Unit 8.

Regulation and Deregulation

Brahim Guizani

Learning Objectives
What are the economic rationale for regulation
of sectors such as electricity,
telecommunications, and airlines?
What motivated the recent the recent
deregulations

 Regulation is broadly defined to be government

intervention to change market outcomes.
The intervention can directly affect market
outcomes, such as prices, quality, product variety,
or the number of service providers, by changing
market institutions.
For instance, banks/insurance companies are not
free to set some of their own commissions
(prices), and are not free to enter the market
without satisfying some requirements.

The Rationale for Economic Regulation

There are two explanations for the existence of
regulation:
The public interest explanation is that
regulation is a response to market failure.
The Economic explanations or theories of
regulation are based on the premise that there is
a demand for regulation from groups who could
benefit from the redistribution of income and
wealth resulting from regulation and that the
political process provides incentives for
governments and politicians to supply regulation.

Public Interest Justifications for Regulatory

Intervention
Public interest justifications are often termed
normative since they are all based on the
premise that intervention is justified because it
leads to an improvement in social welfare.
Regulation in this view is a legitimate response
to market failure: Markets fail when the
market outcome is inefficient.
Sometimes when markets are left to
themselves, total surplus is not maximized.

The characteristics of an efficient outcome

1. Allocative efficiency: results when an efficient level of
output is produced. It is measured by total surplus. The
maximum is achieved at the point where marginal cost
equals willingness to pay (Perfect competition
equilibrium). Failure to achieve allocative efficiency is
usually due to either market power or externalities.
2. Rationing efficiency: it occurs when a (fixed) level of
output is distributed to those with the greatest
willingness to pay.
3. Cost efficiency: output is produced at minimum
opportunity cost.

4. Efficient product selection: refers both to the number

and location of differentiated products. Efficient
location of differentiated products refers to the correct
set of products. For a fixed number of products, the set
is efficient if it provides the best match between
consumers preferences and product availability.
5. Efficient cost reduction occurs when the marginal cost
and marginal benefits of investments in cost reduction
are equal.

The usual market failure suspect that justify

price and entry regulation is:
Natural monopoly.

Natural Monopoly

Natural Monopoly
In natural monopolies one firm can serve the
market more efficiently than more than one firm.
DD is the market demand curve. It is clear that in
such a market, competition will not be sustainable,
even if the market initially has many firms. Price
taking would result in negative profits, since for all
levels of output AC(Q) > P = MC(Q).
Moreover, each firm has an incentive to expand
production since MC is declining. The industry
would be characterized by a period of
consolidation and rationalization involving exit and
merger until the remaining firms had enough
market power to raise price at least up to average
cost.

Natural Monopoly and Regulation

If at the relevant levels of market demand, production
costs are minimized when there is a single firm, there is
some justification to regulate with price and entry
controls. Restricting entry keeps competitors out of the
industry, providing for the possibility that industry costs
will be minimized. If the industry is a natural monopoly,
entry by more than one firm will be inefficient. The
imposition of entry controls needs to be complemented
with the addition of price controls since the imposition
of entry controls creates a monopoly. Price regulation is
required to avoid the allocative inefficiency associated
with monopoly pricing.
Natural monopoly creates a rationale for regulation

The Economic Theories of Regulation

Fundamental to economic explanations for the
existence of regulation is the assumption that all
economic actors are self-interested utility
maximizers.
The seminal contribution is Stigler (1971).
The political process provides incentives for the
government to supply regulation. Politicians are
willing to supply regulation in return for help in
attaining and maintaining political power. In return
for using regulation to restrict competition and
deter entry, firms provide politicians and political
parties with what they need to win elections:
money and votes.

 Stigler observed that this process workseven

though it leads to an inefficient allocation of
resourcesbecause the benefits are
concentrated and significant, but the costs are
small and their distribution diffuse. It is inefficient
because the benefits to the few are less than the
costs to the many.
Stiglers analysis provides theoretical
underpinnings for the notion that regulators are
captured by the very firms they are supposed
to control. In return for votes, financial resources,
or the promise of future employment, regulators
use their power to serve the interests of firms.

 The following figure shows the distributional and efficiency implications

of regulation, which effectively monopolizes a perfectly competitive
industry. Regulation in this case raises price from pc to pm and reduces
output from Qc to Qm. The firms in the industry gain by the amount m.
However, the loss to consumers is this amount, plus the deadweight
loss triangle of DWL.

 The analysis of Stigler was extended by Posner (1971).

Posner observes that regulation is also used by
politicians to redistribute income. Regulatory pricing
structures, Posner observes, often involve crosssubsidies. Some groups of customers pay more than
the cost of providing them with service in order that
other consumer classes can pay less than their cost of
service. More generally, regulation is used not only by
politicians to win votes by creating and distributing
economic rents to firms, but it is also used to gain the
support of other groups with influence, including some
consumer groups and some factors of production.
Traditionally, telecommunications pricing in many
countries appears to fit this pattern.

 In telecommunications, there are, typically at

least five cross-subsidies. One is from long
distance to local; the second is from local
business users to local residential users; the
third is from enhanced or special services to
basic local; the fourth from light users to heavy
users of local service; and the fifth is from lowcost urban centers to high-cost rural areas.

From Regulation to Deregulation: e.g.

Financial Markets
The financial system is among the most heavily
regulated sectors in most countries even though
this sector has been increasingly deregulated since
the 70s in many developed countries.
Regulatory agencies:
The USA: (1) the Securities and Exchange
Commission (SEC), (2) the Commodity Futures
Trading Commission (CFTC), (3) the Federal
Deposit Insurance Corporation (FDIC) and (4) the
Federal Reserve System.
Tunisia: Le Conseil du Marche Financier (CMF) and
la Banque Centrale de Tunisie (BCT)

 The financial crisis of 2007 2009 made clear

the process does not always work well.
The rationale for regulating financial markets:
1. Asymmetric information:
Information is asymmetric if one party that is
involved in the transaction has less information
than other parties. This lack of information
increases the difficulty of making accurate
decisions about the transaction.

 Example: a banks depositors are unable to

evaluate fully if bank managers are taking too
much risk or even making fraudulent decisions.
Thus in the absence of any kind of regulation of
the banking system, depositors would be
reluctant to put any funds into a bank.
A lack of information can also lead to bank panics
as happened in the US in 1819, 1837, 1857, 1873,
1884, 1893, 1907, and 1930 1933.

2. Adverse selection and moral hazard:

Adverse selection occurs prior to a
transaction and refers to the fact that
borrowers most eager to seek out a loan are
the potential bad credit risk just as the people
most likely to buy health insurance are those
who expect to experience health problems. It
leads lenders to be more reluctant to make
loans even though the lenders know that
there are good credit risk as well as bad ones
in the market.

 Moral hazard occurs after a transaction has taken

place. In financial markets, moral hazard is the risk that
a borrower, having received the funds, may make
decisions that decrease the probability that the loan
will be repaid.
In an attempt to mitigate these problems, governments
around the world have enacted different forms of
regulations in the financial markets such as: government
safety net, restrictions on assets holdings, capital
requirements, prompt corrective actions, chartering
and examination assessment of risk management,
disclosure requirements, consumer protection and
restrictions on competitions.