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PA E&G: Economics of Regulation Notes
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Lecture notes of 30 pages for the course Economics Of Regulation at UL (-)
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Notes on Economics of RegulationWeek I:
Lecture notes
Economics is about making decision under scarcity, i.e., how to make the best use of the
available resources. In this course, students will learn how the combination of market and
government regulation can improve social welfare.
Economists believe that markets do not work perfectly, but the competitive market still serves
as a benchmark in economic analysis and in social cost/benefit analyses.
Welfare: everything individuals ascribe value to, such as the consumption of goods and
services but also leisure, environmental quality, and so forth.
Efficiency is a central concept in economic analyses, but it is also a difficult concept to fully
comprehend. The economic definition of efficiency combines both the preferences of
consumers as well as production possibilities. In applied economic discussions however, the
term efficiency is oft restricted to production possibilities in the sense of the cheapest way to
achieve a certain target.
Efficiency can be defined via the pareto-criterion. A pareto-improvement is a change that
makes at least one individual better off, without making any other individual worse off.
Pareto-efficiency refers to the situation where the welfare of an individual cannot be
improved without reducing the welfare of others, i.e., the impossibility of a further pareto-
improvement. This definition of efficiency is seen as very strict, as often improvements do
indeed hurt others.
Therefore, the Hicks-Kaldor-criterion can also be used to define efficiency. A Hicks-Kaldor
improvement is a change where gainers are able to compensators losers. Hicks-Kaldor
efficiency refers to a situation where no adjustment can be made that benefits some
individuals than the cost to others, meaning that the loss of these others cannot fully be
compensated any longer. This definition is broader, since it studies efficiency at a larger,
aggregate level as opposed to an individual level.
1
,Efficiency can be decomposed into three types, being exchange efficiency, production
efficiency, and allocative efficiency. These will be discussed hereafter.
Exchange efficiency: a case where two individuals are given a specific quantity of two goods,
as no production occurs (so the output is fixed). Trade is possible and yields a pareto-efficient
outcome. The specific outcome depends on the negotiation power of both individuals.
Production efficiency: in this case, scarce resources (input) must be divided between various
demanded outputs. Increasing an input (such as time, labour, or capital) will lead to more
output but often in a decreasing manner. For efficiency, it is necessary that each input is put to
its best use and thus that opportunity costs are minimised.
Here, the production possibilities frontier describes the maximum of (two) outcomes that can
be produced by allocating resources efficiently. Points within the frontier are not efficient.
Points on the frontier are produced efficient. In this case, if more of product 1 would be
produced, some of product 2 has to be given up. The degree to which this occurs, i.e., the
marginal rate of transformation, is described by the slope of the production possibility
frontier. Here, production efficiency implies that each output is produced with the lowest
cost possible.
Taken the concepts of exchange efficiency and production efficiency together is the concept
called allocative efficiency. Here, preferences are needed to determine which point on the
production feasibility frontier, i.e., which combination of output, society prefers. This requires
an aggregate demand. Society will therefore need to reveal its preference for outcomes.
Competitive markets occurs when the following conditions are met:
o Property rights are well defined and secure.
o Both consumers and suppliers are price takers (as both do not have market power).
o There is perfect information (i.e., everybody is well informed of the price).
o There is no entry or exit barriers.
In this case, prices (eventually) signal the social marginal production costs of products. Such
that individuals can decide how much of a product they desire, which coincides with the
trade-off faced by society as a whole.
2
, In this competitive market, the demand curve reflects the willingness to pay for the product
by the consumers whilst the supply curve reflects these social marginal production costs of
the product. At the market equilibrium, the marginal consumer pays the cost of producing the
marginal (last unit) of the product.
Infra-marginal consumers pay a price less than their own valuation. This creates a surplus.
The aggregation hereof is called the consumer surplus. The same goes for producers and
their producers’ surplus. The sum of these surpluses reflects the total surplus that society
obtains from this market. It a proxy for the contribution to welfare from this market. On a
competitive market, producers and consumers cause the surplus to be maximised without
government interference (other than protecting property rights).
Market failures cause markets to deviate from the competitive equilibrium, which yield
welfare losses.
The first welfare theorem states that every competitive economy is pareto-efficient. This
requires that all factors of production are however privately owned and that all markets exist,
which is not the case in reality.
The second welfare theorem states that government policy can potentially reach any point on
the utility frontier through redistribution. However, this theorem will not be further discussed
in this course. Instead, government policy can also sufficiently correct for redistributive
fairness with redistributive policies (since efficient equilibria can lead to unfair outcomes).
Market failures can occur out of the following causes, namely the nature of goods (public vs.
private goods as determined through the degree of rivalry and excludability, or the presence of
externalities), the nature of exchange (via the occurrence of information asymmetry), the
nature of the market (through market power), and the nature of the system (through the
business cycle).
The nature of goods can be determined through the degree of rivalry and excludability, but no
product or service falls perfectly in a category, only to a certain degree.
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