Policy And Regulation

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(September 5-6, 1998)

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Introduction

Policy-makers are constantly facing the choice between the market system and the collectivist system for managing an economy. The market system allows individuals and groups to pursue their own welfare goals freely, subject only to certain basic restraints. Under the collectivist system, the state directs and encourages engagement in certain activities which will not take place without government intervention. An essential element of the market system is competition; whereas regulation is the primary means of government intervention. The term "regulation" for purpose of this paper is defined as behavioral control by the government or its agencies, or any such control sanctioned by the government or its agencies, or any such control sanctioned by the government.

As will be more fully set out later, government intervention is aimed at correcting the deficiencies in the market system in meeting the collective or public goals. While economists may produce economic reasons for government intervention or regulation, political or social scientists may identify non-economic goals that are valued by the society as a whole. Government intervention or regulation is not a pure economic concept; rather, it is a politico-economic concept.

Regulation, when defined as a behavioral control, by definition restrains competition.

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Why Competition (market system)?

Few would raise objection to the general proposition that resources can be best allocated in a competitive market. Competition as a means of allocating resources and achieving allocative efficiency is most effective, when the market is right for the operation of competition, i.e. a perfect market. A perfect market in which perfect competition would operate requires the following elements:

-- the number of sellers and buyers is large;

-- products ate homogeneous;

-- entry and exit are completely free;

-- all sellers and buyers are fully informed;

-- all firms pursue profit maximization as the only goal;

-- factors of production are free to move to the most attractive employment.

In real life, perfect markets rarely exist; policy-makers are faced with markets that may be short of one or several of the above elements. Then, the question is whether or to what extent and by what means the government should intervene to attain the necessary degree of efficiency.

The issue may be even more complicated when one takes into account the fact that markets are undergoing constant changes, given the increasing globalization and rapid technology development. Some economists now talk about "economic dynamism" and "dynamic market" and "dynamic efficiency", and places emphasis on two factors: (i) the adaptiveness to changes, and (ii) taking advantage of new opportunities, by the producers on the product market and suppliers on the factor market. The two factors are connected with the intensity of competition. As indicated in a 1987 OECD report, whether firms respond to changes in the economic circumstances depends largely on the intensity of competition. Economic dynamism is low when the market is dominated by a monopoly or firms with market power.

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Why regulation?

The easiest answer to the question is that regulation is needed when the market fails to achieve economic efficiency or to achieve the non-economic goal valued by the community. This is called market failure.

Let me try to give a list of reasons for regulation as compiled by economists, lawyers, and political scientists:

Economic Reasons

Whenever the economic market departs from the perfect market phenomenon, the argument for regulation begins.

1. Natural monopolies and increasing return to scope and scale (rationalization),
2. Public goods (including pure and "impure" public goods),
3. Other externalities,
4. Information asymmetries and "bounded rationality" (i.e. the capacity of individuals to receive, store, and process information is limited),
5. Co-ordination problems (such as standard systems of weights and measures), when transaction costs are inhibitively high,
6. Unequal bargaining power (notably in labour, agricultural markets),
7. Excessive competition,
8. Exceptional market conditions (such as wartime rationing ) and macro-economic considerations (such as removal of impediments to labour mobility, and inflation control through income and price control).

Non-economic Reasons

1. Distributional justice,
2. Paternalism,
3. Community value.

It is important to note that the taking of interventionist steps for the above reasons usually carries two assumptions: (1) economic markets are extremely fragile and apt to operate inefficiently if left alone, and (2) government regulation is costless.

The reality is that with the increasing globalization globalization and technology advances, economic markets are becoming more and more dynamic, and regulation in many instances is not only costly but also ineffective.

The vast amount of theoretical and empirical researches have revealed that regulation is not positively correlated with the presence of externalities, monopolistic market structure or other types of market failure. This gives rise to the private interest theory of regulation, i.e. regulation sometimes is to serve the interest of the industry (especially those incumbent firms in the industry) or particular interest group, the bureaucrats, and/or politicians.

None of the existing theories (public interest/public choice theory, private interest theory) provides full explanation for regulation. One, however, cannot completely rule out the value of regulation.

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Regulatory cost and failure/Pressure for Reform

Governments are increasingly aware of the cost associated with a regulatory regime. Let me try to give an inventory of the costs involved:

1. cost of setting up the regulatory and human resources with the necessary quality,
2. cost of administration and cost in collecting information necessary for setting price cap, standards, and other regulatory requirements (to avoid being "captured" by the regulated firms),
3. industry's cost incurred in complying with the regulatory requirements and the cost involved when dispute arises between the regulator and the regulated firms,
4. efficiency loss when the regulatory goal is not efficiency related,
5. efficiency loss resulting from the possible error made in the enforcement,
6. possible misallocation in other sectors of the economy,
7. indirect cost of regulation (regulated firms tend to (i) use transfer pricing to take revenue out of and load cost into the regulated business from unregulated businesses, (ii) to expand into unregulated activities, (iii) to use the regulated business to subsidize unregulated business, and (iv) to transfer costs to unregulated business where it is easier to pass cost to consumers.)

Moreover, regulatory system may fail to achieve the aim (such as correcting market imperfection) or did so inefficiently. Altogether, a regulatory system may result in the social cost exceeding the social benefit. What is more is that, if the private interest theory of regulation proves to be of merits, regulation, as a result of lobbying or other political exercise, may add cost to the society as a whole, while benefiting only a small segment of the population who rue seeking to grasp the rent representing the difference between the revenue from producing a good and the cost of production.

The cost of regulation would fall on consumers and users of the output of the regulated industries. Particularly, in the public utilities area, such as internal transportation, water, electricity, local telecommunication services, where international trade in a conventional sense is less likely to take place, the users are unable to seek alternative sources of supply. Despite the fact that national governments may be willing to allow foreign investment in the public utilities sector (a form of liberalization analogous to service trade liberalization), the regulatory regime applied to such investment will equally increase the cost to the foreign invested suppliers and, to a greater extent, the consumers and industrial users. The industrial users would have to face increasing international competition in the their own products which in almost all cases are tradable. National governments are therefore under pressure to review their regulatory policy. Clear evidence can be found in that as a result of integration of European markets, member states of the European Union are under pressure to reduce regulation in order to enhance their industries' competitiveness in the intra-community trade.

The nationally regulated industries themselves are also facing international competition, when their products are technically internationally tradable.

In a relatively closed market, governments may be able to give more weight to policy goals that are implemented through regulation, or to be more receptive to be more receptive to political pressure from domestic interest groups. However, the increasing competition from outside as a result of market opening calls for the government's assistance in strengthening the industries' competitiveness. It is natural to see that after several decades of trade liberalization, industrialized countries begin to reformulate their policies with respect to the regulated industries. Economists have also produced evidence to show that economy-wide structural changes has a macroeconomic impact. Studies have shown that increases in production, employment and exports and a decrease in inflation.

The pressure to have regulatory reform is also from outside. Foreign investors competing in the world market, especially multinational corporations, would press for regulatory reform so as to lower their impute cost. Moreover, international firms seeking to invest in the regulated sectors of another country would like to see privatization, de-regulation by allowing new entry, or reduction of regulation. Despite that de-regulation or regulatory reform has not formally become a negotiation issue nor subject to international discipline, we have seen many cases where the issue of regulation was intertwined with trade liberalization, and "unnecessary regulation" is sometimes characterized as a trade barrier and quietly becomes an item on the negotiation agenda. The financial services negotiation of the world Trade Organization (WTO) has provided many examples of this kind, despite the fact that Article 2 of the Annex on Financial Services of the General Agreement on Trade in Services (GATS) acknowledges the right of members to regulate the relevant sectors. There are also cases where the interconnection chare in the telecommunications sector becomes an issue in government-to-government negotiations. The most notable instance of this kind is the WTO negotiation on basic telecommunications, which produces a reference paper setting out among others, regulatory principles with respect to interconnection. (The Reference Paper on regulatory principles used for consideration commitments in offers on basic telecommunications)

In sum, decades of effort to liberalize international trade and investment have provided a momentum for regulatory reform; and more importantly provide a sounder political environment for such reform. Those political forces which expanded regulation are now counteracted by users who themselves facing much keener competition, and foreign firms who seek to enter the local market through trade or investment. Governments may be more willing to consider the option, as empirical studies indicate that regulatory reform at the microeconomic level, especially structural changes, would produce positive macroeconomic results (export performance, employment, and inflation) which are politically more meaningful.

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Reformulating Regulatory Policy

The vast amount of researches and literatures have a high degree of consistency in pointing out the directions for regulatory reform. Let me try to give a brief account of these findings.

1. Privatize state-owned monopoly and replace it with regulation

Regulation has the advantage over public ownership in that regulation is more transparent and can be targeted directly on the identified source of market failure. Market failure which provided the reason for public ownership mostly exits in small parts of the industry concerned. This proposition is rested on two important assumptions: (i) the regulation is carefully designed to prevent regulatory failure, and (ii) a competition regime is in place to enhance in those parts that are not regulated and prevent abuse of monopoly power in the regulated part.

2. Limit regulation to specific areas of market failure

Regulation could be very costly; therefore a rule of thumb is that there should be as little of it as possible. This is particularly so, when the market is facing rapid changes as a result of growing economic integration and technological advances, the risk of regulatory failure is becoming greater and greater, as the regulators are less able to respond to the changes in the market. Studies have also shown that regulation is less necessary in industries with a high rate of technology change, as such change tends to create possibility for new entrants.

Let us use power supply for illustration. The industry can be divided into three: power generation and supply, power transmission, and power distribution. Regulation often applies to vertically integrated firms in the industry. However, scale economy in power generation and supply as well as power distribution is low; with only power transmission (which involve network) possessing features of a natural monopoly. Regulation can be limited to power transmission, with competition principles applying to the other parts. Where there is a vertically, the clear trend in most of the advanced economies is to separate out the natural monopoly part to avoid, among others, cross-subsidizing the competitive part of the business.

Another example would be in the financial service area, where regulation is mostly aimed at correcting information asymmetry, and to prevent frauds. Disclosure requirements are imposed by regulators to ensure the counterparty has sufficient information to make the decision. It would be a matter of over-regulation, if the regulation extends to cover negligence and incompetence which can be dealt with in other ways, such as insurance (if the economy involved is equipped with an insurance scheme).

3. Reduce regulation with goals that are not efficiency related

No matter whether it is for public interest or for the private interest of particular interest groups, regulation in many instances results in efficiency loss. It is therefore a matter of balancing exercise for the government to decide which goals should be given priority. As mentioned, the changes in the world economy have called for giving more weights to the efficiency concern and competitiveness of domestic industries and markets. Domestic user industries, multinationals seeking local investment opportunities, and even governments using macro-economic indicators to serve their political interests, are now serve as counterforces of those lobbying for regulation.

Despite the changes in the political environment, one however cannot ignore the importance of regulation in achieving non-efficiency goals. Governments have to look for other alternatives for achieving the goals.

If the regulation is in response to the request of domestic private interest groups, governments may consider to compensate them with new business opportunities which are preciously reserved for the state firms; for instance, privatize state enterprises or abolish state monopoly in sectors where competition is feasible.

If the regulation is for distributional justice, governments may seek to use tax, income subsidy, and other mechanisms that would not interrupt the market process.

It is noteworthy that not all the alternatives are applicable to each economy. Governments with different political structures and strength of popular support, and economies at different levels of economic development may be subject to different constraints in considering alternatives.

4. Use competition policy as preferred strategy in controlling monopoly

When comparing with regulation of cost, profit or prices of an operation, it should be firmly established that competition policy is always a preferred strategy in controlling monopoly. Where regulation of cost, profit or prices is inevitable, competition policy should supplement such regulation to the maximum extent. For instance, competition law and policy can be used to prevent such practices as predatory pricing aiming at excluding competition, or discriminatory pricing, refusal to supply aiming at elimination of competition.

Competition law and policy, especially enforced through judicial or semi-judicial means can challenge the anti-competitive practices on a case-by-case basis and more precisely target the distortion, as opposed to regulation which tends to be across-the-board and unnecessarily interfering the business decision of the firms.

5. Impose on regulators a general obligation to promote competition in the regulated sector or create a rival institution to be an advocate of competition policy,

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As mentioned previously with the technological changes and increasing globalization, markets that are traditionally subject to regulation may become competitive in whole or in part. Studies have shown that the possibility is greater in the telecommunications, and power generation and supply; whereas potential competition is limited in water supply, sewage disposal and airports. In the potentially competitive cases, the task is to allow new entry whenever it is feasible. This would require the regulators' constant review of the state of the technology and the underlying economic and political environment. In the non-competitive cases, the task is to ensure upstream and downstream competition.

Regulators are presumably the ones most familiar with the regulated industries and therefore vest situated to promote competition in that sector or protect competition in the upstream and downstream sectors. It would be an ideal practice to impose an ideal practice to impose an obligation to promote competition in the relevant legislation which provides the regulators with the authority to regulate the relevant industry. However, it is not surprising to find that many of the regulators are actually "captured" by the regulated firms in that they rely on the industries to provide them with the necessary information, or recruit their officials from the industries, or are simply sympathetic to the incumbent firms.

Under such circumstances, policy makers may consider to establish an institution to serve as an advocate of competition policy and a rival of the regulators. This would created a counterforce and inject competition spirit in the formation of the overall government policy. Moreover, one should not forger that the WTO negotiation on trade in services has pressed for competitive safeguard in the case of telecommunication, and rules for controlling monopolies and exclusive service suppliers (Article VIII of the GATS)

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Developing Economies Dimension

Much of the above is experience from and studies conducted in advanced economies. The question then is whether or to what extent the findings are also applicable to developing economies. Let us now have an examination of the points which might be used to argue for that developing economies should have more regulation and less use of competition mechanism:

1. public ownership is preferred when compared with regulation, when a developing economy does not have the capability to develop a sound regulatory framework, and the risk of regulatory failure is high;
2. regulation is preferred when compared with competition, because the economy has not been equipped with the sufficient legal infrastructure (legal framework such as contract law, business organization law, and trust law, as well as enforcement mechanism and other devices that can reduce the transaction costs associated with coordination and cooperation required for organization of economic activities;
3. the society does not have a sufficient information system (such as credit rating, certification, or grading system as well as information collection and analysis capability) to provide consumers and other decision makers with necessary information to make rational decisions;
4. the society has not developed a social security network, or other instruments to deal with other non-economic concerns, and regulation is used for serving such policy goals (for instance, statutory monopoly may be created for an institution which provide welfare benefit to a particular segment of the population, e.g. retired servicemen; said monopoly would then be subject to government regulation to ensure that the prices and quality of its products would be fixed at the right level.)

I have no intention whatsoever to deny the validity of these arguments, and agree that the choice between privatization, regulation, or competition is a decision that cannot be made in isolation. In fact, the decisions have to take into account the maturity of the economy, the structure of the sector concerned, fiscal and financial stability, the legal infrastructure and associated devices, the rate of technology change in the particular sectors and how fast such changes can be transplanted to developing economies. Political stability and domestic politics are equally, if not more, important to consider.

To what extent experiences accumulated in the advanced economies can be applied to the developing economies requires further research and investigation.

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Conclusion

In this paper, I am running the risk of oversimplifying the economics of regulation. However, this may be necessary sacrifice in my effort to clarify the issues involved and develop an analytical framework for the policy-makers in an area where economics, law and politics intensely interact. I have to intention to overlook the difference among economies, but strongly feel that dialogue and other forms of exchanges are required to help shape the best strategy for each economy.