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Economic Approaches to Regulation

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PRINTED FROM OXFORD HANDBOOKS ONLINE (www.oxfordhandbooks.com). (c) Oxford University Press, 2014. All RightsReserved. Under the terms of the l icence agreement, an individual user may print out a PDF of a single chapter of a title in OxfordHandbooks Online for personal use (for details see Privacy Policy).Subscriber: Pontificia Universidad Catolica del Peru (PUCP); date: 01 May 2015

PrintPublicationDate: Sep2010 Subject: BusinessandManagement,GovernmentandLaw,FinanceandEconomics

OnlinePublicationDate: Sep2010

DOI: 10.1093/oxfordhb/9780199560219.003.0002

EconomicApproachestoRegulation CentoVeljanovskiTheOxfordHandbookofRegulationEditedbyRobertBaldwin,MartinCave,andMartinLodge

OxfordHandbooksOnline

AbstractandKeywords

Economicshasbeenattheheartofregulatoryreformbeginningwiththewaveofderegulationandprivatisationsofthe1980s.Thisarticlefocusesoneconomictheoriesofregulation,andthewayeconomicshasbeenusedtodesignandevaluateregulation.Asthetitleofthisarticlesuggests,thereareanumberofeconomicapproaches.However,theseallsharetheconvictionthatrelativelysimpleeconomictheorycanassistinunderstandingregulation,andprovidingpracticaltoolsforregulatorstomakeregulationmoreeffectiveandefficient.Thesubjectmatteroftheeconomicsofregulationcoversatleastfourbroadareaseconomicregulation,socialregulation,competitionlaw,andthelegalsystem.Hereabroaderviewistakenencompassingcompetitionandmergerlaws,andthefieldknownaslaw-and-economicsortheeconomicsoflawisillustratedwhichlooksatthelegalsystem.Keywords:economics,regulatoryreform,deregulation,privatisations,competitionlaw,legalsystem

2.1IntroductionEconomicshasbeenattheheartofregulatoryreformbeginningwiththewaveofderegulationandprivatisationsofthe1980s.Whilenotalwaysattheforefrontofthesechanges,economistshaveplayedakeyroleinthesedevelopments,andhaveoftenbecomeregulators.Thishasledtobetterregulationand,paradoxically,moreregulation,fuellingfearsthatthegrowthofthestate,evenifaregulatorystate,isinevitableevenincapitalistdemocracies.Partofthistrendhasbeenduetothereplacementofstateownershipwithprivateownershipplusregulation,partduetothenaturaltendencyforregulatorycreep,andtheapparentinabilityofgovernmenttorollbackregulation.

Theeconomicsofregulationisawideanddiversesubject.Ithasnormative(whatshouldbe)andpositive(whatis)aspects;provideseconomicanalysesofprices,access,quality,entry,access,andmarketstructure(regulatoryeconomics),empiricalstudiesofspecificlegislation(impactandcostbenefitassessments),andorganisationalandlegalapplicationswhichexaminethebehaviourofinstitutionsandregulatoryagencies,andthedevelopmentanddesignofrules,standards,andenforcementprocedures.Itisnotpossibletodojusticetosuchavastsubjectina(p.18) shortreview;hencethefocusherewillbeoneconomictheoriesofregulation,andthewayeconomicshasbeenusedtodesignandevaluateregulation.

Asthetitlesuggeststhereareanumberofeconomicapproaches.However,theseallsharetheconvictionthatrelativelysimpleeconomictheorycanassistinunderstandingregulation,andprovidingpracticaltoolsforregulatorstomakeregulationmoreeffectiveandefficient.Thispremisegivescoherencetothedifferenteconomicapproacheseventhoughtheymaygenerateverydifferentviewsandtheoriesabouttherationaleand(likely)impactofspecificregulatoryinterventions.


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Thesubjectmatteroftheeconomicsofregulationcoversatleastfourbroadareaseconomicregulation,socialregulation,competitionlaw,andthelegalsystem.IndeedtheexcellenttextbookbyViscusi,Harrington,andVernon(2005)entitledEconomicsofRegulationandAntitrust,encompassesthefirstthreeareas,althoughmanywouldseeantitrust(tousetheUSAterm)asseparate. Hereabroaderviewistakenencompassingcompetitionandmergerlaws,andthefieldknownaslawandeconomicsortheeconomicsoflawwhichlooksatthelegalsystem(Veljanovski,2006and2007).

Economicregulation:Economicsisatitsstrongestandmostrelevantwhenitdealswithovertlyeconomicissuesaffectingfirmperformance,industrystructure,pricing,investment,outputandsoon.Indeed,aseparatefieldofstudyknownasregulatoryeconomics,startingeffectivelywithAverchandJohnson(1962),anarticleonthedistortiveeffectsofrateofreturnregulation,isconcernedwiththeprinciplesandtechniquesforregulatingautility,usuallyagas,electricity,water,telephone,andrailwaynetwork,whichdoesnotfaceeffectivecompetition(Viscusi,Harrington,andVernon,2005;Armstrong,Cowan,andVickers,1994;LaffontandTirole,1993).Socialregulation:Economistshavealwaysbeenconcernedaboutsocialregulationasubjectasoldaseconomicsitself,arisingaroundthetimeoftheindustrialrevolution.Socialregulationembraceshealthandsafety,environmental,antidiscriminationandotherlaws.Thiscategoryofregulationdoesnothaveoverteconomicobjectivesbutdoeshaveeconomiceffects,costs,andbenefits.Thesealloweconomiststoevaluatetheeconomicimpactanddesirabilityofspecificapproachestosocialregulation.Competitionandmergerlaws:Theseseektocontrolmonopolies,cartels,andabusivepractices,andmergersandjointventureswhichriskgivingfirmsexcessivemarketpower(Motta,2004;O'DonoghueandPadilla,2006).ThecorelegalframeworkofEuropeancompetitionlawisexpressedinArticles81,82,and87oftheECTreatyandtheMergerRegulation. Competitionlawseekstosupportthemarketanddiffersfromtheexanterulesandstandardswhichcharacterisemuchofeconomicandsocialregulationbybeingreactive,orasitisoftentermedexpostregulation.Thisisbecauseitrespondscasebycasetoactualorhighlylikelyabuses,andpenalisesanticompetitiveandabusivepractices.Theexceptionismergerlawswhichseektopreventfirmsfrommergingandformingjointventureswherethiswouldgivethemexcessivemarketpower.(p.19)However,generallyexpostcompetitionlawstandsincontrasttostatutoryregulationwhichistypicallyaprescriptiveexanteapproach.Legalsystem:Thefinalareaisthelegalsystemwithitsrules,procedures,andenforcement.Thisprovidesanimportantbackdroptoregulatoryandcompetitionlaws,andcanoftendeterminetheireffectivenessandlegitimacy.Economiststypicallydealwiththisareainaseparatefieldcalledlawandeconomicswhichlooksattheeconomicsofcontract,property,crime,andaccidentlaws,andthebasiclegalinstitutionsofasociety(Veljanovski,2006and2008).Muchofthisliteratureishighlyrelevanttotheeconomicsofregulation,suchastheeconomicsofcrimewhichoffersmodelsandpredictionsabouttherelativeeffectivenessofdifferentsanctionsinenforcingregulatorylaws,theeconomicsofrulesandprocedureswhichprovidesinsightintothefactorsinfluencingtheireffectiveness,andtheeconomicsofagencyandjudicialbehaviour.

2.2TheoriesofRegulationWhenlookingatthelargeliteratureontheeconomicsofregulationitisimportanttomakeadistinctionbetweennormativeandpositivetheories.Normativetheoriesseektoestablishidealregulationfromaneconomicperspective,andareprescriptive.Theyareusuallybasedontheconceptsofeconomicefficiencyandmarketfailure,andprovideaneconomicversionofapublicinteresttheoryofregulation.Positiveeconomicsistheexplanatoryandempiricallimboftheeconomicsofregulation.Itseekstoexplainthenatureanddevelopmentofregulationanditsimpactthroughstatisticalanalysis,andsometimescostbenefitassessments.

2.2.1NormativeeconomicapproachesNormativetheoriesofregulationprincipallybuildontheconceptsofeconomicefficiencyandmarketfailure,althoughmorerecentlytherehasbeenawidespreadrecognitionthatitismisleadingandcounterproductivetofocussolelyonmarketfailure,sincegovernmentsarejustaspronetofailure.Onetroublesomeareaforthesetheoriesistherelationshipbetweenefficiency,distributivejustice,andregulationwhichwillbetouchedonbriefly.

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EfficiencyThebuildingblocksoftheeconomicapproacharetheconceptsofeconomicefficiencyand,paradoxically,ofmarkets.

(p.20) Anefficientoutcomeoccurswhenresources,goods,andservicesareallocatedtotheirhighestexpected valuedusesasmeasuredbyindividualwillingnesstopay,assumingthatthemostproductiveexistingtechnologyisused.Whenthereistechnicalchangewhichexpandstheproductivecapacityoftheeconomyforanygivenlevelofinputstheneconomistsusetheconceptofdynamicefficiency.Theconceptofdynamicefficiencyisalesswellworkedoutconceptbecausetheprocessoftechnicalchangeandinnovationisstillpoorlyunderstood.

EconomistsworkwithtwoconceptsofeconomicefficiencyParetoefficiencyandKaldorHicksefficiency.

AParetoefficientoutcomeiswherethewelfareofoneindividualcannotbeimprovedwithoutreducingthewelfareofothers.ThusParetoefficiencyisasituationwhereallpartiesbenefit,ornoneareharmed,byareallocationofresources,goods,assets,orachangeinthelaw.Thenooneisharmedconstraintavoidstheeconomistmakinginterpersonalcomparisonsofutility,i.e.evaluatingwhetherthelosstooneindividualiscounterbalancedbythegaintoothers.

ThisParetocriterion,namedaftertheSwissItalianeconomistVilfredoPareto,isbasedontwoadditionalvaluejudgements:

(1)thattheindividualisthebestjudgeofhisorherownwelfare;(2)thewelfareofsocietydependsonthewelfareoftheindividualsthatcompriseit.

These,itisargued,shouldbewidelyaccepted,atleastamongthoseinWesternsociety.

ThedifficultywithPareto'snooneisharmedconstraintisthatitprecludestheeconomistfromcommentingonallbutthemosttrivialpolicychangesincemostpolicieshavewinnersandlosers.Theonlyconsistentwayoutofthisdilemmaistoinsistonthegainerscompensatingthelosersassomepublicchoiceeconomistshaveadvocated(BuchananandTullock,1962).

Todealwith(orrathersidestep)thisdifficulty,economistshaveadoptedKaldorHicksefficiencyalsoknowaswealthmaximisationorallocativeefficiency.ApolicyisKaldorHicksefficientifthosethatgaincaninprinciplecompensatethosethathavebeenharmedandstillbebetteroff.Inotherwords,thecostbenefittestissatisfiedshowsthattheeconomicgainsexceedthelossestowhomsoevertheyaccrue.InthiswayeconomistsbelievethattheKaldorHicksapproachseparatesefficiencyfromthethornyandindeterminateissueofwealthdistribution.

MarketfailureThesecondlimbofthestandardnormativetheoryofregulationistheconceptofmarketfailure(Bator,1958).A(perfectly)competitivemarketachievesaParetoefficientoutcome.Marketfailureprovidesanecessary(butnotsufficient)economicjustificationforstateorcollectiveintervention.

Marketscanfailintheoryandpracticeforfourprincipalreasonsmarketpower,externality,publicgoods,andimperfectinformation.

(p.21)

Marketpower:Whereonefirm(monopoly)orafewfirms(oligopolyoracartel)canprofitablyraisepriceabovethecompetitivelevel,thenthemarketisnotcompetitiveorParetoefficient.Amonopolistchargesmoreandproduceslessthanacompetitiveindustry.Asaresultthepriceitchargesexceedsthemarginalopportunitycostsofproduction,andconsumersdemandlessoftheproductthanisefficient.Thesocialcostsofmonopolyarethelostconsumers'surplus(thedifferencebetweenwillingnesstopayandthemarginalcosts)ontheoutputnotproducedbythemonopolist'sactionofcreatingartificialscarcity.Monopolycanalsoadverselyaffecttheothertermsoftrade(suchaslowerproductandservicequality),reduceinnovation,leadtoexcessiveproductioncosts(knownasXinefficiency),andencouragewastefulexpendituretoenhanceorprotectitsmonopolypositionbyunproductiverentseeking(seebelow).Ontheotherhand,itispossiblethat

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onefirm(anaturalmonopoly)canexistduetothehighinfrastructurecostsnecessarytobuild,say,awaterpipelineorelectricitydistributionnetwork,orfirmsmayacquiremarketpowerbecausetheygeneratemoreinnovation(Schumpeter,1947;Baumol,2002).Externality:Someactivitiesimposeexternallossesorbenefitsonthirdpartieswhichthemarketdoesnottakeintoaccount.Externalitiescanimposelosses(suchaspollution)orbenefits(suchasbeespollinatingorchards).Thepresenceofexternalbenefitsandcostsimpliesthattheactivitygivingrisetothemisunderandoverexpandedrespectivelyrelativetotheefficientlevel.Thisisbecausethecoststructureoftheexternalitycreatingindustrydoesnotreflectthefullsocialcosts/benefitsofitsactivities.Pollution,congestion,globalwarming,litter,antisocialbehaviour,andcrimeareexampleswherethesocialcostsarehigherthantheprivatecostswhichinfluenceindividualactions.Publicgoods:Apublicgoodisoneforwhichconsumptionofthegoodbyoneindividualdoesnotdetractfromthatofanyotherindividual,i.e.thereisnonrivalrousconsumption.Theclassicexampleisdefenceastandingarmyprovidesnationaldefenceforallitscitizens.Publicgoodsshouldnotbeconfusedwithcollectivelyorstateprovidedorproducedgoodsandservices.Acompetitivemarketmayfailtoprovideanefficientlevelofapublicgoodbecausenonpayerscannotbeexcludedresultinginfreeridingandpreferencemisrevelation,andtheinabilitytoappropriateanadequatereturn.Becauseindividualscannotbeexcludedfromconsumingapublicgood,thosewithhighvaluationswilltendtounderstatetheirpreferencesinthehopeofbeingchargedalowerpriceandotherswillfreeride.Moreover,sinceafirmcannotexcludenonpayingcustomers,theseproblemsmaysufficientlyimpairtheabilitytoextractanypaymentthatnoortoofewpublicgoodsareproduced.Asymmetricinformation:Imperfectinformationcanresultininefficientmarketoutcomesandchoices.Further,marketsmayunderproducerelevantinformationbecauseinformation'spublicgoodsnaturecanmakeitdifficultforthose(p.22) investinginbetterandnewinformationtoappropriateanadequatefinancialreturn.Inothercasesmarketsmayfailbecauseofasymmetricinformationwherethebuyerorsellerhasbetterinformation(Akerlof,1970).Asymmetricinformationgivesrisetotwoproblemsadverseselectionandmoralhazard.Adverseselectioniswhereonepartycannotdistinguishbetweentwoormorecategoriesofgoods,actions,oroutcomeswhichhavedifferentcosts,benefits,orrisks,andthereforemakesachoicebasedontheaveragevalueofthese.Forexample,ifaninsurancecompanycannotdistinguishgoodfrombadrisks,itwillchargebothapremiumbasedontheaverageriskofthepool.Asaresultbadrisksgetcheapinsuranceandgoodrisksexpensiveinsurance.Thelossesofthepoolriseasgoodrisksdon'tinsurewhilebadrisksdobecausethepremiumsarecheap.Moralhazardisasituationwheretheprospectofcompensationtocoverrisksandlossesincreasesthelikelihoodandsizeofthelossesbecauseriskybehaviourcannotbemonitoredandpricedappropriately,andexcessivelossesarecompensated.Thisconceptreceivedaconsiderableairinginthe2008/9bankingcrisis.

NonmarketfailureTheimplicitassumptionofthemarketfailuresapproachisthatregulatoryinterventioniscostless,andofcoursethatithasorshouldhaveeconomicefficiencyasitssoleobjective.Inpracticeregulationiscostlyandgeneratesitsowndistortionsandinefficiencies.Coase(1960)pointedtothisobviousflawinahighlyinfluentialarticleandadvocatedthattherelevantcomparisonwasnotbetweenidealmarketsandidealregulationbutbetweenfeasible,imperfect,andcostlymarketsandregulation.Thissetthesceneforagovernmentfailuresframework(Wolf,1988),orwhatDemsetz(1969)calledthecomparativeinstitutionsapproachwhichlaterdevelopedintothetransactionscostsandtheNewInstitutionalEconomicsapproach(Williamson,1985;ShelanskiandKlein,1995).

Thereareotherimplicationsfromtheaboveinsightthatmarketsandregulationarecostly.Thefirstisthateconomistsandothershaveexaggeratedtheincidenceandtheextentofmarketfailure.Oftenmarketsonlyseemtofailbecausetheeconomists'models(orthestandardsetbynoneconomists)ignoredthecostsofusingthemarketandtheexpenseofproposedremedialmeasures.Forexample,ithasbeenshownthatmanyoftheexamplesusedtoillustratemarketfailureineconomicstextbooksandinfluentialarticleshavebeenverywideofthemark.

Take,forexample,theallocationofradiomagneticspectrum.Thiswasseenasaclassicexampleofmarketfailurewheretheprivateuseofthespectrumledtocongestionandradiointerference(marketfailureduetoexternalities).Fromthe1920suntilveryrecentlyitwasfirmlybelievedthatamarketinspectrumwasnotpossible,asitgaverise

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toinefficientusesandradiointerference.Thustheamountanduseofspectrumhadtoberationedandstrictlyregulated.Today,thereisanappreciationthatthereasonwhyearlymarketsinspectrumfailedwasbecauseoftheabsenceofenforceablepropertyrights,whichledtoincompatibleusesofthesamebandwidth(p.23) (Herzel,1951;Coase,1959).Researchhasshownthatnotonlycouldtherebeamarketinspectrumbutthatthelawwasevolvingtodevelopaquasipropertyrightssystemthroughthecommonlawofnuisanceandtrespass(Coase,1959).However,mostcountriesnationalisedtheairwavesandallocatedbandwidthbyadministrativemeans,oftentohighlyinefficientgovernmentandmilitaryuses.

Themarketfailuresapproachalsodidnotrecognisethatoftenthecostsofusingthemarketgeneratedselfcorrectiveforces.Asaresultafalsedichotomywasdrawnbetweenmarketandnonmarketactivities.However,manyseeminglynonmarketinstitutionsevolvedasacosteffectiveresponsetothecostsofusingthemarket.ThiswastheessentialandstilloftenignoredinsightofCoase,whoarguedthatthepositivetransactionscostsofmarketscouldhelpexplainotherwisepuzzlingeconomicandinstitutionalfeaturesoftheeconomy.Thethesisadvocatedbythisliteratureisthatthelawsandinstitutionsevolvewheretheyarealesscostlywayoforganisingeconomicactivity.Indeed,thisexplainstheexistenceofthefirmafirmisseenasanexusofcontractsandnonmarkethierarchal/administrativemethodsoforganisingproductionwhichreplacesarms'lengthmarkettransactions(Coase,1937;Williamson,1985).Thefirmtherebyreplacesmarkettransactionscostswiththeprincipal/agencycostsofinternaladministrativecontrols.Thislogichasbeenextendedtoregulationwhichsomeeconomistsanalyseincontractualandtransactionscoststerms(seebelow).

Distributivegoals,fairness,andjusticeFinally,abriefwordaboutwealthdistribution,fairness,andjustice.Marketsandregulationgeneratewinnersandlosers.Itfollowsthatindividualsasmarketparticipantsandascitizenswilloftenbeequallyifnotmoreconcernedbywhetherlawsincreasetheirwealththanbytheirimpactonothersorsocietyingeneral.Moreover,therewilloftenbeviewsaboutthefairnessandacceptabilityofmarketandregulatoryoutcomes.Thusitwouldbesurprisingiftheeconomicsofregulation,especiallyinitsguiseofanormativetheory,wasabletoignorethesenoneconomicfactors.

Thereisalsoatechnicalreasonwhydistributionalissuescannotbeignored.Thisisbecauseanefficientmarketoutcomeispartiallydeterminedbytheexantedistributionofincomeandwealthinsociety.Thismeansthatthereisaninextricablelinkbetweenwealthdistributionandeconomicefficiencyandmarketoutcomesandbyimplicationregulation.Asaresultitislegitimateinthenormativetheorytoconsiderdistributionalfactors,andindeedthereisavasteconomicliteratureinwelfareeconomics,socialchoicetheory,publicfinance,taxation,andsocialwelfareissueswhichfocusonsuchissues.

However,intheevaluationofregulationeconomistsadoptadecidedlyschizophrenicapproach.Ontheonehandregulationisassessedintermsofeconomicefficiencyalone,ontheimplicitassumptionthatdistributionalgoalscanbeachievedatlesscostbydirect,ideallylumpsum,wealthtransfers.Onthe(p.24) otherhand,theeconomists'positivetheoriesofregulation,discussedbelow,aredrivenbypoliticiansandinterestgroupsjostlingprimarilyoverwealthtransfers.

Thereasonfortheeconomists'reluctancetoincorporatedistributionalconsiderationsiseasytoexplain.Mosteconomistsviewtheuseofregulationtoredistributeincomeasabluntandinefficientinstrument.Itdistortspricesandincentives,andhenceleadstosubstantialefficiencylossesandunintendedeffectswhichoftenharmthosewhomitisdesignedtobenefit(seebelow).Forexample,thepublicinterestgoalofrentcontrolistomakeaffordablehousingavailabletothepoor.Butitseffecthasbeentoreducesubstantiallytheavailabilityofhousingaslandlordswithdrewpropertiesandinvestedtheirmonieselsewhere.Apartfromcreatingahousingshortage,thoseluckyenoughtosecurerentalaccommodationoftenfindthatitissubstandardasthelandlordisunwillingtoinvestinimprovementsandmaintenance.Thelessonwhichmostgovernmentshavenowlearntisthatpricecontrolsdrivenbydistributionalgoalshavesignificantnegativeeffectsandrarelyachievethedesiredredistributionofincomeandwealth.Theeconomists'adviceisthatsuchpoliciesshouldbepursuedbyothermoreefficientmeanssuchasincomesupportpaymentsetc.,thatdonotdistorttheefficiencyfunctionofprices.

2.3PositiveTheories


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Positiveeconomictheoriesseektoexplainregulationasitis.Thecentraltasksofthetheoryofeconomicregulationtoquoteoneofitsfounders(Stigler,1971:3),aretoexplainwhowillreceivethebenefitsorburdensofregulation,whatformregulationwilltake,andtheeffectsofregulationupontheallocationofresources.Thishasledtotheorieswhichseektoexplainwhywehavetheregulationwehave.

Economistshaveusedthemarketfailureapproachtoexplainregulation.ThisissometimescalledtheNormativeTurnedPositive(NTP)theoryofregulation.

TheNTPtheoryassumes(oftenimplicitly)thatgovernmentsseektocorrectmarkets,andtodosofairlyefficiently.Forexample,onesurveybytworespectedBritisheconomists(KayandVickers,1988)inthelate1980sconcludedthat:Thenormalpatternisthatmarketfailureprovidestherationalefortheintroductionofregulation,butthescopeofregulationisthenextendedtoawiderangeofmatterswhicharethesubjectofgeneralorsectionalinterests,regardlessofwhetherthereisanyelementofmarketfailureornot.Whilethispatternwasdiscernible,therewasclearlyalotofregulationthathadlittletodowithcorrectingmarketfailure.Indeed,intheUStherewasmuchtalkofcrisisasregulatorswerecapturedandfavouredbytheindustrytheyregulated.Thatisthattheypromotedproducerinterestsratherthantheconsumers'interests.

(p.25) ThegrowingevidenceofregulatorycaptureintheUSAledsomeeconomiststoincorporatethepoliticalprocessintotheiranalysis.Atthecoreofthesepositivetheoriesistheassumptionthattheparticipantsintheregulatoryprocesspoliticians,bureaucrats,specialinterestgroups,regulatorsareallsubjecttothesameselfregardinggoalsasareassumedtoexistinmarkets,butsubjecttodifferentconstraints.Thatistheassumptionofeconomicrationalitymaximisingnetbenefitssubjecttotheresourceandinstitutionalconstraintsinthepoliticalmarketplace.

Stigler(1971)wasthefirsttodevelopapositiveeconomictheoryofregulation.Hiscentralhypothesiswasthatregulationwassecuredbypoliticallyeffectiveinterestgroups,invariablyproducersorsectionsoftheregulatedindustry,ratherthanconsumers. Itthushadmuchincommonwiththepoliticalscienceviewofregulatorycapture(Bernstein,1955).

Stigler'smodel,furtherdevelopedbyPeltzman(1976),hasfourmainfeaturesorassumptions.

(1)Theprimaryproducttransactedinthepoliticalmarketplaceiswealthtransfers.(2)Thedemandforregulationcomesfromcohesivecoordinatedgroups,typicallyindustryorspecialinterestgroups,andhencediffersfromtherealmarketplace,whereallconsumersarerepresented.(3)Theeffectivenessofthesegroupsisseenasafunctionofthecostsandbenefitsofcoordination(whichalsoexplainswhyconsumergroupsfindithardtoorganiseasaneffectivelobbygroup).Thesupplysideoflegislationislesseasytodefinegiventhecomplexnatureofpolitical,legislative,andregulatoryprocesses.(4)Thestatehasamonopolyoveronebasicresource:thepowerlegitimatelytocoerce.Thisiscoupledwiththebehaviouralassumptionthatpoliticianssupplyregulationtomaximisethelikelihoodthattheywillbekeptinoffice.

Stigler'stheorygeneratesstrongconclusionswhichhavenotbeenfullysupportedbysubsequentresearch,andindeedobservation(Posner,1974;Peltzman,1989).Forexample,Posner(1971)pointedoutthatthecommonpracticeofregulatorsandlegislatorsrequiringpublicutilitiestocrosssubsidiselossmakingoperationsandconsumergroups(suchasruralconsumers)wasinconsistentwiththetheory.Anotherapparentproblemisthepressureforandaccelerationofderegulationandprivatisation,andindeedthemassiveinjectionofeconomicrationalismintoregulatorypolicy,duringtheThatcherandReaganeras.Hereeconomicefficiencyseemedtodriveregulatorypoliciestoremovepatentlyinefficientandanticompetitivelaws.ThederegulationofairlinesandtelecommunicationsintheUSA,andthewidespreadprivatisationandeconomicregulationofthegas,electricity,telecommunications,water,andrailwaysectorsintheUK,andprogressivelyacrossEuropeandtheworld,poseachallengefortheviewthatregulationisdrivenprimarilybyproducers'interests.Theysuggestthatpowerfulspecialinterest(p.26) groupshadlosttheirpoliticalinfluenceoverpoliticianstoratherundefinedpoliticalforcesoptingforthepublicinterest.

Anotherinterpretationofderegulationisthatthegainstoproducersfromthethenexistingregulationsandpublicownershiphadbeendissipatedandwerenolongersignificant.Peltzman(1989)hasreviewedthisperiodandnotedthatitwasnotacentralfeatureofStigler'sapproachthattheproducers'gainsfrominefficientregulationwere

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permanent.Theychangeovertimeandresultinproducersupportforregulationwaning,whichcanexplainderegulation.Thegainsfromderegulationinthefaceofthemountinginefficiencyofexistingregulationcertainlyringstrue,butexistingtheoriesdonotprovideaclearbasisforpredictingwhenderegulationandregulatorychangewillhappen,andinsomeareas(airlines)therewerestillsignificantgainstobehadfromtheexistingregulation.

AsecondapproachstartswithBecker's(1983)workoninterestgroupinfluenceinpolitics.ThisusesthesamebehaviouralassumptionusedbyStiglerbutfocusesnotonpoliticians'desiretostayinpowerbutoncompetitionbetweeninterestgroups.Interestgroupsinvestininfluencingthepoliticalprocesstogainfavourablelegislation.ThekeytoBecker'smodelistherelativepressureexertedbyagroupsincetheinvestmentmadebyopposinggroupswilltendtohaveacounteractingeffectontheeffectivenessofresourcesdevotedtogaininginfluence.Thismeansthata)excessiveresourceswilloftenbeusedtoinfluencethepoliticalprocess;andb)theoutcomewillgenerallybeinefficient.

ThemechanicsandassumptionsofBecker'smodeldonotrequiredetaileddiscussionhere.WhatisofinterestisthatusingsimilarassumptionstotheStigler/Peltzmanmodelhegeneratesmarkedlydifferentpredictionsmoresympathetictothepublicinterest/NTPviewofregulation.Forexample,Becker'smodelindicatesthatastheinefficiencyofregulationincreasesthereislessregulatorylobbying.Thissuggeststhatregulationwhichiswelfareenhancingismorelikelytobeimplemented,andthatindustrieswheremarketfailureissignificantandendemicaremorelikelytoberegulated.Thisisbecauseinefficiencyimpliesthatthelossesaregreaterthanthegainsofinefficientregulation.However,Becker'smodelalsosuggeststhatregulationmayoccurwherethereisnosignificantmarketfailurebecausesomeinterestgroupscanorganisethemselvesmorecheaply.

Yetanotherapproachcomesfromthepublicchoiceschool.Thisbuildsontheconceptofrentseeking(Tullock,1967;Krueger,1980;Rowley,Tollison,andTullock,1988),definedasunproductiveprofitseekingbyspecialinterestgroupstosecurefavourablelegislation.Legislationthatcreatesbarrierstocompetitionorconfersmonopolyrightsleadstoincreasesinthewealthofthosefavoured,whichcannotbeerodedorcompetedaway.Theserentsprovidetheincentiveforproducergroupstoinvestinsecuringfavourablelegislation,hencethetermrentseeking.

Theideabehindrentseekingissimpletoexplain.Takethecasewherethegovernmentplanstoawardamonopolyfranchisetosellsalt,andassumethatthiswillgeneratemonopolyprofitsof20milliontothesuccessfulbidder.Faced(p.27) withthisopportunitypotentialbiddersforthemonopolyrighttosellsaltwouldbepreparedtoinvestresourcesinlobbying(andbribing)thegovernmenttosecurethemonopolyfranchise.Supposethatfourbiddersrevealthemselves.Theexpectedprofitsfromlobbyingforthemonopolyfranchiseis5million(equalto25%ofthe20milliontoreflecttheuncertaintyofwinningthefranchise).Itthuswouldberationalforthefourbidderseachtoexpendupto5milliontosecurethefranchise.Inthiswaythemonopolyprofitisconvertedintounproductiveandwastefulcosts,andinefficientoutcomes.

Takenintheround,economicsisratheragnosticastothepurposeandnatureofregulation.Indeed,thesocalledChicagoSchool,whoseexponentsnumberStigler,Peltzman,Becker,andPosner,donothaveaunitaryviewofregulationotherthanthebeliefthatitcanbemodelledusingeconomics.TheBecker/Posnerapproachisaslikelytoseeregulationastendingtowardefficientresponsestomarketfailure,asitistoidentifyitservingproducers'interestsonly.ThisisgraphicallyseeninPosner'sanalysisofthecommonlawwhichisdrivenbyeconomicefficiencyconsiderations(Rubin,2005;Veljanovski,2008),efficiencymodelsofstatutorylaw,andthegeneraleconomicjustificationforcompetition/antitrustlaws(Posner,2001).Indeed,thoseworkingintheregulatoryfielddonotregardthecapturetheoryasagoodgeneraldescriptionofregulationtoday,whichovertlyseekstoregulatemarketpowerandtofostercompetition.

2.4RegulatoryDesignEconomicshasbeenusedtodesignanddraftefficientorcosteffectivelegalrulesandstandards,andtoidentifytheinefficienciesanddistortiveeffectsofexistingandproposedregulation.Theserangefromratherspecificeconomicapproachestothechoicebetweenlegalrulesandstandard,andexanteandexpostregulation,totheuseofcostbenefitanalysistoensure(cost)effectiveregulationandtocutredtape(HahnandTetlock,2008);ormoreimaginativelytoproposeanddesignmarketlikealternativestothetraditionalcommandandcontrol


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approachtoregulation.Hereweconsidersomeoftheseapplications.

Ithaslongbeenrecognisedthattheinefficiencyofregulationisoftentheresultofamismatchbetweenregulatoryobjectiveandregulatoryinstruments(Breyer,1979and1982).Thisdisjunctionhasbeendueeithertothemultiplicityofgoalsgiventoregulatorsortothebeliefthatnoneconomicgoalscouldbeachievedcostlessly.Ithasalsobeenduetotheexcessiveuseofwhathavebeentermedcommandandcontrolapproaches.Thatis,prescriptiveruleswereusedtoregulateinputsandimposeobligationsbackedbyadministrativeenforcementandpenalsanctions.(p.28) Forexample,safetylegislationwouldrequirecompliancewithtechnicalandlegalrequirementswhichfocusedonsafetyinputs.Theemployerwouldcomplybymakingthenecessarycapitalandotherexpendituressuchaspurchasingmachineswithguards.Thisledtotwoproblemsfirst,itraisedcostsandreducedproductivity;andsecondthemandatedsafetydevicesmaynothavehadanappreciableeffectontheaccidentrate.Italsogaverisetoathirdsetofoffsettingresponsesbythoseregulatedandbenefitingfromregulation(seebelow).Thisresultedintheperversityofincreasedenforcementandcomplianceleadingtohighercostsforindustryyetdisappointingreductionsintheaccidentrate.

2.4.1DesignoflegalrulesEconomicshasbeenusedtoprovideaframeworktoidentifythefactorsthatshouldgovernthechoicebetweenrulesandstandardsandbetweenexanteandexpostresponses.Thisisdrawnfromthelawandeconomicsliterature,butithasdirectapplicabilitytoregulatorydesign.

EhrlichandPosner(1974)werethefirsttosetoutageneralframeworksetaroundminimisingfourcategoriesofcosts:

the(fixed)costsofdesigningandimplementinglegalstandards(rulemakingcosts);thecostsofenforcingthestandards(enforcementcosts);thecoststhattheyimposeontheregulatedindustry(compliancecosts);andthesocialcostsimposedbyregulatoryoffences(harmcosts).

Totheseafifthcostcanbeaddederrorcosts.Judgesandregulatorsarenotomniscientorerrorproof.AsaresulttheymakeTypeIandTypeIIerrors,orsetoutlegalstandardsandrulesthatdonotencourageefficientbehaviour.ATypeIerroriswheretheregulatorfindsaninfringementwhenthereisnone.ATypeIIerroriswhentheregulatorfailstofindaninfringementwheninfactthereisone.Clearlysucherrorsreducethegainsfromcomplyingwiththelaw,andaltertheformallegalstandards.

Anefficientsetofrulesorastandardminimisesthesum(total)oftheseexpectedcostsandlossesbyselectingtheappropriatetypeofrule,andlevelandtypeofenforcement.

Shavell(1984)hasusedavariantoftheaboveapproachtoidentifythefactorsrelevanttothechoicebetweenexpost(liabilityrules)andexantesafetyregulation.Inhismodelthechoiceoftheoptimallegalresponsedependsonweighingfourfactorsamongvictimsandinjurers:

asymmetricinformationconcerningrisks;capacityoftheinjurertopay;probabilityofprivatesuit;relativemagnitudeoflegalandregulatorycosts.

(p.29) Expostresponses,suchastortliabilityandprivatelitigationinantitrust,areattractiveifthevictimisbetterinformed,potentialdefendantscanaffordtopayclaims,thereisahighprobabilityofsuitshouldtherebeanactionablewrong,andlegalprocesscostsarelow.Wherethesefactorsareweak,thenexantelawtechniquesbecomemoreattractive,eitherasasubstituteforprivateorpublicprosecutions,oracomplement.

Thechoicebetweenexanteandexpostlegalresponseshasbeenaperennialtopicinbotheconomicandsocialregulation.IthasfoundnewvitalityinlegalreformacrossEuropeastheEuropeanCommissionandnationalgovernmentsgrapplewiththebestwaytoregulateutilitieswhetherthroughantitrustlaws(anexpostresponse)

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orexantesectoralregulation.TheEU'sNewRegulatoryFramework, whichregulatesthecommunicationsindustry,hasemergedfromanintensedebateonwhethertocontrolthemarketpoweroftelecommunicationsoperatorsthroughgeneralcompetitionlaworspeciallycraftedpriceandaccesscontrolsadministeredbysectoralregulators.TheEuropeansolutionhasbeentodevelopanewsystemofexantesectoralregulationbasedonexpostcompetitionlawprinciples.YetanotherexamplehasbeenthemovetogivethoseharmedbybreachesofEUandnationalcompetitionlawstherighttosueandclaimdamages,thusprivatisingpartoftheenforcementprocess.

2.4.2ComparativeregulatoryeffectivenessEconomistshavealsobeguntoinvestigatewhysimilarregulatoryresponsesappearmoreeffectiveinonecountrythananother.Thishasgeneratedabetterunderstandingoftheregulatoryprocessandtheinterplaybetweenregulation,law,andeconomics.Oneapproachtothistypeofcomparativeanalysisisthetransactionscostsapproachassociatedwiththenewinstitutionaleconomics.

LevyandSpiller(1994)provideonevariantofthetransactionscostsapproach.Theyviewregulationasanimplicitrelationalcontract betweengovernmentandaregulatedfirmcharacterisedbyspecificinvestment,opportunitisticbehaviour,andcommitmentandgovernance.Thenetworkindustries(telecommunications,water,gas,electricity,andrailwaysnetworks)havespecificfeaturesthatmarkthemoutfrommostotherindustries:

(1)theirtechnologiesrequireheavyspecific,sunkinvestments;(2)theygeneratesignificanteconomiesofscaleandscope;(3)theyproducemassconsumed,oftenessential,services.

Regulatedfirmsinthesesectorsarerequiredtomakelargeassetspecificinvestmentsinnetworks,i.e.investmentswhichhavelimitedalternativeusesandsalvagevaluegivingrisetolargesunkcosts(andpotentiallystrandedassets).Governments,ontheotherhand,areoftennotboundtoadheretoagreementsandregulationstheysetoutwhentheregulatedfirmsmaketheseinvestments.Thiscancreatesignificantregulatoryriskstothefirmanditsshareholdersasgovernmentsand/orregulators(p.30) effectivelyexpropriatethereturnsbyincreasingregulatoryandindeedcompetitivepressures.

LevyandSpillerseeregulatorydesignasconsistingoftwocomponents:regulatorygovernanceandregulatoryincentives.Thegovernancestructureofaregulatorysystemconsistsofthemechanismsthatsocietiesusetoconstrainregulatorydiscretion,andtoresolveconflictsthatariseinrelationtotheseconstraints.Ontheotherhand,theregulatoryincentivestructureconsistsoftherulesgoverningutilitypricing,crossordirectsubsidies,entry,access,interconnection,etc.Whileregulatoryincentivesmayaffectperformance,LevyandSpillerarguethatregulatoryincentives(whetherpositiveornegative)onlybecomeimportantifeffectiveregulatorygovernancehasbeenestablished.

Thisrequiresthattheregulatoryframeworkbebasedoncrediblecommitmentsbybothparties.Weakregulatorycommitmentscreatepoorincentivesforinvestmentandineffectiveregulation,andthefailureofregulatoryreforms.

AninterestingaspectofLevyandSpiller'sapproachisthefocusonwhattheytermtheinstitutionalendowmentofacountrywhereinregulationtakesplace.Thisconsistsofhardvariablessuchasthenatureoflegislativeandexecutivebranchesofgovernment,theadministrativecapabilities,andjudicialinstitutions;andsoftfactorssuchascustomsandinformalnorms,contendingsocialinterests,andideology.

LevyandSpiller(1994)arguethatthecredibilityandeffectivenessofaregulatoryframeworkandhenceitsabilitytofacilitateprivateinvestmentvarieswithacountry'spoliticalandsocialinstitutions.Thisapproachissupported,forexample,byworkundertakenbytheWorldBank(2004),whichshows,forexample,thatthelegalheritageofacountryparticularlywhethercommonorcivillawhasameasurableeffectonthelevelofgovernanceandefficiencyoflegalinstitution,andalsooneconomicgrowth(Veljanovski,2008).

2.4.3MarketbasedalternativesTheobviousremedytomanyoftheproblemsidentifiedaboveistoabandonthecommandandcontrolapproachandadoptmarketsolutionsormarketbasedregulation.Thesevaryoveraspectrumoftechniquesthatfocusonoutcomesratherthaninputs,andseektogivefirmsandindividualsincentivestoadoptcosteffectivesolutions.

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Amongthetechniquesavailablearecreatingprivatepropertyrightsandmarkets,auctions,pricing,andfiscalincentives(taxesandsubsidies).

Creatingmarketsisthemostobviousresponsetomanyareaswheredirectregulationiscurrentlyused.Thiscantaketheformofcreatingandenforcingpropertyrightsinpreviouslyunownedresourcesandassets.Thisinturnharnessestheprofitmotivetopreventoverexploitationandhusbandnaturalresources.

ConsidertheplightoftheAfricanelephant.TheregulatoryresponseistohavestaterunNationalParksandamilitiatoprotecttheelephantsfrombeinggunned(p.31) downedbypoachers.Thegovernmentcanrespondtoincreasedpoaching(whichisaproductoftheworlddemandforivory)bymakingthepenaltiesforpoachingdraconianandburninganyconfiscatedivory.Butthisintheendonlysendsthemarketpriceofivorysoaringandincreasesthegainsfrompoaching.Analternativeresponseistoprivatisetheelephants.Ifelephantfarmswerepermitted,normaleconomicforceswouldensurethatthesepreciousbeastswerenotpoachedtoextinction.ThistypeofresponseishappeninginAfrica.

Inothercasespseudomarketscanbesetup,suchastradablepollutionoremissionrights.Forexample,marketableemissionorpollutionpermitscanbeissuedtofirmsuptothelevelofthedesiredcutback.Thepermitscanthenbetraded.Thiscreatesamarketinpollutioninwhichfirmswhofinditunprofitabletoreducethelevelof,say,toxicemissionssellpermitstootherfirmsthatcanachievereductionsatlowcostorwhichvaluetherighttopolluteveryhighly.Inthiswaythedesiredreductioninpollutionisachievedintheleastcostlyway.

Marketsolutionsarebeingusedinotherareas,suchasradiospectrum.Todaytheuseofmarketsolutionshasbecomeaccepted,butnotasyetafullyfledgedmarketinspectrum.AcrossEuropeandelsewhereauctionshavebeenusedtoallocatespectrumtothirdgeneration(3G)mobilephones.Thishastheattractionofbeingamoretransparentandfairerwayofallocatingspectrumthanthepreviousbeautyparadesbasedonadministrativeandtechnicalcriteria,andofcoursehasraisedconsiderablesumsofmoneyforgovernments.Further,reformsareafoottoextendtheuseofmarketstoallowlimitedtradinginspectrum,knownassecondarytrading,intheUK(CaveReport,2002)andEurope,ashasalreadybeenimplementedinNewZealandandAustralia.OnecountrythathasgonefurtherbyembracingamarketsolutionhasbeenGuatemala,underitstelecommunicationslawof1995.Spectrumrightstherehavebeenassignedonafirstintimebasisforusesdeterminedbythosefilingclaimswiththeregulatoryagency.Thosewhohavesecuredspectrumrightscannegotiatechangeofusesubjecttopredefinedtechnicallimitsdesignedtominimisetechnicalinterference.Thismarketdeterminedapproachappearstobeworkingwell(SpillerandCardilli,1999).

Theaboveattractionsofmarketsolutionsmustbequalified.Themerefactthatamarkettypeapproachhasbeenadopteddoesnotguaranteeitsefficiencyoreffectiveness.Thisisbecausegovernmentstillplaysalargeroleinsettingthenumberoftradablepermits,thedefinitionofinitialpropertyrightsandthetaxbaseandrates.Oftentheseareinappropriatelyset.Arecentexampleofgovernmentfailureinthisareawasin2006,whenitemergedthatsomeEUmemberstates(e.g.Germany)hadissuedpermitsallowingmorecarbonemissionthanthelevelofCO2producedbytheirindustries.TheresultwasnoexpectedreductioninCO2emissionsandmarketchaosasthepriceofthetradableemissionrightshalvedfromapeakof30to12pertonneoverseveraldaysinApril2006.Theauctionofspectrumlicencesisanotherexample.Whilethiscanplacetheavailablespectruminthehandsofthosewhovalueitmost,theuse,amount,andparcellingof(p.32) spectrumamongusersisstilldeterminedbygovernment,andtradinginspectrumislimited.Thuswhileanauctionandasecondarymarketcanmakeagoodjobofabadsituation,theoveralloutcomemaystillbefarfromefficient.

Anothersolutionistousepricestorationusageandguideinvestment.Theuseofpriceshasbeenadvocatedformanyyearsbyeconomiststodealwithroadcongestionandpollution.Theadoptionhasbeenhinderedbypoliticalresistanceandtheabsenceofatechnologythatwouldenablesuchpricingschemes.Asthevolumeoftrafficandcongestioninurbanareashasincreased,however,governmentshavebeenforcedtoseeksolutionsratherthanendlesslyattempttobuildthemselvesoutofcongestion.Singaporepavedtheway,andcongestionchargesimplementedincentralLondonhavereducedthevolumeoftraffic.

Thelastapproachisfiscalinstruments.Aregimeoftaxesisimplementedwhichreflectthesocialcoststhataharmfulactivityimposesonsociety.Thus,insteadofhavingenvironmentalcontrols,apollutiontaxisimposedonsomemeasureofemissionorsomevariablepositivelycorrelatedwiththelevelofpollution,suchasunitsofoutputsold.Byimposingataxonpollutionorinjuriesthatapproximatestheuncompensatedlossesimposedonother


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individuals,theindustryislefttodecidewhethercleanupiscosteffectiveandinwhatwaysitcanbeundertaken.Taxesmustideallybeplacedontheundesirableactivitythatoneisseekingtointernaliseordeter.Forexample,ifonewantstoencourageacosteffectivereductioninpollution,theidealtaxisanemissionorpollutiontaxwhichisplacedontheharmfuloutputoractivity.Imposingataxoncarsisnotefficientsinceitdoesnottakeintoaccountthelevelofemissionofdifferentcars,nordoesitencouragetheadoptionoflesspollutingengines.Thusthechoiceofthetaxbaseandthetaxlevelareimportant,asaretheenforcementcosts.

2.5RegulatoryImpactStudiesWhetherandtowhatextentregulationachievesitsstatedgoalsisanunderresearchedsubject.Regulatoryimpactstudiesseektopredictandmeasuretheimpactofregulationoftenusingsophisticatedempiricaltechniques.Sometakethisfurtherbyundertakingcostbenefitassessments(Hahn,2008;HahnandTetlock,2008;RadaelliandDeFrancesco,2010thisvolume).

Impactstudiesarenotstraightforward,easytoundertake,orcommon,andoftentheirqualityislow.Thefirstreasonisthatoftenthedatarequiredtoundertakeanimpactstudyareunavailableorincomplete.Thesecondreasonisthattheeffectsofregulationmaybedifficulttoidentifyandpredict.Toillustrate,considerseveralexamples.

(p.33) Themarketfailureapproachinterpretsenvironmentalandindustrialsafetylegislationasresponsestodealwiththeinabilityofmarketstoprovideadequateprotectionofworkers,consumers,andthepublic.Thisisoftenthestatedintentionofsuchlegislationandassumedtobeitseffect.Yetempiricalresearchoftenfailstofindsignificantimprovementsinenvironmentalqualityandsafetyarisingfromsuchlaws,evenwhiletheyincreaseindustrycostssubstantially.Thissuggeststhatthereisindustrycompliancecoupledwithlowimpactinachievingstatedregulatoryobjectives.Onereasonforthefailuretohaveabeneficialimpacthasbeentheexcessiveuseofcommandandcontrolapproaches.

Thereisanotherfactorwhichoftenexplainswhytheactualimpactofregulationondesiredgoalsislessthanpredictedorestimated.Firms,management,workers,andconsumersoftenrationallyadapttotheseincreasedcostsandconstraintofregulationbyrelaxingunregulatedeffortsandinputswhichmaybemoreeffectiveinreducingaccidents.Resourcesaresimplychannelledintocompliancewithineffectivelaws,ratherthanintopreventingaccidentsinthemosteffectiveway.ThistypeofadaptiveresponseisgraphicallyillustratedbyacaseunearthedbyKaganandScholz(1984)intheirstudyoftheenforcementofindustrialsafetyregulationbytheUSOccupationalSafetyandHealthAdministration(OSHA).AsteelcompanybecameembroiledindisputeswithOSHA,whichduringthe1970sadoptedanaggressiveenforcementpolicy.Oneofthefirm'simmediateresponsestowhatitregardedasunreasonablepersecutionsbyOSHAwastosackthetrainedsafetyengineerwhoheadeditsaccidentpreventionprogrammeandreplacehimwithalawyerchargedwithlitigatingOSHAprosecutions.Thisoutcomeisaclearexamplewheretheresponsewastosubstituteoneinputforanother(inthiscasetodealwithregulation)thatwaslesseffectiveinreducingharmandimprovingworkerwelfare.

Theeffectsofsuchsafetyregulationdonotstopthere.Ithasindirecteffects.Ifregulationisstringentandvigorouslyenforced,itraisesafirm'scostsandmakesentryintotheindustrymoredifficultforthesmallerfirm.Iffirmshavedifferentcompliancecosts,owingtotheirsize,location,ortheproductionprocessused,thenregulationwillhaveamorepronouncedimpactonsomefirmsthanothers.This,inturn,willdisadvantagethosefirmsbearinghighercosts,andthehighercostswillactasabarriertotheentryofnewfirmsortheexpansionofsmallfirms.Anumberofempiricalstudieshaveconfirmedthis.

AstudyofUSindustrialsafetyandenvironmentalregulationsbyBartelandThomas(1987)foundthattheseraisedtheprofitsofindustrieswithahighproportionofworkersinlargefirmsorinthefrostbelt,whilethoseindustrieswithalargenumberofsmallfirmsorlocatedinthesunbeltlostprofits.Thatis,theyactedtogiveacompetitiveadvantagetolargerfirmsandthoseinparticularlocations.Thisisexactlytheoutcomethatpublicchoicetheoristswouldpredictestablished,politicallyeffectivefirmsoftenlobbyforlegalisticcommandandcontrolapproachestoregulationspecificallybecausetheyimposegreatercostsoncompetitorsandenhancetheirownprofits,andthisexplainswhyindustryisoftenhostiletotaxand(p.34) liabilityapproaches,whichwouldhittheirprofitsimmediately(BuchananandTullock,1975).Oritmayjustbetheunintendedconsequence.Eitherwaythesecostsandconsequenceswhicharewiderandmoresubtleareoftennottakenintoaccountanddifficulttomeasure


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retrospectively.

Anotherinterestingillustrationofadaptiveoffsettingresponsesistheexperiencewithcompulsoryseatbeltlegislation.Thereisnowfairlyconclusiveevidencethattheneteffectofseatbeltlawshasbeensmall.Thisisnotbecausetheyareineffectiveinprotectingvehicleoccupantsbutbecausetheyencouragerisktakingandaccidentsbydrivers.Compulsoryseatbeltlegislationreducesdriverrisksandinjuries,whichcanresultindriversadjustingtheirbehaviourbydrivingfasterandwithlesscare.Thiscanleadtofewerdriverfatalitiesandmorepedestrianfatalitiesandinjuries,anddamagetovehicles,thusincreasingaccidentcosts.Theeconomicsofthedrivers'decisionissimpletoexplain.Acompulsoryseatbeltrequirementdecreasestherisksandharmtothedriverwhichcauseshimorhertoundertakemoreriskyaggressivedriving.

Peltzman(1975)testedthissimpleeconomicpropositionusingtheUSNationalTrafficandMotorVehicleSafetyAct1966,whichmadethewearingofseatbeltscompulsory.Usingstatisticalanalysis,hefoundthatoccupantdeathsperaccidentfellsubstantiallyasexpected,butthisreductionwasentirelyoffsetbymoreaccidentstothosenotprotectedbyseatbelts,i.e.pedestriansandcyclists.Whilethisfindingwasridiculedatthetimeasfanciful,subsequentresearchbyeconomistsandtrafficsafetyengineershasconfirmedthatcompulsoryseatbeltlegislationhasnotresultedinameasurabledeclineinroadfatalities(Adams,2001).Indeed,Peltzman(2005)hasrevisitedhisoriginalresearchtonotethattheannualrateofdeclineinhighwaydeathsintheUSAwas3.5percentfrom1925to1960,beforethelegislationwasenactedandattheheightofNaderism;andbetween1960and2004itwasalso3.5percent!

Thetheoryofoffsettingbehaviourisevidentinmostcommandandcontrollegislation.Minimumwagelaws,rentcontrols,sexualandracialdiscriminationlaws,andaffirmativeactionlawsallleadtoadaptiveoroffsettingeffectsthatreduce,sometimessubstantially,theirimpact.Individualsandfirmsseektominimisethecoststhattheselawsimpose,andthisleadstoawiderrangeofsubstitutioneffects,whichmayoftennotbeinthedesiredorexpecteddirection.

2.6ConclusionToparaphraseKeynes,theeconomicsofregulationisnotasettledbodyoffactsbutanapproach.Itusestheeconomists'toolkittodeveloppoliticaleconomytheoriesofregulation,andtoassistregulatorswiththetechnicaldetailsofframingeffective(p.35) regulation.Itishoweverstillinitsformativephases.Thereremainmanypuzzlesandparadoxestobeexplainedsuchasthetremendousgrowthinregulationinparallelwithgreaterroleplayedbymarketsandeconomics;thenatureofregulatoryfailure;whatpropelspublicinterestregulatoryreform;andwhatexplainsthesedifferentregulatorystylesandapproaches.

IamgratefultoDavidRound,DavidStarkie,andMartinCaveforcommentsandadviceonanearlierdraft.

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Notes:(1.)AlsoseetheclassicbutdatedtextbyKahn(1970)whichtakesthisnarrowerview.

(2.)Councilregulation(EC)No139/2004ControlofConcentrationsbetweenUndertakings.

(3.)Thetermexpectedhereisusedtotakeaccountofriskanduncertainty,expectedbeingusedinthesenseoftheexpectedvalueofanuncertainoutcome,andtoemphasisethateconomicefficiencyisanexanteconcept.

(4.)Economistshavegenerallyassumedratherthanestablishedmarketfailure.Aclassicexampleoftenusedineconomicstextsisthebeeandapple.AccordingtothedistinguishedeconomistJamesMeade,whenbeesmakehoneyfromandpollinatetheappleblossomsthisisanexampleofareciprocalexternalbenefitswhichthemarketfailedtotakeintoaccount.Cheung's(1973)studyofbeekeepingshowedthatthiswasnotthecase,andmarketsdiddealwiththisintheabsenceofgovernmentintervention.InWashingtonStatetherewasanactivemarketinnectarandpollinationserviceswhichwasevenadvertisedintheYellowPagestelephonedirectory.Cheung'sstudyshowedawelldevelopedsetofcontractualpractices,whichevendealtwithotherexternalitiesarisingfromstrategicbehaviourwhereapiaristscontractedforfewerbeehives,takingadvantageofpositivebenefitsofneighbouringorchardists,and,secondly,theuseofpesticidespraysdamagingbees.Manyoftheotherexamplesusedbyeconomiststurnoutnottobemarketfailure(Spulber,2002).

(5.)StiglermakesuseoftheinsightsfromtheearlierworkofDowns(1957)andOlson(1965).AseparateliteraturelooksattheeconomicsofbureaucracyandagencybehaviourstartingwithNisakanen(1971).

(6.)Directive2002/21/EConacommonregulatoryframeworkforelectroniccommunicationsnetworksandservices,24April2002(FrameworkDirective);Directive2002/19/EConaccessto,andinterconnectionof,electroniccommunicationsnetworksandassociatedfacilities,7March2002(AccessDirective).

(7.)ThetermcomesfromthewritingsofIanMcNeil(1980),alawyer,inaseriesofarticlesbeginninginthe1960s,andhasbeendevelopedintoaneconomicmodelofcontractbyWilliamson(1975)andothers.Viewsaboutrelationalcontractsdiffer,withMcNeilseeingthemlargelyaslongtermpersonalcontractswhereaseconomistsviewthemascontractswhereassetspecificityiscritical.

CentoVeljanovskiCentoVeljanovskiisManagingPartneratCaseAssociates(London)andAssociateResearchFellowattheInstituteofAdvancedLegalStudiesattheUniversityofLondon.


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