The Theory of Regulation

Regulation
Definition
Controlling human or societal behavior by rules or restrictions. It covers the relation between
government and business.

Forms
 Legal restrictions by a government authority
 Self-regulation by an industry (trade association)
 Social regulation (norms)
 Co-regulation and market regulation

Examples
 Controls on market entries, prices, wages, development approvals, pollution effects
 Employment for certain people in certain industries
 Standards of production for certain goods

Objectives
 Guarantee minimum standards (consumer protection, health and safety at work)
 Protect the weak against the strong (small companies against larger companies) (groups
of companies that work together to fix prices)
 Provide benchmarks of good practice for business to set as minimum standards
 Provide an appropriate framework for ethical business behavior
 Create standards where none exist.

Unregulated Free Market Problems

 Imperfect information
 Transactions costs
 Public goods
 Exclusivity
 Externalities

Externalities
 Positive (A chemical plant that uses a river to carry away its wastes (chlorine). The
chemical plant is upstream from a brewery that uses the river water to make beer.
Reducing cost of brewery water purification)
  Negative (A chemical plant that uses a river to carry away its wastes (mercury). The
chemical plant is upstream from a brewery that uses the river water to make beer.
Increasing cost of removing mercury to produce beer)

Common Access Problem

Definition
The use of a common resource by a party to its satisfaction denies the use by the other party to
its satisfaction.

Solutions
 Internalization
 Privatization
 Regulation
 Cooperation

Bilateral bargaining Solution

Definition
One of the cooperation methods to solve the common access problem. It depends on an
agreement between 2 parties about the cost of an externality resulting one party on the other
one.

The Coase Theorem

Bilateral bargaining can, under a certain set of circumstances, eliminate the common access
problem without resorting to regulation.

Limitation
It depends on an agreement between 2 parties on a common externality, and most real-world
externalities do not involve two well-defined parties.

The Pigouvian Tax Solution

Charge one party that is imposing an externality with a tax that reflects the cost it imposes on
the other party to overcome the externality. It is a normative regulation solution, which means
that it is designed to describe what regulation should do and is not meant to be descriptive of
what regulation actually does.

The Regulation Solution

Enforcing the owner of the externality to eliminate or reduce as much its reflect on the other
party.
Reasons of government intervention in the market place
 public goods
 monopoly /monopsony
 informational failures
 income distribution/discrimination.

Public Goods
A joint consumption good, which can lead to a market failure when people act strategically to
conceal their demand for it (free riding), thus, the normative conditions for welfare
maximization are violated. Government intervention is necessary to correct the social ailment of
the free rider.

Monopoly/Monopsony
Monopoly exists when any firm that could raise price and not lose all of its customers. It can
arise for many reasons, including exclusive or unique asset, location advantage, and patent
protection, along with the use of force to exclude rivals. Government regulation can be used to
protect competition, to ensure the efficiency of the free market, and to limit the deadweight
loss of monopoly. This can be accomplished in a variety of ways, by examining mergers, by
overseeing pricing practices, by monitoring advertising, and by supervising general business
practices.

Cross Subsidization
Company producing a product with total cost larger than total revenues, in order to be able to
produce another product that increases public welfare. Regulation could be used to force the
firm to make both goods and to use excess revenues from 2 nd good to cover losses of 1st good.

Monopsony
A firm or individual is a monopsonist when it purchases a sufficient quantity of a good to be
able to affect the price by the amount it buys.

Informational failures
One party to a transaction has superior or inside information not reasonably available to the
other. The rule can be to enforce a party to reveal all the details of the good being sold to the
other party.

Income Distribution/Discrimination
There are normative economic theories arguing that regulation is necessary in a competitive
market because of the existing distribution of income. Discrimination in all ways, sexual,
religious, or any other type, can lead to economic inefficiency.