Economics Workshop : Day 2 Better Regulation Executive

1. Economics Workshop: Day 2Better Regulation Executive June 2006 Nick CraftsUniversity of Warwick

2. Objectives for the day To • understand the basics of regulatory impact assessment • understand how good regulatory design can cope with uncertainty, informational imperfections, and minimise distortion of incentives • rationale for and implementation of RPI-X regulation • the link between regulation and productivity growth

3. Regulatory Impact Assessment

4. COST-BENEFIT ANALYSIS Analysis that quantifies costs and benefits, including items that the market does not value properly Used for • capital projects and procurement decisions • policy proposals, including regulatory proposals environmental standards, health & safety, business regulation [Cost-effectiveness analysis when benefits are hard to quantify, or externally specified]

5. THE PROCESS • Justify action and set objectives Identify the market failure or the socially-undesirable outcome that calls for regulatory intervention. Examples • discharge of pollutants in atmosphere (an externality) reduces air quality: the objective is to reduce pollutant levels by amount x • congestion externality causes traffic jams in Central London: the objective is to reduce peak-time traffic by 20%

6. THE PROCESS • Identify all options • prescriptive regulation (quotas, speed limits) • provide incentives to change behaviour (taxes and subsidies) • create arrangements or institutions to change outcome (tradable permits) • provide information/educate to alter behaviour (public campaign on dangers of excessive salt, smoking) • no intervention

7. THE PROCESS • Evaluate costs and benefits of each option • Evaluate direct policy costs & administrative costs • Identify benefits and evaluate them as far as possible. Include externalities (esp. environmental ones), consumers’ surplus, etc. • Some benefits (e.g. prevented fatality) are hard to evaluate. Can infer prices from revealed preferences. If not, can use stated preference through contingent valuation: Willingness to Pay (WTP) or Willingness to Accept (WTA) • Identify unintended consequences and cost them too • Where relevant, identify distributional implications

8. What if benefits and costs are uncertain? Risk assessment and management is important. • Identify sources of uncertainty. Not enough to look at most likely scenario: evaluate costs and benefits for range of scenarios. Recognise ‘optimism bias’. • Use pilot programmes to learn more about the true costs and benefits • If possible at reasonable cost, transfer risk to party best placed to control it: outsourcing of technology-related risk to private sector

9. THE PROCESS • Develop and implement solutions Good regulatory design must also consider • regulator’s ability to monitor and verify choices • ease of ensuring enforcement • design of robust targets (avoid targets whose achievement might run counter to objectives) • proportionality, accountability, consistency

10. THE PROCESS • Evaluation • Review costs and benefits of previous regulation periodically to assess its usefulness • If necessary, use sunset clauses in regulation to force evaluation at later date, in light of new information • Likewise, reassess any ‘no intervention’ decision in the light of new information and developments

11. Travel Costs on Motorways, 1993 (£m)(Plowden & Hillman, 1996)

12. Group Work: Impact Assessment For each category of regulation below, identify the social costs and benefits, including any likely ‘unintended consequences’. • Compulsory identity cards • Legislation to keep pubs smoke free • Green Belt as policy for land-use planning • Regulating the introduction of new drugs

13. Information and Incentives

14. An overview Regulation amounts to state-imposed limitation on individual discretion, usually supported by the threat of sanctions (stick) or by provision of appropriate incentives (carrot)

15. Information Individual choices depend on information too. Two relevant aspects. Information tends to be • imperfect (we do not know everything) • de-centralised (we differ & know more about ourselves) The questions • how does information affect case for regulation? • how does information affect scope of regulation? • how does regulation distort information and incentives?

16. Imperfect Information For the class of decisions where • individuals’ information is imperfect AND • the state could better informed, state regulation can correct for individuals’ ignorance and protect their interests Examples • product safety regulation • health and safety regulation

17. Why might the state be better informed? • Individuals cannot easily assess safety aspects of poor product design • Employees cannot always assess riskiness of work environment, especially if damage comes with a lag (asbestos exposure, coal dust) Here the state can be better informed (commission scientific studies) and regulate if necessary

18. Is statutory regulation necessary? Regulation not necessary if markets create incentives for firms to protect consumer / employee interests. For instance, • Reputational concerns may persuade firms to maintain product quality / work-place safety • Risk of legal actions helps too However, these mechanism are less effective when firms are small or new

19. Markets can be informationally efficient.. • There are many contexts in which individuals or firms know more about themselves than others: information is de-centralised • Markets can work with de-centralised information: individuals choices are based on private information but prices convey the essential bits of information to everyone. • Regulatory control, as in a command economy, requires centralisation of information. This informational constraint makes it harder to regulate.

20. ... while efficient regulation is hard to achieve • When firms / individuals have unequal compliance costs, it is economically efficient to impose unequal standards (e.g. ask ‘dirty’ firms to do more abatement) • but lack of information about compliance costs make it harder to tailor-make regulation • so that the same regulation may pose too much burden on some and not enough on others (identity cards, for instance)

21. and getting information is tricky • In principle, the government could try and gather more information • but regulation distorts incentives for providing information • for example, all regulated firms would like to argue that their costs are high • Of course, some regulatory instruments are better able to cope with informational constraints (carbon trading arrangements, for instance).

22. Regulation and Incentives • Individuals choice also depend on incentives • Markets provide sharp (‘high-powered’) incentives, both carrot and stick. (e.g., profits, risk of bankruptcy, promotion vs. sacked) • It is not easy to fine-tune the regulatory stick: road safety is only crudely regulated through speed. • People invest a lot in avoiding detection: better monitoring technology helps but cannot always solve the problem • If penalties are not proportional to violation, it may create perverse incentives

23. Regulation changes behaviour Regulation can have perverse effects Examples • Safety devices like seatbelts and airbags may have a ‘lulling effect’, lower effort in safety and even increase risk levels • Employment regulations that protect workers from being fired reduce incentives to hire them • Complaints procedures that reduce work effort • Penalties for lateness that slow down transport

24. Future of Regulation

25. There is good regulation.. • Some regulation provides the framework of civil society • regulations to protect private property: essential spur to investment • regulation to protect Intellectual Property Rights: provide incentives for R&D and innovation • regulations against insider-dealing: allow capital markets to exist

26. ..and bad regulation • Other regulation stifle growth • price regulation inhibits investment • labour-market regulations create inflexibilities: Euro-sclerosis • regulations that make it hard to set up / wind up business make the economy less responsive to social change

27. A broad correlation... • High regulation, especially in developing countries, seems to stifle growth • But a cautionary note: growth is not an end in itself • If the aim is greater welfare, some forms of regulation increase welfare directly, even if they lower growth rates on the margin

28. The broad trend • The last two decades have seen a trend towards regulatory reform • Economic regulation is down: state monopolies have been replaced by privatised firms, with lighter regulation overall; firms’ entry and exit has become easier • Social regulation is up: not surprising as richer societies invest more in health and safety, environmental regulation

29. The Context • Globalisation (mobile capital) • Technological change and new information makes it important to remove impediments to innovation • Economic theory (asymmetric information)

30. Why does regulation persist? • Some regulation corrects persistent market / information failures, so needs to persist • Political economy: those who would lose from deregulation can lobby more effectively than those who gain from deregulation (similarity with import restrictions) • In many sectors deregulation has led to reduction in prices and profits (airlines, utilities, telecom): we should hardly expect business to support such deregulation.

31. Policy Conclusions • Free markets are usually efficient: the invisible hand works • However, markets are not always efficient. Market failures make a potential case for government intervention to improve efficiency: when the invisible hand does not work, the government can lend a helping hand

32. Beware the risk of government failure: the helping hand may hurt rather than help (heavy-handed intervention) • Informational problems affect both private decision-making and public interventions: regulation may have perverse effects (fumbling hand) • Further, the helping hand may become self-serving (the grabbing hand of a predatory state) Good regulation combines economic theory with practical understanding

33. RPI – X Regulation

34. Regulation of Privatized Industries • Regulate to prevent abuse of market power in cases of natural monopoly or high entry barriers • British approach based on price cappingwhereas traditional American version used rate of return • RPI – Xaims to stimulatecost reductionas well as preventing high price/cost margins

35. Productivity and Prices • In a competitive market p=mc=LAC (including a normal rate of return on capital) • In the absence of productivity growth, over time output prices would rise at the same rate as (the weighted average) of input prices • More generally, output prices in a competitive market rise at the rate of growth of input prices minus productivity (TFP) growth

36. Price Capping • If prices are allowed to rise at RPI-X, the industry will be able to maintain normal profits providing it achieves TFP growth equal to the national average, TFPUK, + X • If TFP growth is greater than (less than) TFPUK + X, the formula implies supernormal (subnormal) profits

37. RPI-X Strong incentives for cost reduction and innovation BUT Quality may suffer Prices exceed costs on average RATE OF RETURN Prices stay in line with costs Quality ‘assured’ BUT Likelihood of excessive investment Weak incentives for productivity improvement RPI-X vs Rate of Return: Key Arguments

38. The Averch-Johnson Problem • Rate of return regulation which allows the firm to earn a rate of return above the cost of capital encourages the firm to accumulate an excessive capital stock • The equity value of the firm will be proportional to the capital stock and, provided the allowed rate of return is above the cost of capital, the share price will be positively related to the capital stock • Have to rely on the regulator to identify unnecessary projects and disallow them from the cost base

39. The Water Industry • Regulation is a hybrid • It’s the Averch-Johnson problem that we should fear in the long-run ….. especially given populist pressures • Excessive capital stock encouraged by • de-luxe quality directives • ensuring no supply interruptions • no peak load pricing Key question: is marginal benefit (willingness to pay) less than long-run marginal cost?

40. RPI-X Regulation: Further Points • Optimal length of price reviews trades off gains from cost reduction against losses from excessive prices …. is shorter the lower is the sensitivity of costs to cost-reducing effort and the higher is price elasticity of demand • Mitigating ‘regulatory risk’ with sunk costs through credible commitment by regulator is desirable • Uncertainty lowers advantages of price caps if need to ensure non-negative profits • Setting X well requires good way of estimating potential for productivity improvement

41. Managerial Effort and Productivity Growth • Implementingproductivityimprovements/cost reductions requires managerial effort, i.e. has disutility for managers • Monitoring managers in context of asymmetric information encounters free rider problems in private sector and may offer no reward in public sector • Competitionis antidote to agency problem

42. Privatization and Managerial Effort • Asymmetric information does not go away • Private shareholders may improve monitoring/incentivizing of managers • Competition may increase • Regulator may have to try and compensate for weaknesses of shareholders and/or competition

43. Privatization and Productivity Performance (Green and Haskel, 2004) • TFP growth raised by the privatization process not by private ownership per se • Productivity growth increased in some cases as X factor made more demanding (e.g. water) • Regulation central to quality implications of RPI-X incentive structure • Overall picture is dominated by levels effect of eliminating inefficiency

44. Total factor productivity in the UK public sector(annual rate of increase, %)

45. Comparative Productivity: electricity, gas and water sectors, 1979-95 (UK = 100) Labour Factor Productivity Total Factor Productivity Source: O'Mahony (1998)

46. Regulated Prices in the UK

47. Conclusions • Productivity performance in privatized utilities may be affected by the incentive structures of the regulatory framework • In practice, not clear that RPI-X has generally been a strong driver of TFP growth • Introducing competition where possible deliversstronger incentives to improve productivity

48. GROUP WORK • When would you expect regulation to have a powerful impact on the productivity performance of a privatized business? • How should a regulator decide the precise value of ‘X’ at a price review?

49. Regulation and UK Productivity Performance

50. Costs and Benefits of Regulation • Regulation that corrects market failures provides gains from a more efficient allocation of resources • Regulation also incurs costs so it is relevant to ask how benefits compare with costs • The costs of regulation may be felt in terms of lower GDP per person