A Competition Economist’s Perspective on Regulation
South African Economic Regulators Conference 2012
Richard Murgatroyd
[email protected]
18 September, 2012
Overview
1. Economic justifications for intervention
2. Economic costs arising from regulation
3. Scope of regulation
4. Nature of regulation
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Economic Justifications
Market failure

Traditional economic justification for regulatory intervention is market failure
(although also other public policy motives – e.g. redistribution)
–

Inefficient allocation of resources when left up to market forces
Sources of market failure
–
Persistent market power – firms raise prices significantly above ‘competitive’ levels
–
Externality benefits or costs of producing a good/service – lead to under- or overproduction as these are not internalised by the firm producing that good/service
–
Incomplete or asymmetric information – e.g. inability of consumers to identify
product quality ex ante leads to lower average quality
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Economic Justifications
Natural monopoly

In essence a natural monopoly is where a single firm can serve the market at
a lower cost than multiple firms

Common examples of natural monopolies are utility networks (or certain
aspects of these networks) - e.g. railways, pipelines, electricity/water
distribution

In such instances it will be inefficient for multiple entrants to incur significant
fixed/sunk costs in replicating (certain aspects of) distribution infrastructure
–

Hence possible motivation to regulate entry
However, monopolies (natural or otherwise) may also exercise market power
–
Hence possible motivation for regulation in order to keep prices low and reduce socalled ‘deadweight loss’
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Economic Justifications
No deadweight loss
Consumer welfare
Cost
Pc
Demand
Qc

Under perfect competition price equals cost, with output (Qc) and economic
welfare (green area) maximised – all going to consumers
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Economic Justifications
Deadweight loss
Kept by consumers
Transferred to monopoly
Lost altogether
Pm
Cost
Pc
Demand
MR
Qm
Qc

Under monopoly, price is above cost, with lower output (Qm) and higher
prices (Pm) than under perfect competition

Economic welfare reduced (orange area), welfare also transferred from
consumers to the monopoly (blue area)
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Economic Costs
Direct costs

Determining optimal regulated price can be highly information intensive and
information may be costly for the regulator to obtain and analyse (and indeed
costly for the firm(s) in question to provide)

Information asymmetries may exacerbate costs if they create incentives for
firms to engage in inaccurate reporting – e.g. over-inflating cost base where
regulated prices depend on costs

Deadweight loss must be larger than direct costs of regulation for regulation
to have a positive impact on total welfare (although not necessarily if we focus
on a consumer welfare standard)
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Economic Costs
Indirect costs (1)


Potentially severe adverse effects from inaccurate identification of the
‘competitive’ price level
If prices are too high consumers lose out – most obviously has the potential to
be problematic in markets where there are a number of potentially competing
suppliers and where competition might drive prices down even further in the
long run

If prices are too low the regulated firm might not be able to make a profit

If prices are too low there will be excess demand, requiring non-price
rationing of goods/services and providing the potential for intermediaries to
benefit rather than consumers
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Economic Costs
Indirect costs (2)


Regulation can mask important market signals because price can no longer
perform its signalling function
–
E.g. high prices and profits arising from insufficient productive capacity signal that
there are profits to be made from investing in further capacity
–
Absent price signalling capacity investments that would benefit consumers by
forcing down prices will not be made
Regulation can distort firm’s incentives to behave in ways that benefit
consumers in the long run
–
Regulated prices reduce firm’s incentives to innovate
–
Rate of return regulation reduces incentives to lower costs of production and can
potentially encourage inefficient entry/expansion
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Scope of Regulation
Only regulate where necessary



If natural monopolies face competition from substitutes then case for
regulation is significantly weakened
Nature of competition may militate against substantial deadweight loss – e.g.
if firms can price discriminate (although will not address distributional issues)
Industries are often characterised by natural monopoly at particular levels
only – blanket industry regulation may be neither necessary nor desirable
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Nature of Regulation
Minimise intrusion to obtain a given outcome



Factors that give rise to market failures are often structural – structural
remedies, where possible, avoid the need for (and cost of) ongoing regulation
E.g. if prices are high because productive capacity is insufficient to meet
demand
–
Price regulation will mask pricing signals and discourage entry so that fundamental
problem is not resolved
–
By contrast, steps to encourage capacity expansion, such as removing artificial
barriers to entry, may remove the need for ongoing price regulation
Less intrusive forms of regulation than price regulation can provide less of a
downside while still obtaining desired outcomes
–
E.g. mandating access to essential facilities
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Locations and contact
London
Brussels
The Connection
198 High Holborn
London WC1V 7BD
Telephone +44 20 7421 2410
Email: [email protected]
Bastion Tower
Place du Champ de Mars 5
B–1050 Brussels
Telephone: +32 2 792 0000
Email: [email protected]
The Hague
Melbourne
Lange Houtstraat 37-39
2511 CV Den Haag
The Netherlands
Telephone: +31 70 302 3060
Email: [email protected]
Rialto South Tower, Level 27
525 Collins Street
Melbourne VIC 3000
Telephone: +61 3 9935 2800
Email: [email protected]
Johannesburg
Augusta House, Inanda Greens
54 Wierda Road West
Sandton, 2196, Johannesburg
Telephone: +27 11 783 1949
Email: [email protected]
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