Levy, B and Spiller, P (1996) ‘A Framework for Resolving the Regulatory Problem’

in B. Levy and P. Spiller (eds.) Regulation, Institutions and Commitment, pp. 1-35.

Week 2 Core Reading: Theories of Institutional Design Summary by Carmel Jorgensen – after class The World Bank sponsored authors consider regulation as a “political economic problem”.1 In the author’s view overcoming the fundamental issue of the commitment problem is necessary for effective regulation. There must be certainty and protection for the investors against political expropriation. Lodge (week 2), views this work within the “principal-agent” category. Key words/concepts: commitment, commitment problem, political expropriation (risk of change to regulatory regime), regulatory design, institutional endowments A summary The World Bank, and others, supported the privatization of nationalized utilities as the solution to their poor performance, and to bring about improved service and lower prices. But found privatization success (measured by investment, fair/low prices to users and profits to shareholders/company) did not always happen. Why? Following their 5 country study2, the author’s conclude that commitment3 to a regulatory regime is key to the success of utility privatization. To have commitment, the regulatory design must take into account a country’s institutional endowments4 in order to minimise change to the regulatory regime from unhelpful political expropriation.5 Political expropriation happens when the rules governing the regulatory system can be easily reversed or changed by politics/parliament. The question utility investors will ask before making a long-term investment is, “How easy can legislation be reversed?” “How far can we trust this regulatory regime”? Investors don’t like the threat of short term arbitrary changes (changes the investors are not in charge of).

This “new institutional economics” approach to regulation is meant to take “…into account the way in which institutions, political and economic, affect the performance of economics over time.” 2 UK, Philippines, Argentina, Jamaica, Chile 3 Commitment here = “restraining mechanisms” to prevent fluctuations/CHANGE. Change can be because of a preference change; an intergenerational change; influenced by the short-term horizon of politics. 4 Institutional endowments, as defined by North and others: 1. legislative and executive institutions – formal mechanisms public appointments and laws and regs, 2. judicial institutions and systems– formal mechanisms for aptg judges, judiciary structure, and dispute resolution private/private and private/state 3. custom and informal norms that tacitly restrain the actions of individuals or institutions 4. societies social interests, balance b/n them and role of ideology 5. Country’s administrative capabilities. This study focuses on the first two and how they interact with regulatory processes and economic conditions. 5 Change is also called “arbitrary administrative action”.


The authors conclude that privatization success happens, whatever the regulatory design, “.. so long as three complementary mechanisms”/ “restraining mechanisms”/commitment assurances ” are “.. in place and properly aligned in order to restrain arbitrary administrative action.”6 These 3 restraining mechanisms are: [1] Substantive restraints on discretionary actions by the regulator, ex Chile – specified in regulatory incentives structures how prices are to be determined. Ex. UK and Jamaica gave freedom to set prices subject to constraints: rate of return in Jamaica and price cap in UK [2] Restraints on regulatory system changes, ex conflict resolution mechanisms built in regulatory system (Chile) [3] Enforcement of restraints (through institutions) ex. Strong judicial system (UK, Jamaica, Chile) to hold up administrative law. To work the regulatory design needs to fit with the institutional realities and be able to resist change. These “regulatory governance” restraining mechanisms are needed for “regulatory incentives7” to work. The authors also say that regulatory incentives and how they are created is also determined by the institutional endowments of a country. If the regulatory system is not compatible with the country institutions then privatization will be disappointing. In countries with weak or unstable institutional endowments, the authors suggest international treaties, or guarantees to shore up the national foundations in order to enable privatization. Ex. International investment guarantee programs, such as those from the World Bank, can “strengthen the resolve of the host country to abide by its commitments”.8 In other words the World Bank can help to hold a country accountable to its regulatory regime. Critique The institutional endowment aspect of the study seems to make sense – country’s with good institutions are more likely to be able to offer a safer long-term investment opportunities for companies. However, this study’s hypothesis and conclusions also leave the authors’ open to critique for stating that in democratic counties (those with many voices having influence in regulatory design) make it difficult to enact “sensible rules in the first place” or to “adapt the rules as circumstances change”. Additionally, the authors’ assert that “In countries with these types of political institutions [democratic], reform [to a regulatory system] may have to await some shock to the political system.”9 A shock would be a time of confusion when the democratic systems are not working as they normally would. This would then be the time to install a regulatory regime that is most favourable to business. From these views a conclusion could be drawn that the authors’ see a destabilising shock to a democratic system advantageous to making opportunistic regulatory system changes in the interests of the industry. This could leave the reader with the understanding that more authoritarian political regimes are more favourable places to set up regulatory structures. Coupled with the authors’ advice to make it very difficult to change the regulatory structure, whatever happens in the political arena, leaves a business centric model, in place. Thus, a newly democratic state would be bound by the conditions set by a former dictatorship (with the leakage of profits to select few that could occur in this unaccountable system). The World Bank is stating that it could help with enforce this conditions.

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Aka political expropriation Regulatory incentives are essentially rewards for performance exceeding minimum standards 8 Page 35 9 Page 5 (Naomi Klein’s 2007 book The Shock Doctrine: The Rise of Disaster Capitalism elaborates and provides many examples illustrating “brutal economic shock therapy” her words)


A point mentioned by Lodge is that in this view/approach development comes before democracy. And that it is necessary to lose some democracy in order to protect the regulatory system against the government, to give business interests a ‘safe’ environment to work in. Another disadvantage to losing flexibility that both the author and Lodge mention is that when technologies change the regulatory system may restrict changes. ***