Sessions 1-2

Introduction to government
regulation of business

B. Sundar, Ph.D

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 Flow
1. Introduction
• Antitrust
• Economic regulation
• Health and safety regulation
2. The making of a regulation
• The regulation making process
• Benefits and costs
• What do regulators maximize?
3. Problems

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1. Introduction
• The government’s role
• Raise taxes and spends on welfare activities
• Regulates the firms and people’s behavior through institutions and legal systems
• Curtail monopoly power, setting prices for public utilities, control pollution emitted by firms, allocates
telecommunication frequencies to private phone firms
• Rules to wear seatbelts, product safety standards
• Government regulations influence citizen’s life and market outcomes
• Fssai labels on milk and breakfast, usage of pesticide in vegetables and fruits, road travel restrictions,
pollution emission control of buses and cars, minimum wages, workplace safety, control of rates for
phone usage, airlines fare regulation, control of smoking in public places, and so on
• Most regulations are not required in perfectively competitive markets, with
innumerable, fully informed buyers and sellers, and with no externalities
• But often, real economies comprise of a small number of large firms, and monopoly
• Labor accepting risky employment do not fully understand the risks
• Firms do not pay for their pollution which generates negative externalities
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1. Introduction …
• There are two ways to deal with the departure from perfect markets

• Impose a tax (as with alcohol, cigarettes, fuel-inefficient cars); but these taxes are imposed
on luxuries and not linked to correction of market failures

• Directly control firm behavior through

1. antitrust policies
2. regulating prices of public utilities
3. specifying technology requirements to control pollution emission by firms

• Both firms and citizens cause market failures and so, regulations are aimed at
both
• For ex. citizens disobey seat belt rules; dispose hazardous waste recklessly

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1. Introduction … (a) antitrust
• Rationale for antitrust regulation
• Many developed economies formulated antitrust laws to prevent monopoly in the early
part of the 20th century; but, these are irrelevant now due to foreign competition
• Ex. in the 1970s, there was concern that ibm, att, and gm would charge high prices due to their
monopolization in usa; now they are humbled mncs, vulnerable to competition from asia
• Concern is now shifted to mergers, buyouts, and acquisitions which restructure
corporations and prevent concentration
• Being big is not totally undesirable; firms like coca cola have exclusive rights over their
formula, and their products are a huge success which may lead to concentration
• Contemporary thoughts on monopoly are different; for instance, if a potential monopolist
perceives an entry from a competitor, her strategies may encourage responsible behavior
• The thrust is to prevent market structures that prevent competition
• Do monopolists rest on laurels and stifle innovation? Or do they innovate more to capture
the whole market? This is an empirical question

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1. Introduction … (b) economic regulation
• Rationale for economic regulation
• In natural monopolies, economic efficiency suggests monopoly structure; but regulation of prices are
needed to prevent overcharging
• It is inefficient to have a large number of small firms to supply electricity to households
• But what is good for a monopolist (ex. microsoft) may not be good for india
• The origins of these regulations in the first world (ex. usa) was in the 20 th century in the case of railroads,
transport, and communications
• Economic regulation recognizes that concentration is inevitable, and often a superior market structure
which reduces welfare losses and improves efficiency
• Factors for setting rate regulation
• Full minimization of rates (ex. electric company) may not be the goal, as low margins may affect firm’s
viability, quality, and capacity to innovate
• We need to balance between providing incentives to firm to innovate (and lower costs), and price low for
users
• Another concern is how to apportion the massive fixed costs (divided equally for all user? as a proportion
to the bills? divide users into groups and charge as per sensitivity?)
• Economic analysis provides some answers to these; prof. kahn proposed airlines deregulation as analysis
showed that competition improved viability and quality
• In competitive markets, such economic analysis is not required 6
1. Introduction … (c)health, and safety regulation
• Us took the lead in creating agencies to regulate health, safety, and environment
• consumer product safety commission, occupational safety and health administration, epa
• In india, we have the atomic energy regulatory board (1983), central pollution control board
(1974), and the food safety and standards authority of india (2011)
• There are two reasons for these regulations:
1. Externalities result from the economic behavior of firms and citizens
• Businesses generate pollution and toxic wastes; citizens burn fuel and generate pollution
2. It is more efficient for government to fund and disseminate research information as firms are
not incentivized
• Such research is required to assess pollution damage to humans in an unbiased manner
• These regulations tend to reduce the risks in the environment, workplace, and the
products we consume
• Courts have been proactive, both with antitrust and regulations
• Rulings align with the basic laws of the land and those passed by the parliament
• Damages awarded to affected are substantial (asbestos industry in us closed down; pharma has
withdrawn several vaccines due to high liability costs) 7
1. Introduction … (c)health, and safety regulation …
What doctrines govern the behavior of regulators and courts?
• Increase efficiency of the economy and move closer to the competitive market
• This means we assess benefits and costs of regulatory policies and maximize their difference
• Sometimes, we need to weigh dis/advantages to poorer sections differently to address issues
relating to equity (ex. subsidies on domestic gas cylinders)
• Regulators’ goal is somewhat different and they respond to political constituents
• Ex. people over-react to low probability risks (a new carcinogen or cancelling vacation due to
terrorist attacks) which creates irrational pressures for regulators
• Often, regulators do not maximize overall welfare; their actions may favor particular
firms and special interest groups, which creates vested interests
• Professor george stigler showed that regulation increased the profits of the industry being
regulated
• Such successive disappointments are called “government failures”; government intervention may
not always yield superior outcome
• The goal of regulation must be to maximize market efficiency and improve citizens’
welfare 8
2. The making of a regulation
• In federal setups (usa, india), all regulations are not national in scope
• Many are of state, and local origin reflecting regional economic conditions
• Historically rail regulations began in usa at the state level, and later adopted nationally
• Several stakeholders influence the making of regulations: (a) special interest groups in industry (b) political
groups (c) parliament and judiciary
• Regulations and antitrust must be consistent with the mandates of the parliament, which would be
reviewed by judiciary
• Most economic regulatory agencies are independent commissions (telecom regulatory
authority, insurance regulatory and development authority, fssai, securities and exchange
board)
• Some agencies are a part of the executive branch (ex. the central pollution control board is
under the moefcc, and prescribes emission standards)
• Often, regulations are determined at the local level
• Smoking restrictions in public places, helmet rules; in usa, some states regulate insurance rates strictly,
while other states have deregulated
• Sometimes, regulations are issued at the national level
• Coastal zone regulations, securities issue, and animal welfare-related are applicable country-wide 9
2. The making of a regulation …
Advantages of state regulations (sr)
• In usa and india, there are more sr than those from the center
• Sr reflect regional economic conditions and preferences (are 8-lane regulations relevant in hill states like
nagaland?)
• This allows citizens who wish different public goods to relocate (non-teetotaler might find bangalore
attractive, and gandhinagar unattractive)
• It helps build a robust regulation at the national level (for ex. hill afforestation regulations from diverse states
help us craft a comprehensive set of national regulations)
• This allows experimentation locally; if it fails, costs are less; if it succeeds, easy to replicate
Advantages of national regulations (nr)
• National agencies have informational advantages (the usfda regulates pharma, which requires sophisticated
product testing and expensive to duplicate locally)
• Nr are efficient for nationally marketed products (one cannot have 100 different pollution standards for cars
in various states)
• Similarly, it is difficult for every state to evolve antitrust; cci is more efficient
• Some issues occur locally, but have national ramifications (ex. most pollution problems, mangrove vegetation
and tsunami)
• Nr ensure that policy outcomes reach all citizens uniformly; ex. civil rights regulations must be nationally
regulated, as uniformity is required 10
2. The making of a regulation …
Overlap of federal regulation (fr) and sr
• In cases of overlap, fr prevails over sr (india, usa)
• Since the 1990s, the center is providing a greater role to the states (more
flexibility and financial powers) to administer national regulations
• The cpcb has asked state pcbs to set regional pollution limits
• Regulations are set at national level, but monitored at regional level with local resources
• Why has there been an increased role for the states in this?
• There are legitimate differences between states, warranting local regulation
• Several national regulations have been unsuccessful and mired in controversies
• The maggi noodles controversy in 2016, involving fssai, is an example
• The trend is to use economic rationale to help states architect regulations, at least in usa;
the office of management and budget (omb) promotes the economic rationale
• In india, the state planning departments provide inputs for crafting various
regulations at the regional level
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2. The making of a regulation (a) rule-making process
• Nr must align with legislative mandate, else they may be questioned in courts
• To ensure rigorous analysis, regulations pass through administrative process where the
agency performs a regulatory, cost-benefit, and inflationary impact analyses
• In a federal set up (usa), procedure is as follows:
1. The regulatory agency (telecom, say) and the omb are major players
2. Telecom decides to regulate a particular economic activity which has a cost impact
3. Omb reviews to ensure there is no duplication, and is in harmony with other departments
4. Telecom performs a benefit-cost analysis of the regulation and sends it to omb for review
5. Omb, by 60 days, accepts or proposes revisions or rejects the regulation; note that the review is not in
public scrutiny; media has criticized omb’s oversight process
6. If the omb rejects the regulation, telecom may appeal to the president
7. On omb’s approval, the regulation, its benefits and costs are put in the public domain
8. The public, and interest groups can comment (30-90 days), which will be processed by telecom again
9. Telecom sends the revised regulation and analysis to omb for review; omb may revise, accept or reject;
after omb approval, the final regulation is published
• Omb oversight evolved in 1980s to ensure that nr improves welfare; the “capture theory”
argues that telecom regulations profit telecom industry and not society 12
2. The making of a regulation (a) rule-making process
• Recent trends in regulations
1. Agency to compute the cost of regulation to assess its desirability and use cost effectiveness
metrics; ex. suppose there are two mutually exclusive policies: policy 1-save 10 lives at a cost
of rs. 1 million per life; policy 2-save 20 lives at a cost of rs. 2 million per life; which to choose?
2. Potential benefits to exceed potential costs (ex. epa’s regulation to phase out lead in gas)
3. Regulations must maximize citizens’ welfare
4. Performance oriented regulations (por)
• The objective is to promote people’s welfare and not to mandate technological improvements
• Firms are given some discretion for compliance ex. fda’s tamper resistant packaging guidelines
• Two issues: (a) loosely worded guidelines for por is difficult to monitor ex. workplace safety guidelines could
be loosely interpreted by firms (b) political and regional economic interests exploit por to their advantage
5. To assess risk in an unbiased manner
1. We have a tendency to focus on the upper limit of potential risk; ex. projection of a carcinogen may be
made by estimating the effect on the most sensitive animal, and not on animals relevant to humans
2. Thus, we focus on lesser known hazards, and ignore real hazards that are fatal; regulations are thus tilted
towards these inconsequential, low probability events
3. Policy makers use arbitrary conservatism factors ex. multiply the risk levels by 1000. Why 1000?
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2. The making of a regulation (a) rule-making process
• But economic rationale alone does not guarantee that a regulation is issued;
political influences are also at work
• Ex. the cotton dust standard imposed a prohibitive cost on the industry, but the labor
ministry, backed by trade unions, persuaded the government to issue the regulation
Regulatory role of price and quality
• Price regulation must be avoided; this principle enabled deregulation of airlines,
truck, and communications industry in usa in the 1980s, and india too
• Minimum wages interfere with this principle; economists argue that minimum
wages increase teenage unemployment
• Standardizing quality through regulation is also not desirable
• Ex. safety measures in cars; regulations prescribe some basic safety features, and make the
more expensive (gps tag, air bags) optional
• If all safety features are made compulsory, cars may become highly expensive affecting
firms’ viability
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2. The making of a regulation (b) benefits and costs
• Oversight process ensures better regulation that advances national interests
• Main concern relates to costs of regulation; estimates show that costs of regulations
in usa is $175 bn (2002), implying ~$1700 per person annually (indirect tax)
• $80 bn is due to epa regulations implying that focus on environment is high
• Benefits of deregulation estimated by council of economic advisors (usa - 2002)
• $15 bn gain per year to airline travelers and companies
• $30 bn gain per year to trucking industry
• $15 bn gain year through railroad deregulation
• India deregulated petrol (2010) and diesel prices (2014); Expected beneficiaries
• Oil and gas – stop making losses as they can sell at market price
• Auto – indian users encouraged to buy 2- and 4-wheelers due to low diesel and petrol rates
• Banking –
• less oil subsidies help government to reduce fiscal deficit, and borrowings, which reduce interest rates (+)
• inflationary upward pressures due to fuel hike may force RBI to hike interest rates, and curtail spending (-)
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2. The making of a regulation (b) benefits and costs …
• In usa, cost of regulation was 9.5 -12% of gdp implying $5935 per household
• Analysis for 2005 in usa shows
• Process regulations (relating to government paper work) – 35%
• Environmental regulations – 25% (increasing importance)
• Social regulations – 10%
• Economic regulations – 11% (this has tended to decrease due to deregulation)
• The number of pages in the “regulation register” is also a measure of regulation
activity; In usa, it swelled from 2599 (1936) to 87000 (1980)
• The nature of regulatory oversight, both in india and usa, has changed from
obstructionist to being a promotor of negotiated settlements
• Ex. omb approved only 30% of the proposed regulations and blocked 6.9% (2005)
• Major conflicts would imply appeal to the president or prime minister, who have other
pressing national issues to manage
• The volume of regulatory activity is ~ 400 regulations per year with environment accounting
for 50%
• Of late, climate change and global warming regulations required presidential scrutiny 16
2. The making of a regulation (c) What to maximize?
• Maximize national interests, and the difference between benefits and costs (naïve
goals), as other influences substantially shape regulatory activity
• The capture theory of professor george stigler
• The regulatory agency is captured by the industry it is meant to regulate; ex. (a) airlines fare
regulation fix a price floor so that firms profit; (b)minimum quality standards can be used by
established firms as a barrier to discourage less advanced firms
• Private and public interests may decide the tenure of regulatory bureaucrats
• Professors peltzman and noll have developed models in support of his theory
• Other research evidence argues that parliament has the more dominant role in
regulation as it controls the budget and appoints the agency officers
• Magat, krupnick, and harrington (1986) list out the following influences from the
study of industry effluents standards:
• Efficiency concerns – Firms with lesser compliance costs must be regulated more
• High quality economic analysis implied more stringent regulations
• Industries with large budgets for their trade associations obtained weaker standards 17
Worked example 1: MB and MC

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Worked example 2: MB and MC
The table shows the marginal benefit to a paper mill of
polluting a river and the marginal cost to residents who live
downstream. In this problem assume that the marginal benefits
and marginal costs are measured at (not between) the specific
quantities shown.

Plot the marginal benefit and marginal cost curves. What is the
efficient quantity of pollution? Explain why neither one ton nor
five tons is an efficient quantity of pollution. In the absence of
pollution fees or taxes, how many units of pollution do you
expect the paper mill will choose to produce? Why?
Quantity of
pollution Marginal
Marginal cost
(tons per benefit
week)
0 $110 $0
1 100 8
2 90 20
3 80 35
4 70 70
5 60 150
6 0 300

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Worked example 3: NPV

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Worked example 4: NPV

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End of session

Thanks

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