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Summary: Understanding Regulation by Baldwin, Cave and Lodge (2012)
Summary Understanding Regulation by Baldwin, Cave and Lodge (2012)
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Understanding regulation: Theory, strategy and practice (secondedition)
Baldwin, Cave & Lodge (2012)
Chapter 1: Introduction
What is regulation?
- A specific set of commands. Regulation here involves the promulgation of a binding set
of rules to be applied by a body devoted to this purpose.
- A deliberate state influence. Broad sense, covers all state actions designed to influence
business or social behavior.
- As all forms of social or economic influence. All mechanisms influencing, whether state-
based or not are deemed regulatory.
It may also be viewed as enabling or facilitative (green light).
Issues on the regulatory agenda
Both inside and outside government, regulation happened over time. One prominent issue was
the governance of regulatory bodies, from one director-general to a collective board. A second
issue focused on the effects and biases of regulatory regimes. Worry about investments in
infrastructure and the environmental effects of regulated industries. The third debate was driven
by the emergence of new technologies and products. Areas like food (genetically modified and
scandals), communication technologies have produced raft of new control challenges. Existing
regulatory regimes like gambling have seen new frontiers with internet gambling. Attention has
shifted towards meta-regulation and auditing inside businesses. A tendency growing is seeing
regulatory issues in terms of risk, and control issues as questions of risk management.
Chapter 2: Why regulate?
Market failure rationales
Monopolies and natural monopolies
Monopoly pricing and output is likely to occur and be sustained where three factors are obtain:
- A single seller occupies the entire market
- The product sold is unique in the sense that there is no substitute sufficiently close for
consumers to turn to.
- Substantial barriers restrict entry by other firms into the industry, and exit is difficult
The market fails because competition is deficient. The firm will restrict its output and set the
price above marginal cost. It will do this because if it charges a single price for its product,
additional sales will only be achieved by lowering the price on the entire output. The monopolist
will forgo sales to the extent that lost revenue from fewer sales will be compensated for by
higher revenue derived from increased price on the units still sold. The effects of monopoly, as
compared to perfect competition, are reduced output, higher prices, and transfer of income from
,consumers to producers.
One response to potential monopolies is to use competition (or antitrust) laws so as to create
a business environment that is conducive to competition. Where a ‘natural monopoly’ exists,
however, the use of competition law may be undesirable. A natural monopoly occurs when
economies of scale available in the production process are so large that the relevant market can
be served at the least cost by a single firm. Thus, rather than have three railway or electricity
companies laying separate networks of rails or cables where one would do, it may be more
efficient to give one firm a monopoly subject to regulation of such matters as prices and access
to the network. If a firm is in a position of natural monopoly then, like any monopoly, it will
present problems of reduced output, higher prices, and transfers of wealth from consumers to the
firm. The regulator will try to set price near incremental cost (the cost of producing an
additional unit) in order to encourage the natural monopolist to expand its output to the level that
competitive conditions would have induced. Not all aspects of a supply process may be naturally
monopolistic.
Windfall profits
A firm will earn a windfall profit (sometimes called an ‘economic rent’ or excess profit) where it
finds a source of supply significantly cheaper than that available in the marketplace. Regulation
may be called for when it is desired either to transfer profits to taxpayers or to allow consumers
or the public to benefit from the windfall.
Externalities
The reason for regulating externalities (or ‘spillovers’) is that the price of a product does not
reflect the true cost to society of producing that good, and excessive consumption accordingly
results.
Information inadequacies
Competitive markets can only function properly if consumers are sufficiently well informed to
evaluate competing products. Regulation, by making information more extensively accessible,
accurate, and affordable, may protect consumers against information inadequacies and the
consequences thereof, and may encourage the operation of healthy, competitive markets.
Continuity and availability of service
In some circumstances, the market may not provide the socially desired levels of continuity and
availability of service. Thus, where demand is cyclical (for example, as with passenger air
transport to a holiday island) waste may occur as firms go through the processes of closing and
reopening operations. Regulation may be used to sustain services through troughs—for example,
by setting minimum prices at levels allowing the covering of fixed costs through lean periods.
Anti-competitive behavior and predatory pricing
Markets may be deficient not merely because competition is lacking: they may produce
undesirable effects because firms behave in a manner not conducive to healthy competition. A
principal manifestation of such behavior is predatory pricing. This occurs when a firm prices
below costs, in the hope of driving competitors from the market, achieving a degree of
domination, and then using its position to recover the costs of predation and increase profits at
,the expense of consumers. The aim for regulators is to sustain competition and protect
consumers from the ill-effects of market domination by outlawing predatory or other forms of
anti-competitive behavior.
Public goods and moral hazard
Some commodities, e.g. security and defense services, may bring shared benefits and be
generally desired. It may, however, be very costly for those paying for such services to prevent
non-payers (‘free-riders’) from enjoying the benefits of those services.
Unequal bargaining power
One precondition for the efficient or fair allocation of resources in a market is equal bargaining
power. If bargaining power is unequal, regulation may be justified in order to protect certain
interests. Thus, if unemployment is prevalent it cannot be assumed that workers will be able to
negotiate effectively to protect their interests, and regulation may be required to safeguard such
matters as the health and safety of those workers.
Scarcity and rationing
Regulatory rather than market mechanisms may be justified in order to allocate certain
commodities when these are in short supply. In petrol shortage, for example, public interest
objectives may take precedence over efficiency so that, instead of using pricing as an allocative
instrument, the petrol is allocated with reference to democratically generated lists of priorities.
Rationalizing and coordination
In many situations, it is extremely expensive for individuals to negotiate private contracts so as
to organize behaviour or industries in an efficient manner—the transaction costs would be
excessive. Centralized regulation holds the advantage over individual private law arrangements,
where information can be more efficiently communicated through public channels and
economies of scale can be achieved by having one public agency responsible for upholding
standards. It is noteworthy that this rationale for regulation is based more on the desire to enable
effective action to take place than on the need to prohibit undesirable behaviour.
Planning
Markets may ensure reasonably well that individuals’ consumer preferences are met, but they are
less able to meet the demands of future generations or to satisfy altruistic concerns (e.g. the
quality of an environment not personally enjoyed).
Rights-based and social rationales for regulating
Governments, indeed, regulate on a host of matters simply in order to further social policies such
as the prevention of discrimination based on race, sex, or age. Social objectives, moreover, are
sometimes furthered by regulating even where this involves overruling the preferences of market
players and acting paternalistically. Thus, society may, as a matter of policy, decide to act in the
face of drivers’ desires and demand that seat belts be worn in motor vehicles. In the strongest
form of such paternalism, the decision is taken to regulate even where it is accepted that the
citizens involved would not support regulation and that they are possessed of full information on
the relevant issue.
, Conclusions: choosing to regulate
Chapter 3: What is good regulation?
Five criteria for good regulation
The legislative mandate
This criterion suggests that regulatory action deserves support when it is authorized by
Parliament, the fountain of democratic authority. For all of these reasons, regulators are seldom,
if ever, involved in the mechanical transmission of statutory objectives into results on the
ground.
Accountability
Regulators with imprecise mandates may, nevertheless, claim that they deserve the support of the
public because they are properly accountable to, and controlled by, democratic institutions. If
Parliament itself or another elected institution is not the body holding the regulator to account,
then the arrangement may be criticized as unrepresentative.
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