The Economics of Government Regulation

Fundamentals and Application in China

Wang Junhao

• Editorial: Routledge
• Año: 2021
• ISBN:
  9781000404845
• Edición: 1
• Categoría: Negocios y empresa
• Categoría: Gobierno y empresas

Regulation is a public policy approach closely related to calculations of the equilibrium of supply and demand and to cost-benefit analyses. Governments combine a variety of incentives and restrictions on behavior, including laws and regulations, in order to guide enterprises and smaller entities within the economy toward pursuing policies in the public interest.
This book offers an in-depth and systematic review of the economic theory of regulation, with particular emphasis on the Chinese context. The basic concepts cover economic and social regulation, regulatory process, regulation under asymmetric information, and capture theory. Drawing on a broad range of cases from across the telecommunications, electric power, and water sectors since the founding of the People's Republic of China in 1949, the author explores economic regulation in China with reference to natural monopoly, investment, price level and price structure, entry, and competition. In addition, he discusses theories of externalities and asymmetric information, which are analyzed in the light of China's environmental and product quality regulation. The author argues that the Chinese government has deregulated its economy to a large extent in the past and proposes that the Chinese government will enforce more social regulation in the future.
Students and scholars of government regulation, economics, and industrial organization will find this volume to be an essential guide.

Part I

Introduction

1 Economic analysis of government regulation

Regulation is a unique public product imposed by a government on society. The main task of this chapter is to use analytical approaches of microeconomics to explain and analyze the supply and demand of government regulation and its equilibrium, along with the causes of this demand and the means of providing the regulation. Moreover, the costs and benefits of regulation will be examined, providing an analytical tool to assess the economic rationality of regulation.

Regulation as a unique public product

Government regulation is a contested concept. Alan Stone defines it as a state-imposed limitation on the possible decisions by individuals or organizations, which is effective owing to the threat of sanction.¹ W. Kip Viscusi et al. highlight the power to coerce, for the same purposes as Stone proposes.² For Daniel F. Spulber, regulations consist of general rules or special actions imposed by administrative authorities that either intervene directly with the market allocation mechanism or indirectly by altering consumer and firm demand and supply decisions.³ Masu Uekusa defines it as an action performed by public institutions to restrict the activities of firms according to certain rules, where the public institutions or administrative authorities are generally referred to as “government.”⁴

Based on this survey, we contend that regulation is a combination of various incentive and restrictive behaviors toward micro-market entities (mainly firms) by government agencies using certain laws, regulations, systems, and a broad range of regulatory methods, in pursuit of public interest. In a market economy system, regulators are supposed not only to restrict firms from certain activities, but also encourage them to improve productive efficiency. Then the lower prices enjoyed by consumers and the incremental gains achieved by firms yield higher social welfare.

The discussion of regulation may be summarized as follows: (1) the subject of regulation is government agencies with regulatory functions (hereinafter referred to as “the government” in this book), which are granted regulatory powers through legislation or other forms and often play the role of “regulators”; (2) the object of regulation is various micro-market entities (mainly firms), which are often referred to as the “regulated entities”; and (3) government’s regulation power is wielded through regulation of various forms, which precisely stipulate the mandates that the regulated entities must be subject to and define the way to control and impose sanctions against violations.

Chief among the three components of the concept of government regulation is policy. It may take the form of laws (such as the Telecommunications Act and the Electric Power Act), or less powerful rules, regulations, and local government policies. Whether laws or normative documents, they are all formulated by the government and have considerable coercive power.

From the perspective of institutional economics, these laws and normative documents are essentially public products. As previously stated, government regulation as a public product is not directed at any specific market entity, but instead at every entity. It is not exclusive in its application and applies to all regulated actors. However, it is unique as compared with other general public products in terms of the following three attributes.

First, a general public product is tangible and physical (such as parks, roads, bridges, and lighthouses), while government regulation is intangible and is represented by legal systems and other rules. It is also flexible and can be subjective in its implementation.

Second, a general public product does not have to be provided only by the government. It may also be provided by private donors (firms or individuals) or supplied competitively by private players through franchise bidding. However, the right to supply government regulation is monopolistic in its nature and is exclusive to the government.

Third, a general public product can provide diverse types of consumers with basically the same benefits. For example, the scenic West Lake in Hangzhou, China, attracts tourists from different countries, thus making a contribution to international tourism. However, government regulation is influenced by such factors as values, ideology, and political systems. It has a certain “regional specificity,” i.e., regulation that is considered to be successful in one country may not be appropriate in another country. Therefore, no one country can copy a regulatory model from another wholesale. Meanwhile, from a microscopic standpoint, regulations will have different effects on different interest groups, which may be beneficial to some while unfavorable to others.

Then based on regulation’s uniqueness, we can use economic principles to analyze the supply and demand of government regulation and its subsequent equilibrium, identify its costs and benefits, and explore effective ways to enhance regulatory efficiency.

Supply and demand of regulation

Supply and demand form the most fundamental concepts for the economic analysis of government regulation. Equilibrium seems to be an ideal goal. However, the demand for regulation is constantly changing due to a variety of factors, while its supply is relatively stable. This implies that the equilibrium is difficult to achieve in reality. Disequilibrium, therefore, is normal. Hence, one of the secondary goals of regulation is to minimize disequilibrium between its supply and demand.

Demand for regulation

Demand for government regulation is the theoretical framework for regulatory policies. Demand analysis will be carried out on both the macroscopic and microscopic levels. On the macroscopic level, demand mainly flows from two sources, namely, natural monopoly and externalities.

Natural monopoly

In a competitive industry, competition contains an inherent incentive mechanism to urge firms to consciously promote productive efficiency (i.e., striving to improve internal operational and managerial efficiency) and allocative efficiency (i.e., pricing at cost including normal profits), thus boosting economic efficiency across the industry. However, a notable characteristic of a natural monopoly to be discussed in Chapter 3 is its subadditivity, i.e., cost can be minimized due to the provision of specific products or services by one firm rather than separate providers. A monopolist in a dominant position will instinctively maximize its own interests. Government regulation, in an effort to maximize social welfare, pursues social economic efficiency as a whole (especially allocative efficiency). Hence, regulation is required. The issue of the demand for monopoly regulation can be broken down into three aspects as follows.

First, regulation is expected to prevent firms from setting inappropriate monopoly prices and maintain allocative efficiency in society. Subadditivity in a natural monopoly means that a product provided by one firm ensures higher productive efficiency on theoretical grounds. However, as the firm is dominant, it may become a price setter in the market instead of a price taker due to the absence of external constraints. It may set a price much higher than its cost to obtain monopoly profits, resulting in a distortion of allocative efficiency. Thus, the need for government regulation arises.

In order to maximize profits, a monopoly sets a price P _m according to the principle of marginal analysis and determines the quantity of production Q _m accordingly (see Figure 1.1). There are at least three options for improving allocative efficiency in society through the implementation of government regulation. In the first option, the government determines the regulated price P ₁ and the corresponding quantity of production Q ₁ at marginal cost. Because this cost is in a progressively decreasing state within a certain range of output, the marginal cost is always below the average cost, resulting in business losses. No firm would operate under such a scenario unless it receives the offset (subsidy) from the government. The second option requires the government to determine the regulated price P ₂ and the corresponding quantity of production Q ₂ at average cost so that the firm will not make a loss and require no government subsidies. The third option is that the government uses the theory of franchise bidding (to be discussed in Chapter 8) to sell the right to exclusive operations of a product or service at auction. As long as competition is sufficient, the result will bring the price closer to P ₂ and the quantity closer to Q ₂ . No matter which option is adopted, government regulation is intended to prevent firms from setting inappropriate monopoly prices, thus maintaining allocative efficiency in society.

Figure 1.1 Monopoly price and government regulation.

Second, regulation is expected to prevent destructive competition thereby ensuring productive efficiency and stability of supply in society. Natural monopolies have distinctive features, such as the demand for hefty investment, a long payback period, high asset specificity, a considerable economies of scale effect, and subadditivity. A monopolistic or oligopolistic market can thereby maximize productive efficiency in society. However, if there are no barriers to entry, then given information asymmetry, multiple firms will blindly enter the natural monopoly and make duplicated investments, resulting in destructive competition. One possible scenario is that stronger firms will eventually drive weaker competitors out of the market, leaving these weaker firms unable to recoup their investment. This could also lead to assets with distinctive specialized characteristics lying idle, which is a waste of social resources. A second scenario is that several firms end up at loggerheads with one another, eventually creating a lose-lose situation. In severe cases of overcapacity, this competition for market share results in productive inefficiencies. Therefore, in order to prevent such destructive competition, the government needs to implement regulation in certain monopolistic industries and curb excessive market entries by creating barriers to entry, thus ensuring productive efficiency in society.⁵

At the same time, the products or services, provided by natural monopolies, such as the telecommunications, electric power, railroad, gas, and water industries, are life-sustaining necessities of society and essential inputs for most firms. It is therefore paramount to maintain high stability in production and supply. Therefore, it is equally important to create exit barriers to prevent firms from arbitrarily exiting a market when there is no profit to be gained or if they seek other avenues for development. This helps to ensure stable production and supply of specific social products or services.

Third, regulation is expected to restrict monopolistic acts of unfair competition. Natural monopoly firms are not monolithic: in reality, a firm involved in a monopoly market often operates in a competitive market at the same time. This provides fertile ground for acts of unfair competition. In the absence of government regulation, it is entirely possible for a monopolist to set higher prices in its monopoly market and lower prices in a competitive one, so as to exclude competitors through cross-subsidization. Meanwhile, it is likely that a number of monopolists might collude to obtain greater monopoly profits. Therefore, government regulation is necessary to restrict these diverse forms of unfair competitions.

Externalities

The issue of externalities has been discussed by many scholars. Externalities are unforeseen consequences to economic activities which cause a divergence between private (firms or individuals) and social costs, or between private and social benefits. Externalities are categorized as either positive or negative. Positive externalities are the benefits enjoyed by the third party at less cost due to a firm’s actions. On the other hand, negative externalities are additional negative consequences faced by an uninvolved party due to a firm’s actions. Externalities are common in many sectors, and regulations are needed to promote positive externalities and reduce or even eliminate negative externalities.

Positive externalities are prevalent in most natural monopoly activities, though negative ones do occur. For example, development of the telecommunications, electric power, railroad, gas, and water industries, not only benefits the industries themselves, but also greatly boosts the national economy and so generates huge positive externalities. This requires the government to promote positive externalities conducive to social and economic development through macro-planning and regulation. Let us take externalities in the telecommunications industry by way of concrete example. A positive externality would arise when old customers of the telecommunications network pay a lower price for a better service due to an increase in new customers. The government should consider such positive externalities when formulating regulatory policies, such as taking measures to encourage new users to join existing telecommunications network systems.

Now consider a natural monopoly involving a transportation or transmission network. A small-scale transport network has a higher unit cost than a larger-scale one, providing reason for the government to encourage competing firms to merge their networks through regulatory policy and thus achieve economies of scale. Another type of positive externalities is associated with the provision of electric power, telecommunications, railway transportation, and other products and services to sparsely populated areas. This would be difficult to implement without government regulation. Of course, while encouraging firms to generate positive externaliti...