Public regulation in a market economy

ARGUMENTA OECONOMICA No 2 (I I ) 2001 PL ISSN 1233-5835

INAUGURAL LECTURE FOR OPENING THE ACADEMIC YEAR 2001/2002

Bogusław Fiedor

PUBLIC REGULATION IN A MARKET ECONOMY

1. INTRODUCTORY COMMENTS - MARKET AND STATE AS CO-ORDINATING AND OPTIMALIZING MECHANISMS

IN ECONOMIC ACTIVITY

D isc u ssio n regarding c o -o rd in a tin g and o p tim iz in g functions of the state and th e market was tra d itio n a lly based on th e assu m p tio n which can be d e fin e d as the dichotom ous co n tra stin g o f ‘an id e a l m arket’ or perfect c o m p etitio n , and an ideal sta te . In this p re se n ta tio n , I start from a co m p letely diverse m eth o d o lo g ic al prem ise, b a se d mainly on the ach ie v em en ts of New P olitical E conom y, (frequently a lso called the theory of p u b lic choice), or in a slig h tly broader in te rp re ta tio n , new institutional ec o n o m ics, whose creation and developm ent is c o n ta in e d within the last thirty y e a rs. The functioning o f every, and also th e re fo re a fully m ature m arket sy stem should be seen in com parison to th at e x is tin g in reality and not m odel institutional a lte rn a tiv e s such as an ideal m ark e t and an ideal state. T h e re fo re follow ing D e m se tz , a distinguished rep resen tativ e of this new tren d in modern econom ics, (he is in p artic u la r o n e o f the co-creators of the th e o ry of the ow nership rig h ts which, to g e th e r w ith the theory of tra n sa c tio n a l costs, co nstitutes a com pletely new b a sis fo r exam ining the m arket an d state as altern ativ e co -o rd in atin g m ech a n ism s). I assum e that the d ic h o to m y - a perfect m ark e t and a perfect state sh o u ld be replaced by d ichotom y im perfect m arket - im p erfect state (D e m se tz 1982). This also m eans th a t the im perfections o f the m arket tra d itio n a lly analysed on the basis o f th e theory of e c o n o m ic s (m arket failu re s), sh o u ld be contrasted with the im perfections of the s ta te (state failures). T h e la tte r are above all co n n ected w ith the fact that in p ra c tic e we cannot ta lk a b o u t a uniform aim of a c tiv ity as subject re g u la tin g the functioning o f th e econom y because p a rtic u la r state institutions ca n be characterized by diverse sets of p re fe re n c e s. (It cannot be e ith e r excluded that they c a n be contradictory).

And a lso d iv erse are p o ssib ilities o f exerting p ressu re to achieve particular aims in m acro-econom ic policy. S uch possibilities can b e different because of the v a ry in g access to in fo rm atio n (Fiedor 1992).

The second assumption of the analysis conducted in this dissertation is as follows. T he problem of state (public) economic regulation in the market system is considered in the context of general, neo-classical, methodological premise that all form s of public regulations aim not at replacing the m arket but only at its widely interpreted improvement in the area of its co-ordinating and optimizing functions. Thirdly, the neo-classical approach also implies that the problem of public regulation should be seen according to a m ethodological paradigm of individualism which in this case m eans mostly the necessity o f including costs and benefits achieved by individual participants of ‘regulating game’: political institutions, direct regulators (regulating agencies), and regulated economic subjects. T his approach refers in particular to the so-called economic theory of regulation, to which I shall return in a later part of the lecture.

In ec o n o m ic literature (p a rtic u la rly Am erican o n e), dealing with the problem s o f state regulation in a m arket econom y, th e re is som etim es applied a distinction betw een eco n o m ic and social regulation. W ithout offering sh a rp e r definitions at th is m om ent, we can s ta te that the scope o f econom ic regulation involves th e direct in flu en c in g o f conditions of prod u ctio n and the ac cessib ility o f the m arket fo r econom ic subjects; w hilst so c ia l regulation reg ard s m ostly the safety an d health of people regarded as consum ers and c itiz e n s. Therefore it d e a ls with safety o f co n su m p tio n o f goods and se rv ic e s, health, en v iro n m e n t protection, and safety an d hygiene of work. B e c a u se of the re stric tio n s o f size in this p re se n ta tio n , I will omit this d istin c tio n , assum ing in particu lar that all form s and k in d s of social re g u la tio n imply directly o r in d irec tly the effects co nnected w ith costs and co m p etitiv en ess such as e x is ts in the case o f narrow ly in terp reted econom ic re g u latio n .

In th is co nclusion of my in tro d u c tio n , I would also lik e to stress that the subject o f th is lecture deals o nly a n d exclusively w ith re g u la tin g the sphere of the real econom y and th e re fo re that it leaves o u t specific problem s co nnected w ith regulating fin a n c ia l sector or fin an cial m arkets. It is at the same tim e c le a r that regulations regarding this sec to r in directly, but to a sig n ifican t degree, can influ en ce th e conditions o f fu n c tio n in g , supply and dem and, an d com petitiveness in ‘the real m arkets’. P rim e examples here are all th e regulations in flu e n c in g the conditions o f creatin g credit by banks o r b an k in g prudential re g u la tio n s.

2. THE NOTION (DEFINITION) AND GENERAL CLASSIFICATION OF REASONS FOR PUBLIC REGULATION

IN A MARKET ECONOMY

B oth in specialist literature and in practice o f th e activities of public institutions dealing with econom ic regulation, we can com e across very diverse, narrow and broad definitions of regulation. F o r example, Stigler presents a very broad, and therefore insignificant in an operational sense, definition, which describes econom ic regulation as a result of the state exercising its power to coerce (S tigler 1986).

Kahn, w hose definition of regulation is widely used in economic literature and in the practice of regulation, accepts that in d efin in g this category one should m ostly refer to the fact th at in reality the su b jects of regulation are above all the infrastructural sectors o f the economy and operating within them utility com panies (both public and private). Hence, eco n o m ic regulation means defining by the government the main aspects o f stru ctu re and economic activity o f public utility com panies (Kahn 1991). Such definitions seem too narrow bccausc they leave out the fact that the intended purpose of state activities can also be influencing the sectors of industry and services which are not o f an infrastructural nature, o r influencing the decisio n s of consumers. Therefore, in accordance m ostly with the interpretation o f Spulber, public regulation in a market econom y w ill be ultimately d efin ed as follows: public regulation o f economic activity constitutes general principles or specific actions o f government agencies o r other subjects o f public administration which directly influence the allocation m echanism o f the market via influencing the decisions of producers and consum ers regarding supply and dem and (S pulber 1989).

So interpreted, into public regulation, we can and sho u ld include, although it is not so in the literature o f the subject, the activities o f som e corporations of public law . This means corporations which are the organs o f professional self- governm ent (medical, judicial) active in the so-called professions of public trust if these activities influence the conditions of supply and availability of services in the markets corresponding to these professions.

W e should not include how ever in public regulation such activities of the state w hich serve to promote econom ic growth, or eith er stim ulating or slowing prosperity conducted within fundam ental m acro-econom ic policies: monetary, fiscal and comm ercial. In this case this would mean identifying regulation with all form s o f state intervention in the economic sphere. A similar argument implies th at as to public econom ic regulation, we sh o u ld consider activities

undertaken within the so-called selective sector policies (industrial, agricultural, etc).

R em aining within the neo-classical approach, as I defined it in the introduction to the lecture, the need for public regulation within the market econom y should be connected w ith the fact that in m any real markets we can observe failures of the market m echanism in achieving a state which is in accordance with the fundamental assumptions o f a m odel of a perfect com petitive market: effectiveness o f allocation, equilibrium , maximization of the p ossible to achieve econom ic surplus that is social welfare (Pareto optim um ). T hese so-called m arket failures (im perfections) can be divided into two large groups:

1. failures connected with abusing the principles o f com petition;

2. failures connected with the functioning of the system of individual (private) property laws (laws o f disposing).

B ecause o f limited space, we do not enter into a detailed classification of the varieties o f market failures connected with these tw o groups. I shall restrict m yself to listing those among them which occur most frequently or have the broadest area o f occurrence, and because of that, are m ost often the subject of public regulation.

a) S ituations of monopoly, including in particular those connected with natural m onopolies. Natural m onopolies occur most frequently in public utility sectors, and other infrastructural sectors. A certain sector is a natural monopoly when the total costs o f producing a specific hom ogenous goods are always sm aller when it is produced by one company and not by several, as in conditions o f a competitive solution. In a more formal way, a natural monopoly can be d efined as a situation w here in the long-term curve the average costs in a given branch shows a constant decreasing trend. In o th er words, there occur long-term econom ies of scale in this sector. Natural m onopolies have very frequently a local or regional nature, and can be connected with companies with a relatively small scale of production or services rendered (for example, entities providing heating, water, sanitary services etc) (S harkey 1982).

b) O ccurrence of so-called direct externa! effects both negative and, what is more rarely noticed, positive ones (connected for exam ple with environmental protection, the educational process, creating and spreading scientific and technical knowledge). This can lead both to excessive (in relation to the level m axim izing social welfare), and insufficient (in the case o f external benefits) supply o f certain goods and services.

c) O ccurrence of public goods therefore goods characterized by their non­ rival nature o f consumption w here this consumption also frequently generates external effects.

d) Inform ation imperfections creating unjustified com petitive advantage for certain subjects or unabling other subjects making optim al decisions from the m icro-econom ic viewpoint.

e) O ccurrence of uncertainty and risk (Forlicz 2001).

Let m e underline this once again. Public regulation does not signify replacing the market. It is used only to remove m arket failure or also (generally) to minimize negative social and econom ic results of their occurrence. In effect, regulation serves the growth o f the effectiveness of the allocation mechanism of the m arket. There is even th e possibility of the situation w here regulation creates certain new m arkets. T his can take place owing to creating institutional solutions without which m arkets cannot be even formed, o r are functioning very poorly. Such an exam ple could be: the market of tradable permits for certain types o f pollution, or the m arkets of scientific and technical information which can function effectively under the condition that the state creates for them such regulations as: a system of administrative concessions, system of patents and licenses etc.

At the beginning of the lecture, I mentioned that, in the real world, the institutional alternative that we deal with is generally n o t a perfect market versus perfect state, but an im perfect market versus an im perfect state.

P articu lar dimension of this alternative comes from the fact that, frequently, the ineffective functioning o f a certain market has its source in errors of the state or, to put it more precisely, in particular parliam entary bodies formulating regulations or regulative agencies responsible for th eir implementation and functioning. A spectacular current exam ple here is the regulation of the power generating sector in the USA, particularly in C alifornia (in American tradition, regulation has a frequently decentralized nature, which m eans it is realized at state level). The energy crises in C alifornia in 2001 w as in fact the result of regulatory errors occurring m ostly from the effect o f enforcing on the com panies very high standards regarding security and safety and environm ental protection, w hilst at the same time they h ad no possibility of transferring respective costs to the prices paid by co nsum ers which inevitably had to lead the companies o f this secto r to financial crisis.

3. FO R M S AND M E T H O D S O F R E G U L A T IO N

P ublic regulation and m arket econom y can be and is realized using a very diverse set o f instruments. Firstly, it results from the n ecessity for the precise addressing o f diverse, as I m entioned before, form s o f market failures. Secondly, it is caused by the specific technical and econom ic nature of the regulated sectors of the econom y. Thirdly, it results from the specific nature of

the co ncrete aims which the regulating agencies want to achieve thanks to the use o f certain instruments. Due to restrictions of space, I shall limit myself to showing such regulating instrum ents which are m ost frequently implemented in practise (Kahn 1991):

1. C ontrols of entering a given sector (entering a market). This is connected with the varied concessions and adm inistrative permits. However, som etim es this control can have an indirect character. I shall use here the example o f the fishing industry o f New Zealand, w hich is one of the most im portant sectors of the economy in this country. Using the criteria of the long­ term sustainability of resources o f certain species o f fish, the government determ ines only the so-called global quotas of catchm ent, and their allocation among p articular companies takes place as a result o f the m arket actions.

2. C ontrol of costs and prices. T his can contain m any kinds of regulating activities. A m ong them:

■ direct determination of prices, the dynamics or top-level of prices

■ determ ining the principles o f shaping prices, for exam ple through the so- called ta riff systems (especially in the case of the pow er industry)

■ determ ining the kind and level of costs that can be included when calculating prices. Frequent phenom ena here are reg ulating errors stemming from the fact that the com panies do not have any, or to an insufficient degree, the possibility of including costs w hich are indispensable to their functioning and developm ent. And so for exam ple, before the introduction of new energy law in Poland (1998), the existing regulations did not allow for the inclusion of financial costs connected with the modernizing and development of investm ents, including investm ent in environmental protection.

3. D irect influencing of profitability through:

■ setting a possible ( ‘sen sib le’) rate of return on invested capital; the method frequently used in the sectors o f infrastructure.

■ determ ining the possible pro fit margin; the solution frequently used in regulating w ater and sewage m anagem ent.

4. Determining the quality and conditions of rendering services in connection with the mechanism of issuing administrative permits. The exam ple here can be the regulation o f the radio and TV broadcasting market and the telecommunication market in many countries. In particular, regulations regarding them frequently include a clause of ‘common availability’ in the area where the regulated company is active. Such availability in conjunction with the principle o f non-discrimination in terms o f pricing towards the receivers of the service often forces the companies into so-called cross-subsidization their services and products; that is covering the deficit connected with the services rendered for certain (for example, regionally defined) groups of consumers, high profits obtained from the sales of such services

and products to other groups o f consumers. Determining standards regarding quality and conditions of services rendered can sometimes, as for example in the sector o f telecommunications, result in the necessity o f making significant investments, therefore high costs which in practice will also influence the ‘conditions o f exit’ (high sunk costs act as a two-way barrier both on the side of entering a given market and the exit from it).

5. A pplying standards o f safety, ecological, technical and other nature. This instrum ent has a fundam ental significance in environm ental protection as well as in protecting the health and safety of consum ers. A nd it is frequently applied, som ew hat independently, in relation to other reg u latin g tools.

4. THEORETICAL PREMISE OF REGULATION

The public regulation of a m arket economy can and should be considered also on a strictly theoretical level, therefore through referring to the theory of general equilibrium, category of social w elfare (optimum Pareto), as well as to fundamental methodological assum ptions, especially - if w e assume as it is in this presentation the neo-classical approach - the assum ption o f methodological individualism. Theoretical reflection on the public regulation allows for a fuller understanding of its essence and reasons and also can contribute to such m odification of institutions and regelating instruments w hich will result in the increase o f its efficacy and efficiency. Lastly, such a reflection can also justify the need for the complete or partial deregulation of certain sectors, the process of which can be observed in the econom ic reality of the m ost developed countries within the last twenty years. T he character and extent o f this presentation results in the fact that further on I shall restrict myself to a very synthetic presentation of the fundam ental theories of regulation in a modem econom y (Spulber 1989; Viscusi, V ernon, Harrington 1997).

4.1. Normative theory of regulation

In a perfectly competitive m arket, in the state o f g eneral equilibrium, the m axim izing o f social welfare takes place, that is, equilibrium is Pareto optimal. Such a fundam ental statement o f neo-classical econom ics, translated into the language o f practise, means that individual decisions regarding supply and dem and m ade by the owners o f th e factors of production and the sellers and buyers o f the final goods lead to th e simultaneous m axim ization of economic surplus achieved by all econom ic subjects. As regards the final products, this means th at a perfectly com petitive market ensures th at all the transactions conducted by sellers and buyers o f these goods are beneficial to both sides. If

so, then both sides can realize the maximum benefits in the form of a so-called consum er surplus and p roducer’s surplus, which is fulfilling the Pareto optimum .

H ow ever, the problem is based on the previously m entioned fact that the conditions o f the competitive m arket are very restrictive and as such are not fulfilled in many markets. Im perfections of the market do not however make it im possible to achieve equilibrium . But, such equilibrium is not effective i.e. not optim al in the sense of Pareto. Hence, the fundam ental statement of the so- called norm ative theory of regulation is as follows:

I f such ineffectiveness is relatively large, which m eans it implies costs and social losses significantly exceeding the costs o f potential regulation, then the state sh o u ld regulate the m arket in order to m axim ize social welfare or, in other words, diminish the losses on the level o f such w elfare existing in the pre-regulation phase.

4.2. Alternative theories of regulation

The norm ative theory understood in the above sense has been subject to diverse criticism s, which has m eant not exactly its total rejection, but pointing out its weaknesses. I shall nam e here ju st two of these:

A. In the economic reality we can observe m arkets which fulfil almost com pletely the assumptions o f the model of perfect competition and nevertheless are regulated. Such an example can be the market of road transport in several countries, including Poland.

B. Secondly, normative theory o f regulation insufficiently or too one-sidedly explains why certain markets are subject to regulation. Hence, for example, the question whether a real state, understood as a system of legislative institution (producing regulation) and regulating agencies are in reality subject to one and only one criterion of counteracting losses in social welfare.

C onnected to the above and o th er reservations, in the last twenty years there appeared several alternative theories of public regulation in a market economy. Further on I shall present briefly their nature without entering into details of model approaches or discussion o ver their internal consistency and ability to explain and predict real econom ic phenom ena and processes occurring in the m arkets regulated by the state.

4.2.1. R egulation as a service provided for entrepreneurs (Stigler)

T his theory is usually called the Theory of Capture, and sometimes even the privateering theory of regulation. T his is connected to one of the fundamental statem ents o f the New Political Economy, according to which economic

regulation in a market economy should be regarded as a good. Which means one should identify subjects volunteering demand for regulation and supply of regulation as well as the definite factors determined by such supply and demand. According to this general approach, regulation is treated as goods offered by regulating institutions responding to demand on the part o f a certain sector or even to the dem and of entrepreneurs active in this sector. They com e to the conclusion that the cheapest way of restricting entry into the market o f new competitors or maintaining prices above the competitive prices (thus ensuring extra-ordinary benefits in relation to prices corresponding with competitive equilibrium) is the use of a regulating mechanism. Hence, they also exert some amount of pressure on political and legislative decision-makers.

4.2.2. E conom ic theory of regulation

T he capture theory of regulation was criticized as b ein g as one-sided as the norm ative theory. The joint result o f rejecting both th ese theories is the so- called econom ic theory of regulation. Within the New Political Economy there have been formulated several m odels belonging to the economic theory of regulation (G. Stigler, S. P eltzm an, G. Becker and o thers), therefore I shall restrict m yself to presenting the g ist of this theory:

■ T he fundamental resource at the disposal of the state is the ‘power to coerce’ ;

■ All actors of political and econom ic life including politicians, legislators and regulators (the latter understood as functionaries o f regulating institutions), behave rationally and maximize th eir utility (function o f the utility);

■ Politicians are m otivated mostly by criterion of gaming and/or m aintaining a position o f pow er. Groups of in terest competing among them selves offer them their support or funds to run election campaigns. Politicians ‘choose’ the group w hich is rated highest fro m that point of view and, in the event of electoral victory, offer the regulation which amply repays the costs connected with exercising political pressure: lobbying, clientelism;

■ R egulation is usually m ore beneficial for producers than consumers. The main reason for this comes from the fact that the potential sum of benefits that can be achieved by consumers, for exam ple due to higher standards of safety of products o r ecological standards, can be very large in ab so lu te terms, but offers small advantages per capita. S econdly, consumers, b ecau se o f their numbers, find it h arder to rank their preferences regarding the subjects and forms of regulation;

■ P lay o f interests leads to optim al (this does not usually mean optimality in the sense o f Pareto) division o f benefits stem ming from regulation among the entrepreneurs and politicians, i.e. regulating institutions.

4.2.3. R egulation as a principal-agent problem

The econom ic theory of regulation can be subject to criticism because it totally rejects the situation w hen political decision-m akers undertake regulation only because of the fact that the market presents certain failures and therefore should be regulated to increase social welfare. L et us remember that according to the economic theory o f regulation, the governm ent undertakes it just because it aims at m axim izing its political support. T h is poses a particular contrast w ith the normative theory of regulation according to which the governm ent is motivated only by m axim izing social w elfare. W ithout details of regulation in terms of principal and agent, we can state that it is a particular eclectic theory or ‘com prom ise’ in relation to the norm ative and economic theories. Its nature, therefore, can b e summed up by the follow ing statements:

■ P ressure groups (industry, consum ers) maximize th eir individual welfare (utility);

■ R egulating institutions function in a sim ilar way as a particular subordinate in relation both to parliam ent, i.e. politicians in the narrow sense of the w ord, and to economic subjects (in its broad approach also including consum ers);

■ T he Parliament (legislator) maxim izes social w elfare.

An im portant premise o f this theory is the assum ption of information asym m etry, i.e. the unequal access of the above subjects to diverse kinds of inform ation.

FINAL CONCLUSIONS: WHETHER AND HOW TO REGULATE

1. If w e start from the statem ent about the existence o f market failures in econom ies functioning in reality, public regulation in the m arket economy has to be seen as an inevitable phenom enon and not as an institutional solution depending on particular theoretical options (m onetarism , Keynesism, new political econom y, etc).

2. M arket failures cannot be treated in an ahistorical manner but evolutionarily, in particular including the fact that m odern technical progress can at least weaken the scope and effects of their occurrence. The example here is the problem of the natural monopoly in the telecom m unications and power industries, whose actual range o f occurrence in fact has been decreasing over recen t years due to the extension of the reach o f cellular telephone netw orks and the appearance o f power generating equipm ent allowing to effectively produce electric energy on a small scale, either alone or in

conjunction with heating energy. T his creates the prem ise o f the deregulation of several markets.

3. In designing the regulating system s we always have to consider the costs and b enefits they imply. If the level of irreversible social loss, that is a m easurable decrease of social w elfare occurring in a situation of a lack of regulation, is small in relation to the benefits arising from the regulation, then we have to be very prudent in introducing the regulation o r even should give it up.

4. A ccording to the econom ic theory of regulation, regulating systems are created as a result of a particular play of group of interests. In perfecting the existing regulations, and in designing new ones, these interests should be taken under consideration if the regulation is to be successful, that is to ensure achieving its proposed objectives.

5. P articu lar regulating instrum ents should be, like all the instruments of econom ic policy, assessed from the point of view o f th e ir efficacy, economic effectiveness and distributive results. Because regulation is always a particular form o f redistributing income, the latter criterion is especially important. R egulation, while removing or diminishing m arket failures, generates additional economic advantages divided among various pressure groups. That is why institutions formulating regulation should in particu lar pay attention that such benefits are not com pletely appropriated by one group of entities, for exam ple com panies, at the ex pense of another group, fo r example purchasers of goods and services offered in regulated markets.

6. M oving slightly beyond the subject of this presentation, but on the other hand m entioning one of the m ain elements of the process of economic transform ation in Poland, it is worth reflecting briefly on the relation: privatization versus regulation.

T heoretically they are two possible options present. T he first means that sectors o r areas where public regulation is inevitable, for example infrastructure and public utilities, should be quickly and at any cost privatized disregarding the quality of the existin g system of th eir regulation. The second option, supported by the author o f this presentation, m ean s that introducing an efficacious and economically efficient regulating system which sometimes could m ean only some m odifications o f the existing solutions, should precede the process o f privatization. T he argum ent supporting such an option is the fact that effective and efficient regulation, especially if it includes the interests of both producers and buyers in regulated m arkets, decreases the general uncertainty and risk in econom ic activities, whilst at the sam e time it increases the in terest o f private investors in entering a given m ark et and simultaneously increases the market value o f the privatized com panies.

R E F E R E N C E S

Demsetz, H. (1982): Economic, Legal an d Political Dimensions o f Competition. Amsterdam - New York - Oxford.

Forlicz, S. (2001): Niedoskonała wiedza podm iotów rynkowych [Impetfect Knowledge o f Market Subjects]. PW N, Warszawa.

Kahn, T. (1991): The Economics o f Regulation. Principles and Institutions. Massachussetts Institute o f Technology, Cambridge MA.

Neoklasyczna teoria instytucji [Neoclassical Theory o f Institution] (1992) in: Fiedor, B. (ed.): Kierunki rozwoju współczesnej ekonom ii [Trends o f Development in Modern Economics]. WUE, pp. 180-190.

Sharkey, W., W. (1982): The Theory’ o f N atural Monopoly. Cam bridge University Press, Cambridge.

Spulber, D. (1989): Regulation and Markets. Massachussetts Institute o f Technology, Cambridge MA.

Stigler, G. (1986): The Theory o f Economic Regulation in: Leube, K., G ale, T., Moore (eds.): The Essence o f Stigler. Hoover Institution Press, Stanford, pp. 243-264.

Viscusi, W., Vernon, J., Harrington, J. (1997): Economics o f Regulation and Antitrust. MIT Press, Cambridge MA.