Understanding Economic Regulation

In the daily life, one frequently faces economic phenomena that seem so strange or difficult to understand, especially related to regulatory actions. Therefore, understanding economic regulation may help one in responding facts or events which occur. Here is simple note about the topic which is summarized from several references presented in the end of this blog.

What does economic regulation?

• Regulation is “a state imposed limitation on the discretion that may be exercised by individuals or organizations, which is supported by the threat of sanction.”
• However, market power still plays a large role because it is impossible to intervene every decision of firms and consumers.
• Furthermore, economic regulation “refers to government-imposed restrictions on firm decisions over price, quantity, and entry and exit”.

When does economic regulation happen?

• Basically, there are two common conditions in which government intervention occurs. Firstly when an industry is natural monopoly or secondly when it is plagued by externalities.

Who are the regulatory actors?

• Regulation occurs through legislative action (legislator) and the behavior of the regulatory agency (regulator).

• We should notice that judiciary also has key role in the regulatory process. When a regulation needs to be reinterpreted (to implement a change), it must need judicial consent.

How does regulation affect the economics agents?

• Regulation controls the market through three main variables which are:

Control of price. Regulation may set a price that firms must charge, or restrict firms to setting prices within a range. In regulated industries (public utilities), it is common to set price so that the firm earns a normal rate of return. Another form is price incentives such as imposing a tax on various activities.

Control of quantity. Generally regulation set maximum production limits. Controlling quantity may be used with or without price regulation. In electricity industry, for example, the regulator sets the price while leaving quantity as unregulated. However, in the oil industry, oil production for OPEC members is set while allowing the price to be determined by the international market.

Control of entry and exit (Number of firms). Regulation may control entry by new firms, and also entry by existing regulated firms into a new industry or new geographic market. Actually, controlling price and number of firms are the main targets of regulation because both are keys for promoting allocative and productive efficiency.

• In fact, regulation occasionally controls other variables such as quality of product and firm’s investment.

Why does economic regulation exist?

• Mainly, three theories exist to explain the reason behind certain regulation occurs. These three theories are: (a) Public Interest Theory or Normative Analysis as Positive Theory (NPT); (b) Capture Theory (CT); and Economic Theory of Regulation (ET).
• In general, the conclusions of these theories are that regulation occurs because (1) the government is interested in overcoming information asymmetries with the operator and in aligning the operator’s interest with the government’s interest; (2) customers desire protection from market power when competition is non-existent or ineffective; (3) operators desire protection from rivals; or (4) operators desire protection from government opportunism.
• More explanation of those three theories as follows.

References:

1. General Concepts/Theories Regulation. (2012). Retrieved 01 2012, 2012, from Body of Knowledge on Infrastructure of Regulation: http://www.regulationbodyofknowledge.org…
2. Loomis, D. G. (2011). ECO 335 Economics of Regulation and Antitrust. Lecture Notes.
3. Viscusi, W. K., Harrington, J. E., & Vernon, J. M. (2005). Economics of Regulation and Antitrust. MIT Press Book.