NOTE ON REGULATORY CHOICESGROUP 6 DE V I NA M , E VA D, K A I L A S H H, N I K HI L K , RA TNAVA L I B

INTRODUCTION Government interaction influences firm conduct industry structure

Government intervention in the form of Deregulation Regulatory schemes

Knowledge of these schemes important for managers to Devise specific business strategies Understand approaches that provide scope for long term private sector involvement

WHY REGULATE? Often to enhance public interest What is public interest? Munn vs. the State of Illinois 1877 When 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

Two contrasting opinions on what has been taken up as public interest interventions Enhance social welfare Promote self-interest of citizens, interest groups, politicians

INTERVENTIONS TO PROMOTE SOCIAL WELFARE Hypothetical free market economy Individuals seek to maximise self interest Perfect competition Full market Efficient outcome

The perfect economy might not exist in reality due several market failures Government intervention required to raise social welfare But why do markets fail?

MARKET FAILURES MARKET POWER CONCERNS Market power - Natural monopoly characteristics present Industry controlled by a few players Lack of good substitutes High entry barriers High economic efficiency

Market power - Natural monopoly characteristics absent Artificial market segmentation Buy up competitors Deter new entrants

Government interventions to address market power Change industry structure to get markets to resemble competitive market Enforce penalties in case of abuse

MARKET FAILURES EXTERNALITIES Competition fails to address the actions of the firms which affect individuals but are not reflected in the prices faced by individuals Negative externalities associated with untreated effluent discharge Positive externalities arriving from safety conditions provided by firms which are not rewarded

Government intervention are carried out to avoid such market failures by providing subsidies for the positive externalities and taxes for negative externalities.

MARKET FAILURES IMPERFECT INFORMATION Competition also fails to maximise social welfare when there are other weaknesses beside imperfect competition Imperfect capital markets where the lenders have limited information about the borrowers Information Asymmetry between the buyers and sellers of goods & services. . For example a flier may not have sufficient information on the safety measures deployed by different airlines to make an informed choice.

Government interventions in such cases may bridge the gaps

INTERVENTION FOR PUBLIC FINANCE Equity Vs Efficiency It is impossible for govt to intervene and reallocate resources without affecting the actions of individuals. Hence there is always a trade off between Equity and Efficiency Govt may intervene to address their equity goals to favour some firms and burden other firms For example most environmentally friendly technologies are favoured Interventions for neutralising effect of externalities

INTEREST GROUP POLITICS AND GOVT INTERVENTIONS Interest group politics What political actors might do is different from what in fact they do Politicians intervene for reasons contrary to industry interest if they are to benefit from certain vote banks Politicians may act in the interest of the industry, against social welfare if they are to gain monetary benefits through bribes

Demands and costs of political interventions Different interest groups have different costs of mobilization Consumers and citizen groups are difficult to mobilize where business groups are smaller in numbers hence easier to mobilize

Competition for political intervention Concentration of benefit groups on both sides of interventions helps to predict the type of political relationship may evolve and the likely outcomes

FORMS OF GOVERNMENT INTERVENTION

Concession Contracts

Rules for firm conduct

Use of antitrust rules

Regulation of industry structure

COMPETITION , INFORMATION AND CONCESSION CONTRACTS Market failures, monopoly Is continual regulation of an industry a good option? Where competition in the market is not possible, why not substitute competition for the market? auctions for the right to serve people Advantages Government need not have more information than the firms seeking the right to serve

Note of caution The auction design should be competitive enough and the winner is the bidder who guarantees the citizens the lowest price to serve

Examples U.S Cable industry ; U.K rail passenger service

ISSUES IN IMPLEMENTATION Imperfect initial bid Lack of bidders Imperfect information for bidders Collusion amongst bidders

The need for monitoring Hard to measure goals Difficult to investigate compliance

The ability to resell the right to serve in a competitive auction regularly Usually the rebids are not competitive Renegotiations of contract terms because the contract is incomplete

INDUSTRY CONDUCT REGULATION Traditional Pricing To whom to sell products

Method Cost plus method Issues Info gap between government and the regulated firm Corruption in the regulatory process Weak incentives for the firm for cost efficiency

COST-BASED/RATE OF RETURN REGULATION Should reflect its costs of production and not the consumers willingness to pay. Charge rates that will result in a profit to a fair rate of return on the capital invested. If profits fall below this level, the firm can request a rate increase in a rate case Rules and constitutional statutes implemented by regulatory bodies and the legal system Time period between rate cases vary Revenue requirement = operating expenses + (Depreciated Rate Base*Rate of Return) Average Rate = Revenue requirement/ Expected Demand

COMPONENTS OF PRICE THAT THE FIRM CHARGESLegitimate operating expenses

The firms expected demand

Components

Firms depreciated rate base

A reasonable rate of return on the rate base

EVALUATING COST-BASED REGULATIONFirm Viewpoint

Advantages Framework for insuring financiers Diminishes the risk to investors (stabilization of future revenues of projects with long term payback) Demand risks are adjusted in the formula Cost risks are adjusted by prior regulatory approval

But.. If allowed ROR exceeds the firms true Cost of Capital, firm has an incentive to overinvest in capital Little incentive to keep operating expenses down Incentive to game the timing of rate cases Will seek rate relief only when the costs go up, try to evade regulators if the costs go down

And Zealous regulators will. Impose onerous reporting requirements Require regulatory approvals for large investments Do not allow firms to participate in certain non-regulatory businesses

EVALUATING COST-BASED REGULATIONRegulatory Viewpoint Advantages Serves public interest well Other objectives

Disadvantages Burdensome and detailed nature of rate casework Gaps in information held by firm and Government Subjective judgments might result in firm lobbying Untimely decisions due to time lag

INCENTIVE BASED REGULATION Regulations to provide greater incentives for producing the services at low cost. Price Cap Broad Based and Common Form of Incentive based regulation. Other Forms of Incentive based regulations (Hybrid)

PRICE CAP REGULATION FRAMEWORKRegulated Price Level -Review YearMechanism for Automatic Adjustment over the initial period - Cap PeriodPrice Cap Regulation For Specified years - Next Review Year Specified -

EVALUATING PRICE CAP REGULATIONFirm View Point Advantages Profits only limited by firms ability to lower their cost. For Investors, they have the advantage of fixed legal contract.

Disadvantages Firm will lose if it cannot keep cost below price cap. Firms financial stability might be threatened. Uncertainty at each price review might be a disincentive for efficiency.

EVALUATING PRICE CAP REGULATIONRegulatory View Point Advantages Bureaucracy can be reduced. In Public Interest.

Disadvantages Vulnerable to information gaps Inflexibility to changing economic circumstances

INDUSTRY STRUCTURE REGULATION Changing the Industry structure to increase competition. Forcing the firm to break up into multiple competing firms Restricting mergers in the same Industry

Approach of vertical unbundling Influence the rules regarding vertical integration

Outlawing anti competitive practices Influence the rules for the exceptions

DEGREE OF INDEPENDENCE OF THE REGULATOR Independence of regulator is indicated by length of appointment, terms, funding Dimensions of regulatory independence Decision making Where the regulators are located

Independent thinking in regulators can be enhanced by Appointing professionals trained in law, economics or business Appointment terms not coinciding with electoral cycle Exemption from civil service status, for higher salaries

Costs of regulatory independence Possible limited knowledge of the regulator in the evolving industry Regulators might take decision that are not politically sustainable

HOW ARE DECISIONS MADE? Government decides Kind of decision making process Number of regulators to be involved

Regulatory Commissions For permanent, impartial, technical experts to control the industry under regulation Advantage formal deliberative process for all interested parties to submit their views Disadvantage Time consuming, adversarial, costly

Single-Person Regulator To centralize decision-making authority with staff support Advantage Speed, lesser resources required, accountability Disadvantage Singular perspective, vulnerability

REGULATORS INDUSTRY SCOPE Final decision for Government in designing regulatory authority Based on state of the industry, economy and technology at the time Industry-specific regulators Multi-sector regulators

REGULATORY CHOICES AND BUSINESS STRATEGY Great variety of regulator choices Same industry e.g. Telecommunications in US and New Zealand Country level differences e.g. Telecommunications and electricity in Germany

Number of common functions that can be addressed Improving competition to address social concerns Reducing information gaps Defining and enforcing property rights

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