Edited by Gerrit De Geest
[In: Volume 9, (ed) Regulation and Economics]
1. Economics of Regulation and the Purpose of this Book
The goal of this book is to offer the reader a non-technical, but scientifically rigorous, overview of the major themes in the economics of regulation. This is a very ambitious goal for at least two reasons. First, regulation is ubiquitous. It is virtually impossible not to be confronted with regulation in a typical day of our life. Second, regulation of different activities raises different issues. Although the economic explanations and rationales for regulation can be conceptualized in certain categories, they interact quite differently depending on the specific activity in which individuals and firms engage. A few examples may help clarify both points.
We all use electricity, gas and water on a daily basis; most of us use transportation and telecommunication services with the same frequency. The provision of these services is extensively regulated, and the fundamental reason is that parts of the supply chain of these services present natural monopoly features. Natural monopoly implies that supply of a certain service or part thereof is economically viable only in the presence of a monopolist, which raises a number of problems. The most obvious difficulty for consumers is high prices and limited supply, both of which are countered by regulation. However, other problems may just be subtler. They tend to be industry-specific. Water, for instance, presents important safety issues. For electricity, there are problems of efficient generation and environmental impact. These and similar problems suggest that keeping prices low in industries that cannot be entirely exposed to competition may not be the only goal of regulation.
Equally important is the fact that regulation does not only operate in the presence or in the proximity of a natural monopoly. Going back to the examples from our daily life, we all drive cars that are safer than 20 years ago. This is largely due to safety regulation. Cars also pollute less, which depends on environmental regulation. Cars have become more expensive for these reasons. This raises two additional questions. First, one may wonder whether it is economically efficient for individuals to pay for safety and environmental-friendliness if p. 2they do not value these features sufficiently. Second, one may suspect that behind increasingly sophisticated regulatory standards lies the automobile industry’s interest in stimulating demand for new cars. Car manufacturers in a particular EU country may also favour harmonization of safety standards if it provides them with a competitive advantage over their foreign rivals. As it turns out, the compulsory character of regulation and regulators’ dependence on the industry for information make both questions essential for regulatory analysis.1
Finally, regulation is often contested. It is not uncommon for public opinion to blame regulation for anything that goes wrong. Curiously, the blame can go in opposite directions depending on whether, at a certain point in time, the market economy is overall delivering gains or imposing losses on society. In the first situation, regulation is often perceived as an obstacle to capturing opportunities for profit, growth, and well-being; thus, markets should be ‘liberalized’ or ‘deregulated’. In the second situation, it is often said that regulation has failed to stop market forces from undermining social welfare; therefore regulation should be ‘strengthened’. Examples of these swings between pro-regulatory and anti-regulatory sentiment are abundant these days. One instance is the different attitude towards financial regulation before and after the global financial crisis. Another topical example is the changing attitude towards risks and safety regulation after the disaster of Fukushima. In both cases, one observes a shift from a critical to a more positive attitude towards regulatory intervention. These swings explain many of the political determinants of regulatory reform, thereby affecting the ability of regulation and deregulation to actually enhance social welfare.
In this book we try to address systematically the above set of questions and others that are more specific to the regulation of certain activities or industries. The research question throughout the book is the economic logic underlying regulations. This implies two kinds of exercise. On the one hand, the economic justifications for regulation, namely the reasons why society should be better off with regulation, need to be analyzed. This is known as the normative approach to regulation. On the other hand, the interests and the forces that shape regulation, making it look the way it is regardless of how it should be, must be discussed. This approach is known as the positive theory of regulation. p. 3We have asked prominent experts in specific regulatory fields to perform these exercises, sticking to a comparative law and economics methodology (see De Geest and Van den Bergh, 2004). This implies, most importantly, that the economic analysis of regulation in each chapter of this book is not confined to a specific institutional setting. Although some chapters, for instance Chapter 3 by Rubin and Chapter 4 by Cseres, focus on one jurisdiction or group thereof, this book always takes a functional approach to regulation. This implies that the economic analysis of regulation, both positive and normative, holds regardless of the specific legal environment in which it is applied. This approach to the economic analysis of law naturally enables the comparison of different forms of regulation, which is effectively performed in the vast majority of the chapters of this book. In addition, because this approach is applied to real-world instances of regulation, it is more concrete than the formal analyses prevailing in the theoretical, economic literature.
This volume belongs to the second edition of the Encyclopedia of Law and Economics. In contrast to the first edition, each volume is now more selfcontained and so are the individual chapters. In addition, the emphasis is on scientific discussion of the state of the art on certain law and economics subjects rather than on the inclusiveness of the bibliography. However, the major difference from the first edition is the significant update of the academic and policy debate on single regulatory items. Whenever possible, we have asked the contributors to the previous edition to write a chapter for this book. This has not always been possible particularly because we have taken the opportunity to expand the coverage of topics in regulation, on which there was no separate volume in the first edition of the Encyclopedia. As a result, many of the chapters of this book are entirely new. Still, this book only covers some of the most important subjects in regulation. It is simply impossible to cover them all, and we had to use considerable discretion in selecting the topics. However, we have tried to illustrate all the major areas in which regulation takes place by presenting them in a consistent structure. Before explaining this structure, we need to be more precise about what we mean by regulation and the economic problems underlying it.
2. What is Regulation and Why Should it Make Economic Sense?
Definitions and understanding of regulation vary considerably (see Baldwin and Cave, 1999). For economists, regulation is often a synonym for government intervention in markets. In particular, a distinction is made between contracts and regulation, the former being the private discipline of transactions enforced by courts and the latter being the public discipline of transactions p. 4enforced by governments (Shleifer, 2011). While interesting, this understanding of regulation tends to be over-inclusive and may lead to confusion, for instance with regard to mandatory rules in contract law and tort law. Although these rules undoubtedly constitute forms of government intervention in markets, they do not qualify as regulation stricto sensu. In defining the boundaries of regulation, also with the purpose to avoid overlaps with the other volumes of the Encyclopedia of Law and Economics, we rather take stock of the distinction between private and public law in the Civil Law tradition. Both bodies of law include legal rules affecting the functioning of markets. However, private law focuses on the individual rather than on the collective dimension. For this reason, the vast majority of private law rules can be opted out of by mutual consent, are backed by private sanctions, and are enforced individually in courts. In contrast, public law is mainly compulsory, backed by criminal or administrative sanctions, and it is enforced by the government or its agencies. For the purposes of this volume, by regulation we mean the discipline of individuals’ and firms’ behaviour through legal rules which are defined by the following three attributes: compulsory, backed by criminal/administrative sanctions, and publicly enforced.2
It is well understood that regulation, especially in its more interventionist definition sketched out above, should be justified. Governments may pursue different goals through regulation, but in one way or another they need to take economic efficiency into account. Even when economic efficiency is not a goal in itself, economic analysis sheds light on the costs of certain policies in terms of efficient use of resources (Viscusi et al., 2005). In this book, as in the rest of the Encyclopedia of Law and Economics, economic efficiency is assumed to be the normative criterion for legal analysis. As a result, regulation is economically justified when it is efficiency-enhancing. Because – since Adam Smith’s (1776) celebration of the ‘invisible hand’ – free market exchange is deemed to lead to the efficient allocation of resources, regulation can only improve on market outcomes when markets malfunction. Thus, at least from a normative perspective, regulation is justified in the presence of one or more market failures.
Market failure is a notion of neoclassical economics, meaning departure from one of the conditions of general economic equilibrium in the allocation p. 5of resources, which relies, in turn, on the model of perfect competition. The typical categories of market failures are the following: (a) lack of competition, most prominently monopoly; (b) information problems, most importantly asymmetric information (but also including uncertainty, bounded rationality, and different attitudes to risk); (c) missing markets, including both negative externalities and public goods. Traditionally, in economics, these situations are considered sufficient grounds for legal intervention. However, since Coase (1960), this logic has been brought into question. The sense of Coase’s critique of the neoclassical, particularly Pigouvian (1938), treatment of market failures is threefold. First, in a frictionless world, market failures would be self-correcting only on condition that property rights are well specified and contracts are enforceable at no cost. This is the famous Coase Theorem that holds in a world of zero transaction costs. The second point is that, when transaction costs are positive, as happens to be the case in most of the real world, legal devices other than regulation may do better at achieving an efficient outcome. Liability, which in some situations is the best way to cope with negative externalities, is the most prominent alternative. The third issue is that regulation is not immune from the problem of transaction costs. Inefficiencies in the design and the implementation of corrective measures due to high transaction costs may imply that society will be better off in the absence of regulation.
One important lesson from the Coasean approach to market failures is that the latter are not sufficient to justify regulation. As Ogus (1994) puts it, the case for regulation rests on the association of market failures with private law failures. For instance, it may not be necessary to regulate, beyond what contract law already does, the duty of the more informed party to a contract to inform the counterparty. But such regulation may well be justified when the potential harm of misinformation is diffused and it is unlikely that the threat of civil liability will deter deception, as for instance in the case of adulterated food or securities fraud. Shavell (1984) has framed the problem as a choice between liability and regulation, which is a prominent dimension in assessing the relative merits of private versus public enforcement (Shavell, 1993). According to this approach, regulation is preferable to liability when the government has better information than private parties on the social harm arising from market failure; when the magnitude of social harm and/or its dispersion among members of society is such that liability consistently under-deters: and when the administrative costs of regulation relative to liability are not so much higher as to offset the previous advantages. More recent literature (e.g. Schwartzstein and Shleifer, 2009) has tried to connect the efficient choice of regulation with the failure of courts to guarantee predictable outcomes in adjudicating liability. This line of inquiry seeks to identify the theoretical reasons why the threat of private litigation sometimes over-deters valuable activities, p. 6which is consistent with the empirical evidence in certain US industries (Viscusi, 2007).
A second important implication of Coase’s approach to regulation is that, in some situations, the cure (regulation) may be worse than the disease (market failure). This depends on the problem of regulatory failure. The causes of regulatory failure are manifold, but at least two stand out. First, regulators do not have sufficient information about individuals’ and firms’ behaviour, which makes it very difficult, if not impossible, for regulation to effectively improve on market outcomes, however flawed the latter may be. This point is stressed by the Austrian School economists (e.g. Von Mises, 1949), who add that regulation is self-perpetuating exactly because of its unintended consequences. Faced with regulatory failure, uninformed regulators react by adding new regulations rather than by repealing the existing ones that have failed. This leads us to the second main source of regulatory failure: in designing and enforcing regulation, legislature and bureaucrats pursue their self-interest, which may or may not include the public interest. Therefore, it is illusory to expect that regulation will even aim to correct market failures, as the public interest theories of regulation predict. The private interest theories of regulation predict the opposite, namely that regulation serves the interest of those involved in its implementation, particularly the industry on whose information the bureaucrats depend (Posner, 1974). Based on the findings of these theories, which in turn build on the public choice approach of political science, economists have become increasingly critical of the normative, public interest theories of regulation.
While the positive, private interest explanations of regulation are documented at length in the following chapters, our scepticism towards regulation is not so strong that normative theories are absent from this book. Indeed, the gist of the Coasean approach is that the efficiency of regulation depends on a comparative institutional analysis. The problem of transaction costs affects the functioning of markets, private institutions, and public institutions, but not in the same fashion and not with the same intensity. Therefore, in some situations regulation can improve on market outcomes despite the self-interest of bureaucrats and politicians, perhaps because the information flow is processed most effectively by a central agency and results are sufficiently unambiguous to make the latter accountable (e.g. aircraft safety standards). In other situations private law can score better, for instance when the parties affected by market failure are limited in number but are still likely to behave opportunistically, as in the case of nuisance. Finally, in some situations it may simply be too costly to improve on market outcomes, in terms of both generation of private rents and other unintended consequences, as is sometimes the case in consumer protection (see Van den Bergh, 1997). In these situations it is best to do nothing. The opposite contention, namely that government intervention p. 7is warranted in the presence of whatever market inefficiency, has been famously labelled ‘Nirvana Economics’ by Harold Demsetz (1969). Normative support for regulation only to the extent that regulation can positively improve market outcomes has formed the intellectual basis of cost-benefit analysis, which is a recurrent theme in this book.3
3. Forms of Regulation
Regulation has not always been widespread. In many areas, such as environment and safety for instance, regulation is a relatively recent phenomenon, although according to an influential strand of literature (La Porta et al., 2008), the regulatory state is historically characteristic of the Civil Law tradition as opposed to the Common Law tradition. Without taking a position on the role of legal origins in the build-up of regulation, it seems uncontroversial that regulation around the world – including the US – had quite a narrow scope before the 1970s (Viscusi et al., 2005). Regulation used to be confined to industries where competition was problematic or allegedly undesirable, with restrictions of competition bringing about the well-known problems of monopoly. This type of regulation is known as economic regulation and its public interest rationale was mainly the existence of a natural monopoly.
In the presence of very high economies of scale and scope only one firm can recoup the fixed costs of providing certain services, typically public utilities. This naturally involves the presence of a monopolist, which leads to a number of inefficiencies, particularly concerning pricing. Regulation is needed to cope with these inefficiencies. The last proposition has never been uncontroversial in either the academic or the policy debate. Historically, the approach to natural monopoly was different on the two sides of the Atlantic, with the US mainly regulating private monopolies and European governments basically running them under public ownership. The very notion of natural monopoly was challenged by private interest theories of regulation (Stigler, 1971), which claimed that every monopoly owes its sustainability to legal support, which depends, in turn, on the capture of regulators by vested interests (Posner, 1974). Nowadays, traditional, vertically integrated public or private monopolists have ceased to exist. The notion of natural monopoly has been narrowed down to concepts of essential facility at specific stages of the production chain; the remainder of the value chain, presenting no natural monopoly concerns, has been privatized and/or liberalized.
p. 8Although the importance of natural monopoly has shrunk relative to other problems, the label economic regulation is still widely used. However, economic regulation is no longer the most pervasive and the most expensive form of regulation in modern societies. This primacy has been taken over by another kind of regulation, known as social regulation, which typically includes health, safety, and environmental regulation, as well as consumer protection (Viscusi et al., 2005). The underlying idea is that, in contrast to economic regulation, social regulation aims to cope with market failures independent of the market structure, namely externalities and/or information problems. For the purpose of exposition, this book maintains the traditional distinction between economic and social regulation. But the reader should be warned that this distinction is blurred and nowadays it might just be a matter of semantics. The reason is twofold.
First, the regulation of natural monopolies deals with externalities and information problems as well, whereas social regulation cannot ignore competition issues. The modern regulation of public utilities includes a lot more than price regulation and competitors’ access to essential facilities. Energy markets, for instance, raise issues of pollution and sustainable development, which are externality problems. Furthermore, the quality of retail supply of utilities like water and telecoms is affected by asymmetric information problems, specific to the technology employed but conceptually no different from the problems faced by consumers of unregulated experience/credence goods (Nelson, 1970; Darby and Karni, 1973). Finally, transportation facilities have important public good dimensions, with implications for the development of regional and national markets. Economic regulation cannot and actually does not ignore these issues.4 Likewise, it is not always true that social regulation abstracts from competition problems in dealing with information problems and externalities. Emission trading systems, for instance, are negatively affected by concentration in the permit and in the product market (Revesz and Stavins, 2007) and the choice of instruments of environmental regulation must take this problem into account.5
A second factor undermining the significance of the distinction between economic and social regulation is that the former is not exclusively concerned with natural monopolies. Actually, some of the oldest forms of economic regulation were established not to counter market power, but rather to insulate the supply of certain services from ‘excessive’ or ‘destabilizing’ competition. Financial regulation and regulation of liberal professions are two prominent p. 9examples. Although they emerged well before health, safety, environmental, and consumer regulation, their public interest rationales – externalities and information asymmetries – have a lot in common with social regulation (see Ogus, 1994). Formally, however, these forms of economic regulation directly affect market structure and conduct. The idea that competition can be excessive or destabilizing may be uncomfortable for an orthodox economist, which explains why securities regulation and legal professions were early targets of private interest theories of regulation (Stigler, 1964; Arnauld and Friedland, 1977). However, it is well known that information and externalities problems, which undoubtedly plague both liberal professions and financial markets, can undermine the efficiency of competition. For instance, it is often argued that there is a trade-off between competition and stability in banking (Carletti and Hartmann, 2003). But, especially after the global financial crisis, the last word on the topic has not yet been written.6
Although we have not abandoned the distinction between economic and social regulation, taking into account the above-mentioned ambiguities we have grouped the various forms of regulation dealt with in this volume differently. Specifically, ‘social regulation’ has been defined narrowly, including only consumer protection, environmental regulation, and regulation of health and safety risks. Similarly, the core of economic regulation – current or former natural monopolies – has been grouped under the heading ‘regulation of public utilities’, including telecommunications, electricity, gas, water and transportation. Other important kinds of economic regulation – insurance, banking and finance, and biopharmaceuticals – are presented in a separate part, labelled ‘Regulation of Non-natural Monopolies’. Finally, considering of its growing importance in the academic and the policy debate, the regulation of professions is dealt with in yet another part, including legal, medical, and accounting professions. These four parts are preceded by three more general chapters dealing with the theories and the tools of regulation.
This brings us to the next topic, namely the structure and the contents of the present book.
4. Structure and Contents of this Volume
This volume includes 17 chapters on different topics in regulation. As mentioned earlier, despite this extensive coverage, we had to be selective because regulation covers much more than can be documented even in a large book. Therefore, we have decided to present the various topics starting from p. 10the more general subjects and progressing gradually towards the more specific and technical sectors. To this end, we have divided the book in six parts.
Part I, ‘Regulation in General’, deals with the overall framework of regulation from an economic perspective. It includes a chapter on general theories of regulation, introducing the main themes dealt with in the rest of the book. Part II is named ‘Regulatory Tools’ and includes two cross-sectoral chapters: ‘Price Regulation: Theory and Performance’ and ‘Regulation of Information and Advertising’. This part illustrates two major tools which are at the regulator’s disposal to correct market failures. Notwithstanding the above caveats on the taxonomy of regulatory forms, Part III deals with ‘Social Regulation’ narrowly defined. It includes three chapters: ‘Consumer Protection in the European Union’, ‘Environmental Regulation’, and ‘Risk Regulation’. Part IV discusses the ‘Regulation of Public Utilities’, including ‘Telecommunications Regulation’, ‘Electricity Regulation’, ‘Regulation of the Natural Gas Industry’, ‘Regulation of Water and Wastewater’, and ‘Regulation of the Global Transport Industry: An Institutional Account’. The economic regulation of other industries presenting no natural monopoly characteristics is dealt with in the next two parts. The chapters of Part V – ‘Insurance Regulation’, ‘Regulation of Banking and Financial Markets’, and ‘Regulation of the Biopharmaceutical Industry’ – cover three topical examples of ‘regulation of non-natural monopolies’. Part VI deals with prominent instances of ‘Regulation of Professions’, including three chapters on the legal, the medical, and the accounting professions.
Below we summarize the major takeouts from the various chapters, seeking to emphasize – again selectively – a few key issues.
4.1 Theories and Tools of Regulation
Chapter 1 by den Hertog presents the essential notions of the economic analysis of regulation. Starting with the distinction between positive and normative theories, it surveys and discusses the main public interest grounds for regulation as well as the findings of different private interest theories. This chapter is an indispensable toolbox for the reader not yet familiar with the law and economics approach to regulation. However, Den Hertog does not only survey the state-of-the-art regulation theories; taking stock of the recent problems arising from privatization, liberalization and re-regulation of various industries, he also discusses the main challenges ahead in regulatory reform.
Particularly in the area of economic regulation, two critical issues are worth mentioning. First, there is the problem of investment in the sustainability of networks (relevant for all public utilities, most prominently in the energy sector), despite the adverse incentives depending on the obligation of monopolists to grant competitors access to the essential facilities they own. The problem p. 11is exemplified by the so-called ‘stranded’ assets, fixed costs whose financial value cannot be recouped by a formerly vertically integrated monopolist after the introduction of competition (Joskow, 2007). The second, related, problem is that economic regulation involves a trade-off between providing utilities at a low price and the control of (current and prospective) externalities. In a situation in which both private and public actors have insufficient incentives to invest with a long-term horizon, some of the social costs of cheaper utilities will have to be borne by future generations (Viscusi et al., 2005).
Coming to the tools of regulation, Chapter 2 by Netz illustrates one major instrument: price regulation. The chapter focuses on the problem of natural monopoly, starting with general theory and continuing with rate-of-return regulation, the traditional and still widely used approach to regulating the price of public utilities. Netz explains why firms subject to rate-of-return regulation tend to over-invest in capital and to expand into other markets (perhaps creating additional competition problems), an effect famously identified by Averch and Johnson (1962). Thereafter, alternative and increasingly popular forms of price regulation aimed to improve on the monopolist’s incentives are discussed, including price-cap regulation and profit-sharing mechanisms. Finally, the chapter illustrates a set of issues intertwined with, and complementary to, price regulation, namely access to essential facilities and its relevance from a competition policy perspective.
Chapter 2 develops a broad framework for understanding the regulation of public utilities which is at the same time general (i.e. not specific to a particular industry or country), scientific (i.e. based on established theories and empirical evidence), and practical (i.e. always referring to actual forms of price regulation). This chapter is therefore a realistic introduction to the regulation of natural monopolies, its shortcomings, and its evolution on both sides of the Atlantic, including the recent conflicts between regulation and competition law. Unlike the more technical literature on the subject (which tends to overstate the practical relevance of the Averch-Johnson effect – see also Joskow, 2007), the chapter discusses the practical issues and the balance between rate-of-return and incentive regulation in the modern, vertically de-integrated, provision of utilities.
Chapter 3 by Paul Rubin discusses another major tool of regulation: information regulation, which is mainly employed in the domain of social regulation.7 This is by no means exhaustive of the instruments of social regulation, p. 12which includes inter alia prescriptive standards of various kinds, as well as licensing of services and prior approval of products (Ogus, 1994). Information regulation is, however, the least interventionist form of (social) regulation because it does not compel or prohibit any specific action, but simply mandates – and sometimes prohibits – disclosure. Rubin makes two strong points concerning information regulation. First, there is hardly any economic justification for limiting the amount of information disclosed. The only valid argument against disclosure is deception, which involves false information. The problem with information regulation is that, in order to prevent diffusion of false information, regulation has systematically erred (mainly for reasons of private interests) in the direction of restricting truthful information. The second and explicitly more tentative claim by Rubin is that information regulation should be exclusively concerned with the release of false information and refrain from both mandating disclosure and policing misleading information (especially in advertising).
Rubin’s chapter provides a rigorous framework for understanding information regulation under the traditional assumption of unbounded rationality of decision-makers. The conclusions about desirability of regulation, particularly information regulation, may differ under different assumptions about individual (ir)rationality and uncertainty of future contingencies. These assumptions have had considerable influence on social regulation.
4.2 Social Regulation
In Chapter 4, Cseres discusses the economic (public interest) rationale of consumer protection and applies this framework to the analysis of consumer protection in the EU. One important point about consumer protection is that this concern has recently informed both regulation and contract law, with the EU legislature being very active in both fields.
The increased emphasis on consumer protection in the academic and the policy debate owes much to the development of behavioural economics, which, building on insights from psychology, argues that individuals behave irrationally and/or tend to make poor choices in a number of situations. Although controversial (see e.g. Pacces and Visscher, 2011), this line of inquiry has been particularly appealing in the domain of consumers’ (and investors’) choice. The downside of applying this approach to regulation is paternalism, which on top of overriding individual preferences may conceal regulatory capture by interest groups. An intermediate solution has been authoritatively advocated by Sunstein and Thaler as ‘libertarian paternalism’. This is implemented by means of default rules and information regulation aimed at ‘nudging’ individuals towards the right choice (Thaler and Sunstein, 2008).
p. 13In addition to illustrating the above debate and connecting it with the more traditional economics of information, Cseres discusses the institutional architecture of consumer protection in the EU. Her chapter shows how consumer protection has evolved from an instrument of market integration based on mutual recognition to a system of legal harmonization tout court. Based on the law and economics of the principles of subsidiarity and proportionality in EU legislation (Van den Bergh, 1994; 1998), it is argued that decentralization of consumer protection at the member state level – perhaps with the option to choose an EU model on a voluntary basis – is likely to yield more efficient outcomes regardless of the paradigm (behavioural or rational choice) we use for interpreting consumer choice.
The case for centralization of social regulation may be stronger in another major domain of social regulation: environmental law. Decentralization of environmental regulation is usually challenged on two grounds: the argument that regulatory competition would result in a race to the bottom and the problem of interjurisdictional externalities. In Chapter 5, Faure shows that the first argument is not supported by empirical evidence, while the second could have more merit (although Revesz and Stavins, 2007, focusing on the US, claim that interstate externalities have limited relevance in practice). This is just one of the numerous aspects of environmental regulation discussed by Faure in his comprehensive chapter. Chapter 5 otherwise presents a detailed survey of the literature on externalities as applied to environmental protection, on the various instruments of environmental regulation (as opposed to environmental liability and environmental crime, dealt with in other volumes of the Encyclopedia – Faure, 2009a and 2009b), and on cost-benefit analysis of standard setting. Particular emphasis is given to topical issues like regulatory responses to climate change and the increasing use of market-based instruments in environmental policy, such as the trading of emission permits.
Faure also discusses the highly contentious issue of regulation of environmental risks under uncertainty, that is, under the structural incapability of individuals and regulators quantifying risks (Knight, 1921). This problem is actually broader than environmental regulation as it affects a number of issues in connection with economic and scientific development. It is known as the problem of risk regulation, which is the subject-matter of Chapter 6 by Arcuri.
Arcuri deals with two sets of problems: first, individuals’ bounded rationality, which includes both limited information about future contingencies and how to deal with them (the uncertainty/information concern) and individuals’ inconsistency in processing available information (the behavioural concern). These problems call for a reappraisal of traditional theories of regulation as applied, for instance, to safety, health, food, new technologies and so forth, possibly in the direction of libertarian paternalism. However, this approach triggers a second problem with the political choice of socially acceptable p. 14levels of risks. Arcuri endeavours to discuss this highly topical issue from the perspective of cost-benefit analysis, presenting both its strengths in allowing comparison between different regulatory options and its weaknesses in attempting to assign a dollar value to goods that are not traded in any market. While emphasizing that cost-benefit analysis has a natural tendency to support technocracy despite disagreements in risk perceptions by different members of society, Arcuri warns against the disadvantages of throwing out the baby with the bathwater. Scrapping cost-benefit analysis altogether might have likewise anti-democratic implications.
4.3 Regulation of Public Utilities
Part IV discusses the regulation of several public utilities. Unlike the previous edition of the Encyclopedia, where public utilities were dealt with jointly (Geddes, 2000), this volume includes separate chapters on the most representative industries, namely telecommunications, electricity, gas, water, and transportation.
The reason for this choice is that public utilities have undergone important transformations over the last decade, making the regulatory issues more specific to the industry concerned. On the one hand – as discussed in general by den Hertog and Netz in earlier chapters of this volume – technology and economic regulation have evolved in such a way as to provide consumers with more choice and lower prices. On the other hand, the introduction of competition in the provision of public utilities has created new challenges for regulation. These challenges depend on the problems of long-term investments by the former monopolists (more generally, the owners of the essential facilities) after their exposure to vertical de-integration, mandatory access, and network competition. Likewise, the exposure of these industries to competition raises concerns about safety, the environment, and other externalities. Both investment problems and the scope of the externalities vary considerably across industries. And there is increasing awareness that competition patterns also differ between public utilities, if only for technological reasons.
Chapter 7 by Renda illustrates the regulation of telecommunications. After important liberalizations have occurred on both sides of the Atlantic and the old debate between rate-of-return versus incentive price regulation has lost its appeal for telecoms, other issues are more topical these days. In particular, the focus is on the network(s) because the technical characteristics of the latter affect the pattern of competition and the judgement as to its social desirability. In this context, Renda points to two critical problems. One is the unbundling of telecom services, which is a historical legacy of so-called asymmetric regulation (placing incumbents at a competitive disadvantage relative to insurgents) in the re-regulation of the former telecommunication monopolies. p. 15Mandatory unbundling and access policies are misguided in the absence of monopolization attempts, because these regulations affect the ability of the network owners to protect their investments (Kahn, 2001). The second problem is that the competition between platforms that we observe in the telecommunications industry, together with impressive rates of technical innovation, may have changed the way competition is understood in this industry. It seems that competition is engineered in a more dynamic fashion, namely as competition for the market instead of competition in the market as long advocated by Demsetz (1968). This development in telecommunications suggests that traditional notions of relevant market, access and unbundling in both competition law and regulation need to be updated in order to account for two-side markets (markets that mutually benefit from increasing the number of users) and duplication of networks.
Both problems – underinvestment and competition for the market – are relevant in the energy sector, but the emphasis depends on the specific industry. Chapter 8 (by de Hauteclocque and Perez) and Chapter 9 (by Moselle et al.) provide a comprehensive overview of the regulatory issues faced by the electricity and the gas industry, respectively. The two main themes of these chapters are price regulation and liberalization of the segments no longer considered natural monopolies. Although the liberalization of both energy markets poses similar problems and calls for similar regulatory measures (particularly regarding transmission networks and access thereto), important differences are worth mentioning.
Competition in electricity markets has been introduced by liberalizing power generation. A wholesale power market exposed to competition creates problems of long-term investments, both retrospectively (the problem of the former monopolist’s stranded assets – see supra, Section 4.1) and prospectively. In the latter respect, there is a trade-off between long-term supply contracts (that try to protect investments along the production chain despite vertical de-integration) and openness to competition (spot supply contracts obviously facilitate entry in the liberalized segments). This is a crucial problem for electricity regulation, which from a public interest perspective should care not only about low prices, but also about efficiency, reliability, and sustainability of electricity generation, transmission, and supply. One application of this reasoning is the promotion of Renewable Energy Sources in Electricity (RES-E), which deals with an externality problem. In coping with these problems, regulation is significantly influenced by the private interests of the industry and of the bureaucracies. Particularly in the EU, this has resulted in reluctance by member states to delegate powers to the newly established Agency for the Cooperation of Energy Regulators.
The regulatory issues in the gas markets are similar, but not identical. For one, gas is a storable, natural resource, whereas electricity cannot be stored. p. 16This shifts the emphasis from generation to transmission of energy. In addition, gas allows for competition between networks, particularly in long-distance transportation. The possibility of so-called pipe-to-pipe competition creates an alternative to mandatory access to transmission networks. This is a major difference with electricity whose networks need instead to be widely interconnected for technical reasons. The key role of transmission makes the gas industry somewhat similar to telecoms, at least for regulatory purposes. On the one hand, liberalization of other segments along the value chain can be achieved by mandating competitors’ access to one network. On the other hand, issues of reliability and/or protection of investments in capacity can be dealt with by duplication of networks, which can be socially desirable at the wholesale level. One topical example of infrastructure competition along these lines is the duplication of gas pipelines from Russia to Western Europe.
Chapter 10 by Gibson, McKean, and Piffaut deals with another peculiar utility: water. The water industry is divided into two main areas, the provision of potable water and the disposal of wastewater, which together form the water value chain. Traditionally, the provision/disposal of water was operated by local monopolists subject to price regulation and to strict quality standards. Deregulation has maintained local monopolies licensed by the government in the network components of the industry (pipe distribution and sewage collection), while trying to liberalize other services (e.g. retail billing and metering, treatment, disposal). This has brought into focus two issues: first, the safety and reliability of the water supply having unique public good and life-threatening features; second, the control of the environmental impact of wastewater disposal. Therefore, in the regulation of the water industry, problems of natural monopoly and liberalization thereof now intersect with important externalities in terms of safety, consumer and environmental protection. Chapter 10 analyzes these issues as applied to the recent experience of deregulation in the UK.
Transportation, the last in our sample of public utilities, is discussed in Chapter 11 by Jacobs and Kuipers. The natural monopoly problems with transportation are not evident at first glance. In fact, several means of transportation rely on infrastructure with natural monopoly characteristics (for instance, highways, railways, airports). However, means of transportation have been increasingly competing with each other both in static and in dynamic terms. In this perspective, the upcoming regulatory problem with transportation is concerned with positive and negative externalities. This is not to say that the problems of price regulation and access to essential facilities are no longer relevant for transportation. Access to hubs, ports, rail and roads, as well as the price of that access, is still crucial for achieving an optimal balance between competition and investment in infrastructure. However, public goods and negative externalities are topical issues informing the modern regulatory p. 17debate. On the one hand, the growth of transportation networks, with its repercussions on regional development, has always been high on the market integration agenda, particularly of the EU. On the other hand, increasing concerns for cross-border pollution, safety and terrorism have boosted international regulations. Fom this perspective, this chapter discusses a number of recent regulatory initiatives at the European and international levels.
4.4 Regulation of Non-Natural-Monopolies
As discussed before, not only are former natural monopolies increasingly regulated for reasons other than market power, but also economic regulation applies to industries having no natural monopoly characteristics. Part V of this book presents three examples of non-natural-monopoly industries that are regulated because of externalities and asymmetric information concerns. Somewhat differently from social regulation, which also deals with externalities and/or information problems, economic regulation of these sectors considers market failure so important as to call for explicit limitations of competition in the form of entry licensure, structural restrictions, and conduct rules. This logic has been applied inter alia to the regulation of insurance companies, of banking and finance, and of the pharmaceutical industry.
Chapter 12 by Porrini illustrates the well-known problems of moral hazard and adverse selection in insurance and how insurance firms manage to cope with these problems. In particular, sharing of information between competing insurance companies is needed to overcome asymmetric information and to achieve a second-best efficient outcome. This requires that some of the competition law prohibitions on information exchange be lifted. These exceptions are indeed part of the regulation of insurance, specifically in the EU, although it could be argued that this outcome was influenced by the industry’s lobbying. Another regulatory response to asymmetric information is consumer protection, which has much in common with social regulation. There are peculiarities, however. For instance, insurance rate regulation, which is a form of price regulation, is sometimes implemented, typically in combination with mandatory insurance. Finally, regulation of the insurance industry is increasingly concerned with financial stability problems. Capital regulations and portfolio restrictions traditionally aimed at guaranteeing the individual solvency of insurance companies in relation to their customers. However, after the US government had to rescue AIG, a major insurance company, in order to avoid a worldwide systemic breakdown, prudential regulation is more and more concerned with macro-instead of micro-solvency issues.
The problem of systemic stability in financial markets is the Leitmotiv of Chapter 13 by Heremans and Pacces. They review the economics of banking and financial markets and the regulatory response to market failure. Market p. 18failure in finance depends on problems of information and externalities. Regulation addresses these problems through conduct of business rules and prudential requirements. This approach has recently proved insufficient to prevent financial crises. Governments and central banks had to step in with massive safety nets in order to prevent financial meltdown. Although the appropriate regulatory response to global financial crises is still to be discovered, this chapter tries to draw a few lessons for financial regulation and supervision. First, prudential regulation needs to monitor, and possibly to limit, competition between banks and non-banks in order to identify timely new sources of systemic risk. Second, financial stability policies need to strike a difficult balance between ex-ante strictness and ex-post leniency in order to deal with non-quantifiable risks (Knightian uncertainty). Finally, because systemic externalities are cross-jurisdictional in modern financial markets, at least coordination among monetary and supervisory authorities of different countries is needed.8
Chapter 14 by Danzon deals with the unique features of the pharmaceutical industry. There is hardly any other industry where all sources of market failure are so much intertwined. First of all, the pharmaceutical industry is characterized by massive investments in Research and Development (R&D), which are potentially valuable for society. Competition from producers of generic drugs needs to be restricted for this reason. However, the question remains, what is the optimal balance between competition and innovation? Relatedly, the levels of R&D supported by national regulation have an important public good dimension in globalized markets. This circumstance calls for international rules aimed at preventing free-riding. Finally, in most industrialized countries, consumers of biopharmaceuticals rely on public or private insurance. This implies that regulation needs to balance safety concerns (an externality issue), incentives to innovate (calling for restrictions on competition), and appropriate control of consumers’ and producers’ moral hazard (a problem of asymmetric information) in the design of an optimal pricing and/or reimbursement policy. In her comprehensive survey, Danzon reviews not only the major contributions in the academic literature, but also the various policies that have been implemented in different countries in order to cope with the above-mentioned problems.
4.5 p. 19Regulation of Professions
The public interest rationale for regulating liberal professions is no different from that underlying the regulation of non-natural monopolies reviewed in the previous section. In both situations free market competition is deemed harmful for society because of asymmetric information and/or externalities. For these reasons many, if not most, liberal professions are both protected from competition and subject to sectoral regulation. Part VI of this volume discusses the economics of regulating the legal, the medical, and the accounting professions.
Chapter 15 by Stephen, Love and Rickman surveys the various issues underlying regulation of the legal professions. The analysis is conducted from both the private interest and the public interest perspective. The private interest approach traditionally regards self-regulation of legal professions as a substitute for cartel agreements that should be prohibited. This view is contrasted with the market failure approach, defending licensure and self-regulation of legal professionals on grounds of asymmetric information (difficult for customers to assess quality of service) and related negative externalities (other markets malfunctioning because of low quality of legal counsel). Theory has sometimes identified unnecessary restrictions of competition (such as e.g. regulation of fee levels and prohibition of advertising), but many other issues – like control of entry and fee structure (particularly contingent fees) – remain highly contentious. The chapter surveys recent empirical studies that have tested the effects of regulatory restrictions and of their removal, but in many situations (like conveyancing in the UK) the empirical evidence remains ambiguous. Despite the resistance of powerful vested interests to deregulation, some legal services have been liberalized in certain countries, but not in others. This provides natural or quasi-experiments for further empirical research.
Chapter 16 by Olsen reviews the literature on regulation of medical professions, focusing on two aspects. On the one hand, the licensing of the medical profession is analyzed. On the other hand, liability for medical malpractice is discussed. This chapter is an application of the choice between liability and regulation, discussed earlier (Shavell, 1984 – see supra, Section 2), to the medical profession. Licensure is presented as a joint result of public and private interests at play, although the proportions between these two determinants still need additional empirical investigation. While the case for licensing the medical profession in order to cope with problems of asymmetric information and negative externalities remains ambiguous, the literature on medical malpractice seems to be more straightforward. After decades of perceived ‘crisis’ of medical malpractice in the US, recent empirical studies suggest that increased medical liability is simply an efficient response to p. 20changes in medical practice (perhaps in conjunction with the failure of insurance markets to allocate risk efficiently). In this perspective, medical malpractice could be sufficient to deter negligent treatment, which is the main source of market failure addressed by regulation of the medical profession. This approach, however, may be difficult to transplant outside the US, if only because of the differences in civil procedure on the two sides of the Atlantic.
Chapter 17 by Philipsen illustrates the regulation of the accounting professions, including auditors, accountants, and tax advisers. The chapter reviews both public interest and private interest explanations of regulation and the form in which the latter has been implemented with regard, inter alia, to licensure, price regulation, advertising and ownership structure. Theoretical insights and empirical evidence are discussed with reference to real-world regulatory approaches. The chapter also focuses on two very topical issues. One is the role of statutory audits as gatekeepers (Coffee, 2006), which has received increasing attention since the turn of the century. In this perspective, liability may be a complement rather than a substitute for regulation. Another important subject covered by Philipsen is the debate on accounting standards. While only tangentially related to the regulation of the accounting professions, this debate became very heated in the aftermath of the global financial crisis. The latter has shown that marking-to-market of financial intermediaries’ balance sheets has pro-cyclical effects, which, like inflexible capital adequacy regulations (discussed in Chapter 13), exacerbate systemic vulnerability.
5. Concluding Remarks
Regulation is widespread and complex in modern societies; so is the economics underlying it. We have tried to guide the reader though the different forms, explanations, and rationales of regulation with the aid of economic categories of analysis (e.g. market failures, private interest groups) and traditional taxonomies (e.g. economic versus social regulation). But the fact remains that the regulation of economic activities, both those performed by individuals and those performed by firms, involves a number of sector-specific issues. It is no longer possible to distinguish forms of regulation depending on the kind of market failure they are supposed to address, because in virtually every field regulation has to cope simultaneously with multiple market failures.
Of course, this implies that the actual outcomes of regulated markets will depart significantly from the idealized world of perfect competition. Every chapter of this book accounts for this fact, focusing on how specific markets operate, malfunction, and are corrected by regulation in the real world. Not only does this reflect the comparative law and economics methodology that informs this volume of the Encyclopedia. It also avoids the Nirvana fallacy of p. 21analyzing regulation by taking abstract economic models as benchmark, a problem denounced over 40 years ago by Demsetz; a problem that still pervades the academic and policy debate today.
We hope that this introduction has sufficiently stimulated the reader to dwell on the economics of regulation discussed in the following chapters.
The answers – for those not familiar with the law and economics approach – lie in the public and the private interest theories of regulation. The public interest rationale for safety and environmental regulations that make products more expensive is the efficient control of externalities, which should improve social welfare. However, the actual development of safety and environmental standards is influenced by the industry’s lobbies, which pursue private interests that do not necessarily enhance the welfare of society. See infra, Chapter 1 by Den Hertog.
See e.g. Ogus (1994). It may be objected that the distinction between private and public law is becoming blurred. For instance, private enforcement is increasingly relying on collective action tools, particularly in the area of consumer protection. On the other hand, public law is gradually moving from command-and-control forms of regulation to more market-based instruments, e.g. the trading of emission permits. This volume discusses these grey areas as well. See, for instance, Chapter 4 by Cseres and Chapter 5 by Faure.
See particularly Chapter 6 by Arcuri.
See Chapter 5 by Faure.
This issue is briefly touched upon in Chapter 13 by Heremans and Pacces.
Information regulation is not exclusively relevant for social regulation. For instance, information regulation is very important in various financial industries,particularly insurance and banking. See Chapter 12 by Porrini and Chapter 13 by Heremans and Pacces.
Awareness of this problem has induced the EU to establish a new European System of Financial Supervision, characterized by as much centralization as allowed by the proportionality and subsidiarity principles in the EU treaties. Of course, this outcome can also be interpreted as the effect of the European bureaucracy’s interests and the financial industry’s lobbies.
2003), ‘Competition and Stability: What’s Special about Banking?’, in P. Mizen (ed) (ed.), Monetary History, Exchanges Rates and Financial Markets: Essays in Honour of Charles Goodhart, Vol. 2. Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 202–229.and (
1997), ‘Wer Schützt die Europäischen Verbraucher vor dem Brüsseler Verbraucherschutz? Zu den Möglichen Adversen Effekten der Europäischen Richtlinien zum Schutze des Verbrauchers’, in C. Ott (ed) and H.B. Shaefer (ed) (eds), Effiziente Verhaltenssteuerung und Kooperation im Zivilrecht, Türbingen: Möhr Siebeck, pp. 77–97.(