Ô
Ô 


 

|
 

 
  

@
 

  

     

 Emergence of Broad Framework of Study

 Are we regulating or de-regulating?

 Feedback ± Market failures -> Regulation




    
›  
›
 

 
Ô 
›

Ô   



Objective of Regulation ± Market Efficiency and Equitable Distribution

 


  

›

 

›
  
 

D
 |

 [erfectly Competitive Market
r Goods/services offered are all same
r Numerous buyers and sellers and no single buyer or seller can
influence the market price - price takers

 Oligopoly
r Few sellers
r Each participant is aware of the actions of the others

 Monopolistic
r Goods/services are slightly differentiated
r Numerous sellers ± each seller has some ability to influence
the price

 Monopoly
r No substitute available for the goods/services offered
r Only one seller and this seller sets the price ± price maker
 


  

›

 

›
  
 

[
 
|


 Free markets allocate
r Supply of goods to the
buyers who values them
most
r Demand for goods to the
sellers who can produce
them at least cost

 Free market produces the

quantity of goods that
maximizes the sum of consumer
and producer surplus

 Competitive forces efficiently

allocate the scarce resources

(Arrow, Kenneth, and Debreu, Existence of an

equilibrium for a competitive economy, 1954 ±
Formal proof under which the market equilibrium
is [areto efficient)
 


  

›

 

›
  
 

D 
 Adam Smith stated in 1776, ³ «while he intends
only his own gain«he is «led by an à
àà
 to promote an end which was no part of his
intention«´ ± that is to maximize the wealth of
the nation

 Dhe competitive market guides and controls the

self seeking activities of each individual to
maximize the wealth of the nation.

 §à
à± ³Allow them to do´ opposes state
economic interventionism ü








 |


 



  |
 

 Market failure occurs when freely
functioning markets, operating without
government intervention, fail to deliver an
efficient or optimal allocation of resources

 Dherefore economic and social welfare

may not be maximized

 Dhis leads to a loss of economic efficiency

 |


  
 


R
 
 |
 


 [reclassical economics ± primarily government regulation; nineteenth
century classical economics ± harmonization of self interest and social
interest; neoclassical economics ± presence of market failures and
government to act as an efficient coordinating force

 John Stuart Mill, Henry Sidgwick mark a turning point in the literature of
market failure

(Steven G. Medema, 2004)

 Dhe concept of market failure initially appeared as a means of explaining

in economic terms why the need for government expenditures should arise
± normative judgement about the role of government

 As it matured the market failure concept on an additional characteristics ±

diagnostic tool by which policy makers learned how to objectively
determine the exact scope and type of intervention (Weimer and Vining,
1992)
 |


  
 


è  |
 

 Market failure when the competitive outcome of
markets is not efficient from the point of view of
the economy as a whole

 Dhis is usually because the benefits that the

market confers on individuals or firms carrying
out a particular activity diverge from the benefits
as a whole

 ³a case in which a market fails to efficiently

provide or allocate goods and services´ in
comparison to some ideal standard, such as the
perfect competition model´
 |


  
 


|   |
 


 Externalities causing private and social costs and/or benefits to
diverge

 [ublic goods and Common Resources

 Market dominance and abuse of monopoly power

 Imperfect Asymmetry
r Adverse Selection ± Ignorant party lacks information while negotiating a
transaction (Akerlof ± Lemon¶s [roblem);
r Moral Hazards ± ignorant party lacks information about performance of
the of the agreed upon transaction ([eltzman argument on insured
driver taking more risks);

 Equity issues ± Markets can generate an unacceptable distribution

of income and social exclusion
 |


  
 


|
 
 
 

 Externalities create divergence between private
and social costs and benefits

 Individual consumers and producers may fail to

take externalities into account when making
consumption and production decisions

 Consumers and suppliers are assumed to

consider their own private costs and benefits
 |


  
 


|
 
 
 

 Negative Externalities
r Over production of goods where the social costs >
private cost
r Over consumption of demerit goods where social benefit
< private benefit

 [ositive Externalities
r Under consumption/provision of merit goods where the
social benefit > private benefit
r Information failure may lead to under-consumption
(individuals not fully aware of the benefits to themselves
of consuming a merit good)
 |


  
 


|
 
 
 

Negative Externalities [ositive Externalities

·
    
 
   

  


 
    
 
    

  


 

 |


  
 


|
 
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 |


  
 


|
 
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 Free market economy will fail to deliver the efficient quantity
of public goods because of their characteristics
r A problem arising from public goods is the free rider issue

r [eople take a free ride when they benefit from consuming

a good or a service without paying for the costs of
provision

r Many goods have a public element but they are not pure
public goods ± congested motorway

 Common resources ± non excludable but rival ± example

fishing etc

 Because people are not charged for their use of common

resources, they tend to use them excessively (Dhe Dragedy of
Commons, Garret Hardin 1968)
 |


  
 


|
 
 |
[

 Monopoly ± A price maker compared to price
taker of a firm in competitive market

 A firm is monopoly because of

r It owns a key resources
r Dhe government provide a single firm an exclusive right
to produce some good or service ± patents and
copyrights given by the government
 [rovide incentive for research and creativity activity offset
by the monopoly prices
r Natural Monopoly - Dhe costs of production make a
single producer more efficient than a larger number of
producers
 |


  
 


|
 
 |
[
!

|

 In a competitive firm ± price equals marginal
cost while in the case of monopolized market
price exceeds marginal cost

 Monopolist charges a higher price therefore

earning a higher profit

 Also there is a deadweight loss implying that

the monopolist produces less than the socially
efficient quantity of output.

 Monopolist chooses to produce and sell the

quantity of output at which the marginal
revenue and marginal cost curve intersect;
while the social planner would choose the
quantity at which the demanded marginal cost
curves intersect.

 Dhe monopoly may also use some of its profit

paying for its monopoly profits paying for
these additional costs. Dherefore the social
loss from monopoly includes both these costs
and the deadweight loss resulting from a price
above marginal cost
 |


  
 


|
 
 " 
|


 High fixed costs of entering an
industry which causes long run
average costs to decline as output
expands

 Dhe marginal cost of producing one

more unit is constant ± average
cost declines as output increases
over a much large range of output
levels.

 Delecommunications, electricity,
water, railways etc. are some
natural monopolies

(Mankiw, 2007)
 |


  
 


|
 
 #


 In reality a firm is neither perfectly competitive or monopoly in
nature rather somewhere between.

 Oligopoly is a market with only a few sellers:

r A key feature of oligopoly is the tension between co-operation and self-
interest.
r Dhe group of oligopolists is best off co-operating and acting like a
monopolist ± producing small quantity of output and charging a price
above marginal cost ± cartel or collusion
r However the self interest is hindrance to co-operate (example of two
prisoners) ± dominant strategy leading to Nash equilibrium which is less
than what monopolist would make profit
r As the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more like a competitive market. Dhe price approaches
marginal cost, and the quantity produced approaches the socially
efficient level

 Co-operation between oligopolists is undesirable from the

standpoint of society ± to move the allocation of resources closer to
social optimum, policy makers should try to induce firms in an
oligopoly to compete rather than co-operate.
 |


  
 


|
 
  
 $ 
!

%[

$

&
 Buyers and Sellers will have
different information about
the product¶s attributes

 In one instance when the

consumer is less informed ±
there will be a producer
surplus but also a net loss to
society

 Adverse Selection, Moral

hazards are a result of
information asymmetry
Wiemer and Vining (1999)
 |


  
 


$
 D|
 
'

 Finally the market for poor quality of cars only exist ± Good products and
good customers are under represented while bad products and bad
customers are over represented
([indyck and Rubinfeld (2001)
 |


  
 


|
 (
 
 



 Dhe higher the current rate of unemployment, and the higher the wage
paid over the market wage, the more effective will be the threat of
dismissal

([indyck and Rubinfeld (2001)

 |


  
 






|


 

 Dhe economic rationale for Government intervention
r (i) Correction for market failure/loss of economic efficiency
r (ii) Desire for greater degree of equity in the distribution of income
and wealth

 Several forms of government intervention are possible to correct

for perceived market failure

 Do employ the diagnostic approach, analysts attempt to identify

both the precise type of problem that gives rise to the market
failure

 [olicy analysts argue that existence of a market failure provides a

necessary, not a sufficient justification for public policy
interventions. A double market failure test is required. (Weimer &
Vining, 1992).

 Sufficiency is established when the gains from government

intervention outwieghs the dangers of government intervention
 |


  
 






|
 


(1) Command and Control technique (including regulation)

(2) Government subsidy and other forms of financial

assistance (including research grants and tax
allowances/tax exemptions)

(3) Daxation (including indirect taxes designed to control

pollution)

(4) [olicies to increase competition and reduce the

immobility of factors of production

(5) [rovision and finance of public and merit goods

(6) Introduction/expansion of market based incentives to

change both consumer and producer behaviour
 |


  
 






|
 


[
  

   








 




 of public goods
 





 Financial intervention:  (equal to the  
 

 monetary value of the MEC) are imposed on >§eaves space for market forces to interact
individuals or a firm, internalizing ECs >Provision of revenue for the government

 
>èifficulty in valuating EC
>Overvaluation means output is below social
optimum, as with undervaluation means that output
is not sufficiently lowered (ie, society͛s welfare is not
always maximized)
>Effectiveness of tax dependent on PEè
§egislation:  and 

 
  are Enforcement is difficult and expensive
passed to prohibit or regulate behaviour that
imposes an EC, e.g. pollution permits
Education, campaigns and advertisements solve Benefits must outweigh the costs of implementation.
the problem of imperfect information by A lot of time may be needed for effects to be felt
allowing the external costs to be made known to
the consumer, discouraging demand
 |


  
 






|
 


[


 Financial intervention:  

 made to the  
 

 producer or consumer >Considered the most effective way of solving
underconsumption as it is easily implemented

 
>§ike taxes, the valuation of EB is difficult
>High government expenditure is required
>Okun͛s leaky bucket: each dollar transferred from a
richer to a poorer individual, results in less than a
dollar increase in income for the recipient. §eaks
arise as a result of administrative costs, changes in
work effort, attitudes etc. arising from the
redistribution

§egislation include regulation seatbelt usage, Enforcement requires constant checking which may
compulsory education etc. translate to high costs.
 |


  
 






|
 








 Dhere is a need to produce merit goods (which are naturally underconsumed) at low prices or for free due



 to four reasons
*


 
: they should be provided according to need and not ability to pay
  


 

, for example in the provision of free health services helps to contain and
combat the spread of disease
  are subject to their guardians decision which are not necessarily the best, therefore the
provision of services like free education and dental treatment is needed to protect dependants from
uninformed or bad decisions
 
: Dhe problem of imperfect information makes consumers unaware of the positive
externalities and benefits that arise from consumption

  Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken as
  tax. Governments may also regulate MC/AC pricing for monopolies.

Government may impose regulations to control a monopolies

1.Forbidding the formation of monopolies (e.g., antitrust laws)
2.Forbidding monopolistic behaviour (like predatory pricing)
3.Ensuring standards of provision.
4.Ensuring competition exists (e.g., deregulation)
 |


  
 






|
 


 



 In the case of Natural Monopoly the essence of regulation is the explicit replacement
of competition with governmental orders with principal institutional device for
assuring good performance.

In the case of natural monopoly the primary guarantor of acceptable performance is

conceived to be not competition or self restraint but direct governmental prescription
of major aspects of their structure and economic

Dhere are four principal components of this regulation that in combination

distinguish the public utility from other sectors of the economy: control of entry,
price fixing, prescription of quality and conditions of service, and an imposition of an
obligation to serve all applicants under reasonable conditions.
(Dhe principles of economic regulation, A.E.Kahn)
 |


  
 



   

a    
   
  a


Utilities ·    CERC, SERCs Licensing, Dariff Electricity Act 2003
Externalities, [ublic fixation, QoS
Good, standards, Dispute
Resolution

Oil & Gas ·   , [etroleum and Natural Licensing, Dariff [etroleum and Natural
Externalities Gas Regulatory Board fixation, QoS Gas Regulatory Board
standards, Dispute Act 2006
Resolution [etroleum Act 1934
[etroleum and Minerals
[ipelines Act, 1962

Dele Communications    , DRAI Licensing, Dariff DRAI Act 1997
Oligopoly fixation, QoS
standards,
Interconnection,
Spectrum Management
(Advisory)

Banking    RBI Monetary policy Banking Act 1959

 Supervision &
Regulation

£
 
 

 
 
£
 Ô

 


D
 


 First Dheorem
r If (1) households and firms act perfectly competitively, taking price as
parametric, (2) there is a full set of markets, and (3) there is perfect
information, then a competitive equilibrium, if it exists, is [areto
efficient

 Second Dheorem
r If household indifference maps and firm production sets are convex, if
there is a full set of markets, if there is perfect information, and if
lump sum transfers and taxes may be carried out costlessly, then and
[areto efficient allocation can be achieved as a competitive equilibrium
with appropriate lump sum transfers and taxes (Dhe size of output is
not shrunk)
r Ideally, this would be achieved through measures that did not destroy
the efficiency properties, and much of welfare economics is based on
the assumption that non-discriminatory taxes and transfers can be
carried out

(Albert & Hahnel)

 Ô

 


[ [
  

 

 Utilitarianism

 Liberalism

 Libertarianism
 Ô

 


[
 



 Minimum Wage Laws

 Welfare

 Negative Income Dax

 In-kind transfers

 Antipoverty programs and work incentives

Drade-off between equality and efficiency

(Mankiw, 2007)
  !  

 Dhe possibility of market failure underpin the economic
rationale for state regulation of market economies.

 Regulations can take different forms with different roles

r Health, safety regulations and environmental regulations can

be rationalized on the basis of imperfect information and
externalities

r Economic regulation of public utilities can be explained by

economies of scale and scope and need to protect the
consumers from monopoly exploitation

r Aspects of fiscal policy can be rationalized on the basis in

terms of wealth and income redistribution

r Regulatory intervention for universal service obligations etc.

  !  

 Regulation cannot be limited to economic issues ±
means to ultimately achieve non-economic ends
 Intentions and outcomes are therefore defined by a
combination of economic, social, political and
bureaucratic factors and cannot be attributed to one
set of factors alone
 Involvement of disciplines other than economics (law,
political science, sociology etc.)
 Broad definition ± ³ the use of public authority to set
and apply rules and standards´ (Hood et al, 1999)
(Economic Regulation ± A [reliminary literature review and summary of
research questions ± [arker)
 As an effort by the state ³to address social risk, market
failure or equity concerns through rule based direction
of individual and society´ ([lanning Commission
consultation paper on Regulation)
  !  

 Regulation is a complex balancing act between advancing the
interests of consumers, competitors and investors, while
promoting a wider, µpublic interest¶ agenda.
r minimum prices to benefit the consumer (maximize consumer
surplus);
r ensure adequate profits are earned to finance the proper
investment needs of the industry (earn at least a normal rate of
return on capital employed);
r provide an environment conducive for new firms to enter the
industry and expand competition (police anti-competitive
behavior by the dominant supplier);
r preserve or improve the quality of service (ensure higher
profitability is not achieved by cutting services to reduce costs);
r identify those parts of the business which are naturally
monopolistic (statutory monopolies that are not necessarily
justified in terms of either economies of scale or scope);
r take into consideration social and environmental issues (e.g.
when removing cross subsidization of services).

([arker, 2000)
 

 
1. Mankiw, N. Gregory. (2007). 

 . 3rd Indian Edition,

2. Friedman, D. (1990). !"
#


. Chapter 18. [rice Dheory. Southwestern
[ublishing

3. Djolov, G. George. (2008). 
 £
 $ 

 !

.
Jaico publishing house

4. Michael, A. & Hahnel, R,. %

&

 '



( Online book.

@ 
1. Dollery, B. and Worthington, A. (1996). 
 &
  )
 
(
Normative Economic Dheories of Government Failure. Journal of Interdisciplinary
Economics 7(1):pp. 27-39.

2. Medema, G. Steven. (2004). !

*'" 

&

  
 

"


. History of [olitical Economy

3. Stigler, J. George. (1971). 
 




 ( Bell Journal of
Economics 2(1), [age 3-21
 

4. Shleifer, Andrei. ÿ
 

 ( European School of
Management, Vol 11, No. 4, 2005, pp 439 ± 451

5. Hammond, J. [eter. (1997).
 


!"


#

( Elements of General Equilibrium Analysis, Basil Blackwell

6. [arker, D. (1999). 


 & +
)
 
 
 

ÿ


&

( International Journal of [ublic
Sector Management. Vol 12, pp 213-236.

7. Dollery, B., & Wallis, J. (2001). 
 
"





"
,
 &

 . Working [aper
in Economics

8. Consultation [aper(2006).  


 


 ( [lanning Commission, Government of India
D )