provision of effort by the inefficient type θH, eH* < 1ii. There are informational rents accruing to the efficient type θL, sL*-(max{0,eL* })²/2 > 0


g yp , ( { })

2. Yardstick Competition and Information

Maintain asymmetric information about θ.

However, now let’s assume we have two producers with identical cost functions:

ci = θi – ei

where ei is the effort level by producer i and each firm has a specific cost parameter.


Yardstick Competition (cont.)

Let us start from the simple case of idiosyncratic random realizations of cost parameters θi

and θj.

Distributions of θ are uncorrelated.

In this case R cannot learn anything from one firm about the cost structure of the other firm.

The problem remains the same as the one of the previous slides. Second best for both firms.



Consider the opposite case of perfectly correlated realizations of cost parameters θi and θj.

Same θ for both firms. θi = θj = θ

In this case R can learn a lot from one firm about the cost structure of the other firm.

Consider the following contract for firm i reporting cost ci :

si = ψ(e*) – (ci - cj)= ψ(e*) – ((θ –ei) – (θ –ej)),ψ( ) (( ) ( ))

Notice how the subsidy depends on the costs of both firms.



Relative performance evaluation will help.

To see how, notice that firm i will maximize si - ψ(ei) =

ψ(e*)– ((θ –ei) – (θ –ej)) – ψ(ei) = ψ(e*)+ ei – ej – ψ(ei)

So ei = e* = 1.

and firm j will do the same. Both firms will earn their reservation utility 0.

When yardstick competition can be used, optimal effort can be obtained as in first best, notwithstanding informational asymmetries.


Yardstick competition takes away the informational rents. Incentives to cheat go to zero.

3. Regulated Prices: Setup

The choice of output and price is another important aspect of regulation.

A regulator R is concerned with protecting consumer’s welfare.

R is attempting to force a natural monopolist M to produce a certain good at the lowest price for taxpayers.

P bl Th l t d t h ifi i f ti b t M’ t t t θProblem: The regulator does not have specific information about M’s cost structure θ.

The project has a variable scale q. Total cost C of producing quantity q is given by:C = (θ e)qC = (θ – e)q

So now the marginal cost of producing the good isc = θ – e


Regulated Prices: First Best

Define V(q) the social surplus generated by the production of output q. Assume it increasing d f i li iand concave for simplicity.

R will want to increase output and keep payments low.

If costs are observable, R’s problem is the first-best problem:

min{P - V} = minq,e{s + C – V(q)} = minq,e{s + (θ – e)q – V(q)} (6)

Subject to the constraint of making M not suffer losses (Participation Constraint)

s - ψ(e) = s - (max{0,e})²/2 ≥ 0


First Best Solution

The constraint of making M not suffer losses will hold with equality (no rents, R will try to minimize payments to M)

s - ψ(e) = 0

I will replace it in (6) and differentiate for q and e.

The first-best solution to R’s problem is given by the solution e*, q* of the two first order conditions:conditions:

q = ψ’(e) (7)θ – e = V’(q) (8)

which of course will be contingent on the realized state θ.

To get first-best prices I can plug q* into the inverse demand function p = P(q)


To get first best prices I can plug q into the inverse demand function p P(q).

Regulated Prices: Second Best

R’s problem when costs are unobservable is different:

min{E(P - V)} = min{β (sL + CL – V(qL)) + (1-β) (sH + CH – V(qH))}

subject to the participation constraints (make sure the firms wish to operate):

si - (max{0,ei})²/2 ≥ 0 for i=L,Hand the incentive constraints (make sure the firms wish to do the right thing):

sL - (max{0,eL})²/2 ≥ sH - (max{0,eH - Δθ})²/2

sH - (max{0,eH})²/2 ≥ sL - (max{0,eL + Δθ})²/2


Second Best: Simplified Setup

R’s problem can be simplified by the arguments we used before to:

minqL,qH,eL,eH{E(P - V)} = min{β (sL + (θL – eL)qL – V(qL)) + (1-β) (sH + (θH – eH)qH – V(qH))}

subject to a binding participation constraint for the high-cost type:

sH = ψ(eH) (9)

and a binding incentive constraint for the low-cost type:g yp

sL - ψ(eL) = sH - ψ(eH - Δθ) (10)


Second Best: Solution

(9) and (10) can be replaced into the minimand to get the unconstrained problem:

min{β (ψ(eL) + ψ(eH) - ψ(eH - Δθ) + (θL – eL)qL – V(qL))+ (1-β) (ψ(eH) + (θH – eH)qH – V(qH))}

The second-best solution to R’s problem is given by the solution eH*, qH* eL*, qL* of the four first order conditions:

L LqL = ψ’(eL)

θL – eL = V’(qL)

qH = ψ’(eH) + (ψ’(eH) – ψ’(eH - Δθ))β/(1- β)


θH – eH = V’(qH)

Second Best: Interpretation

Note:

i. Output and effort are the same as under full information for the efficient type θL. ii. There are informational rents accruing to the efficient type θL (PC is slack for the low-

cost type), sL*-(max{0,eL* })²/2 > 0iii. A low-powered incentive scheme is given to the inefficient type to limit the efficient

type’s rents. There is under-provision of effort by the inefficient type θH, eH* is lower th d f ll i f tithan under full information.

iv. In second best we are going to have lower output and higher prices when costs are high relative to first best.


Conclusions

The issues of antitrust and regulation have been investigated in the light of potential informational asymmetries.

Main empirical and institutional features.

We have seen models of the New Theory of Regulation & Informational models of Regulation and Procurement.

This is a particularly active area of policymaking right now (think about housing market or financial services regulation) and a fruitful avenue of research.


Documents

GtdMktGovernments and Marketsfaculty.arts.ubc.ca/ftrebbi/590_lectures/trebbi_lecture...that allows entry of other firms). This seems to be the case even for energy markets. 2. Monopoly