Lecture week 1
What is regulation? A term with many definitions, which could refer to:
A specific type of legislative instrument in the EU legal order – for example: The Council
Regulation (EC) No 139/2004 of 20 January 2004 on the control of concentrations between
undertakings (known as the EC Merger Regulation)
Delegated or secondary legislation – legislation passed by the executive branch of
government, such as ministries, agencies and supervisory bodies
A form of governance – ‘a process involving the sustained and focused attempt to alter the
behaviour of others with the intention of producing a broadly identified outcome or
outcomes’. (Julia Black, 2002. ‘Critical Reflections on Regulation’)
What is regulation? A different approach - à “threat-backed governmental directives aimed at
correcting private ordering defects that diminish total social welfare” (Lambert 2017, p. 6)
When is market regulation justified?
The indispensable role of markets
In mainstream (neoclassical) economic theory, economic agents are rational, have steady preferences
and seek to maximise the utility they derive from those preferences, subject to external constraints
(e.g., capital and time):
• Buyers seek to maximize the satisfaction they derive from consuming goods or services; and
• Producers attempt to maximize the profit they receive by producing units of a good or
service.
In this framework, competitive markets are considered the primary mechanism for striking a
balance between these conflicting interests.
Market equilibrium
Competitive markets help define the optimal level of the distribution of productive resources through
the establishment of prices, which are determined by the forces of supply and demand:
Imagine that buyers want to buy a car at a certain price.
But producers may not find it beneficial to manufacture the number of cars required by all
buyers at this price.
Buyers who value the product the most will bid up the price they are willing to pay, in order to
outperform other buyers.
As prices change, the imbalance between buy orders and quantities offered is reduced.
At a certain price, the cost for the supply of cars will match the demand. This is known as
equilibrium price.
Back to the real world: Market failures
What is market failure?
Market success is defined as the ability of a competitive market to achieve an allocation of
resources that is Pareto efficient.
Accordingly, market failure occurs when this outcome is not attained, that is when resources
are allocated through the markets in a way that does not maximize total welfare.
In extreme instances, the market might not even be able to allocate resources to a certain
productive activity at all (complete market failure).
In these cases, therefore, regulatory intervention may be justified in an effort to improve
economic outcomes by addressing or ameliorating the market failure.
,Types of market failures
-Market power
One or more firms may have substantial market power either because of their superior goods
or services (positive scenario) or due to barriers to entry (negative scenario).
Barriers to entry can range from the perpetual ownership of a scarce resource (natural
monopolies), to high set-up and sunk costs, exclusive contracts, brands, intellectual property
rights and vertical integration.
-Externalities
The production or consumption of a good or service may impact a third party which is not
directly involved in the transaction. These indirect effects of market activities are called
externalities.
Externalities can be both negative (the activity generates external costs) and positive (the
activity generates external benefits).
Impact - If not addressed, externalities may result in resource misallocation and, thus, cause a
market failure.
-Public goods
These are products or services that are “non-rivalrous” and “non- excludable”.
Non-excludability: it is impossible or prohibitively costly to prevent
non-payers from enjoying it once the good has been produced.
Non-rivalrousness: the consumption of the good by one person does not reduce the
consumption opportunities of others.
There are also some goods which have only one of these features: they are either non-rivalrous or non-
excludable (quasi-public goods).
-Information asymmetry
Neoclassical economics assume that market participants have perfect information and that
they will use it to maximize their utility.
In practice, information is often unequally distributed with some parties having more
knowledge than others.
This can lead to adverse selection and moral hazard (risk- taking because one party does not
bear the full consequences). In these scenarios the market supplies fewer products or services
than the societal optimum (or none at all)
-Bounded rationality: decision-making heuristics and biases
Neoclassical economics assume that market participants are rational decision makers, that is
they follow the course of action that will maximize their utility on the basis of all available
information.
However, insights from behavioural sciences indicate that humans suffer from cognitive
limitations, and they are only boundedly rational.
Instead of seeking to maximize their utility they use mental shortcuts (‘heuristics’) to
determine the course of action that leads to a solution that is ‘good enough’ even though not
optimal (‘satisficing’ v ‘optimizing’).
Information on public goods / decision making heuristics
Public goods
Due to their special characteristics, public
goods may be subject to market failure.
Problems: under-production, over-
consumption (depletion – tragedy of the
commons)
As public goods are non-excludable, those
who benefit from them can use them
without paying a fair share or without
paying at all (“free-rider problem”).
, Moreover, due to the non-rivalrous character of public goods, consumers will not need to
compete with each other to obtain them. Accordingly, unless consumption can be excluded
(e.g., through fees), the price they are willing to pay would tend towards zero.
In this regard, no market equilibrium can be achieved, since the marginal cost of production
will outweigh the value that consumers attach to the public good. Absent some kind of
intervention, therefore, competitive markets will not produce public goods and some quasi-
public goods at socially optimal levels (if they produce them at all).
Decision-making heuristics and biases
Kahneman and Tversky identify three main types of heuristics: representativeness (Judging
likelihood based on similarity to a prototype), availability (: Cognitive shortcut that relies on
what immediately comes to mind.) and anchoring (occurs when you focus on the first piece of
information you receive during a decision-making process and fail to consider any other
information that follows) Heuristics are quite useful and often yield reasonable judgements. In fact,
they are an adaptive mechanism which allows us to operate in an increasingly complex environment.
• However, reliance on heuristics may also lead to cognitive biases = systematic errors in
thinking that lead to decisions that deviate from rational economic behaviour.
• If left unaddressed, cognitive biases may, thus, lead to the misallocation of resources and
reducing of the total welfare.
How does regulation work?
Essential steps of regulation
1. Identifying a desirable state of the world (setting the “benchmark”)
2. Comparing the state of the world with that benchmark>do things work as they were supposed
to?
3. Defining possible strategies to address the deficiencies detected /achieve the desired outcome
4. Selecting the best strategy (including option zero): impact assessment (cost-benefit analysis)
5. Implementing and enforcing the preferred strategy
6. Measuring outcomes / reviewing (back to “a”)
Key components of regulation
Broadly speaking, “regulation” includes:
• Rule-making (laws; regulations)
• Supervision: oversight of regulated parties’ behavior by an administrative entity
• Enforcement: discovering, deterring, rehabilitating, or punishing parties who violate rules their
regulatory obligations
Why regulation fails
Market failures typically provide the rationale for nonmarket (government) interventions
which aim at remedying the shortcomings of the market mechanism.
, However, nonmarket remedies may also “fail” to the extent that they do not produce the
efficiency or distributional goals that unregulated markets failed to deliver.
Nonmarket failures (Just as markets can fail, so can government interventions.)
Private goals and internalities
Economic theories of regulation often assume that government agencies intervene in the
market to pursue the public interest (i.e., maximise total welfare).
However, they overlook that policymakers are also driven by their own self-interests (e.g.,
reelection) which often differ from those of the public at large (‘public choice theory’).
At the same time, internal standards and objectives established within nonmarket agencies
(‘internalities’) also materially influence and motivate their actions.
Imperfect information
Public interest theories of regulation also assume that regulators have sufficient information
and are aware of the costs and benefits of their decisions.
In practice, however, policymakers also operate under a veil of ignorance and cannot foresee
all potential effects of their actions. (Regulators may lack complete information about the
costs, benefits, and unintended consequences of their actions)
As a result, despite their good intentions, when making decisions they may not be able to
define this course of action that best serves the public interest.
Regulatory capture
Regulated industries have a strong interest in influencing regulators and devote large budgets
for that purpose.
By contrast, individual citizens are less keen and motivated to advocate for their own rights,
due to limited resources and time.
As a result, regulatory agencies may come to be dominated by the industries they regulate and
not by the public interest.
This is not necessarily the result of corruption (quid pro quo); regulators may simply think
like the industries they regulate, either due to heavy lobbying or even because they come from
these industries (‘revolving door’). (Industry influence can lead regulators to adopt policies
that benefit specific industries rather than the general public, even without explicit corruption.)
Tutorial week 1
1. How does Lambert define regulation?
Governmental directives aimed at correcting defects in private ordering that reduce total social
welfare.
2. It is sometimes said that ‘Not all law is regulation and not all regulation is law.’ What does
that mean? Can you give an example of law that is not regulation and regulation which is not
law?
Law: Laws are general rules and principles established by governmental authorities to govern
behavior. These laws include statutes passed by legislatures, court rulings that create common law,
and constitutional provisions. Laws are broad in scope and provide the foundation for a society's legal
system.
Regulation: Regulations are specific rules or directives issued by governmental agencies based on
authority granted by legislation. These rules aim to enforce, implement, or interpret the broader laws
and often focus on detailed and specific aspects of behavior or industry practices.
