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New regulatory economics to back monopoly regulation

BY Li Sanxi | 2014-11-27

China Mobile, a state-owned telecommunications giant, suffered a public backlash for monopolizing mobile phone rates. 

The theory of new regulatory economics founded by French economists Jean Tirole and Jean Jacques Laffont provides a base and analytical framework for China to regulate large-scaled natural monopolies.


According to microeconomics, when an industry is monopolized by a firm, the latter will take advantage of its monopoly position to push up prices of products or services, which consequently causes efficiency losses. Therefore, there is a need for the government to regulate the firm. This is where new and traditional regulatory economics are in common.
 

New regulatory economics challenges the theoretical base of traditional regulatory economics, as well as regulation policies developed on this basis. It is new in two ways.


Adopting a new approach
Firstly, new regulatory economists stress the importance of information asymmetry in the process of regulation.


Traditional regulatory economics presupposes that regulators and regulated firms share symmetric information. However, new regulatory economists have found this is unrealistic, claiming that regulation policies formulated regardless of asymmetric information will be non-effective.
 

For example, the so-called regulation policy based on average cost pricing, which was most commonly used in the US, faced adverse selection and moral risk of firms.
 

Adverse selection refers to a process in which the regulators had little information about production and operation costs of the firms involved, so the latter overstated costs and demanded higher prices. On the other hand, moral risk indicates that the firms lacked incentives to lower production and operation costs due to average cost pricing.
 

Secondly, new regulatory economics takes the newly-initiated mechanism design theory as the major analytical tool and develops a uniform and powerful framework for analysis.
 

As a new branch of economics grounded upon game theory, mechanism design studies how the principal devises a set of mechanisms, such as regulation policies and game rules, when information between principal and agent is asymmetric. This is so that after the agent gains a full knowledge of the mechanisms, his self-interested behaviors can help achieve desired goals of the principal.


Core ideas
Incentive compatibility is one of the core ideas of new regulatory economics. It believes that the key to overcome information asymmetry lies in whether the regulation policy is incentive compatible with the regulated.

 

In the past, most regulation policies complied with the principle of closing loopholes, while new regulation policymakers hold that closing is not as good as unclogging. They admit that firms are self-serving and then smartly design institutions to guide firms to behave in their own interests in the right direction.
 

Another core idea of new regulation theories is the tradeoff between efficiency and “information rent” to be collected by firms.
 

“Rent” is a common concept in economics. House owners lease their houses to get house rent and landlords rent out their land for land rent. As firms have more information, regulators must “pay” for it if they desire to obtain the information.
 

New regulatory economics has proved that there is a tradeoff between efficiency and “information rent.” For the sake of efficiency maximization, regulators must “pay” a large amount of “information rent” to firms. Any degree of reduction in “information rent” would undermine efficiency.


Development of the discipline
After placing information asymmetry at the core of regulation theories, Laffont and Tirole further enriched and developed new regulatory economics with government commitment power and regulatory capture as new focal points.

 

Firstly, new regulation theories take the commitment power of government as the premise for effective implementation of regulation policies. Commitment power means that the government never scraps the contract during the multiple stages of contract execution and sticks to the originally agreed-upon articles all along.
 

Laffont and Tirole claim that if the government is weak in commitment, monopolies will hardly disclose any information at the beginning. They believes that if information is disclosed at the outset, the government will change the contract later and no longer grant them any “information rent.” Wary of that, they would cleverly hide their information, which is what the famous “ratchet effect” in economics is about.
 

Secondly, according to new regulatory economics, regulators are often subject to being captured because they are not angels striving initiatively to maximize social benefits. Driven by huge interests, interest groups on behalf of regulated firms usually attempt to “capture” regulators by committing briberies or trading other interests.
 

In regulation, therefore, it is necessary to further reduce immediate interests and incentives for interest groups to capture regulators. Meanwhile, consideration should be given to incentives for regulators as well. Both carrot and stick should be adopted to protect regulators. Appropriate restrictions should also be imposed on the power of regulators to prevent corruption caused by excessive power.
 

Application in China
New regulatory economics is of great academic and policy significance to the ongoing economic restructuring in China and conducive to deepening regulation of natural monopolies.


However, it is noteworthy that many developing countries have suffered bad consequences from copying the experience of developed countries. The privatization of water and electricity in Mali is a case in point.
 

Taking advice of international experts, Mali imitated developed countries in setting prices that were just enough to offset project costs and building an independent regulatory body to lessen government intervention.
 

However, it turned out that the project didn’t develop as expected. Due to their low payment ability, Malians refrained from increasing prices, so the government had no alternative but to significantly subsidize the project. When prospective firms recognized the huge political and investment risks within, they were much less willing to make investments as a result.
 

Worse still, the imperfect design of the contract and enormous gap of subsidy gave rise to disputes among politicians, so that regulators lost their political independence. Eventually, the project ended up with withdrawal of foreign capital.
 

In his book Regulation and Development (2005), Laffont underlined that regulation theories suited to developing countries should take into account four differences between developing and developed countries.


Firstly, developing countries are inferior in regulation. Shortage of regulation experience and limited fiscal expenditure are hampering developing nations from recruiting most capable talents.


Secondly, developing countries feature weaker government commitment power. Great uncertainty of their policies diminishes regulatory effects significantly.
 

Thirdly, legal systems of developing countries are mostly so imperfect that the execution of contracts is in question.
 

Fourthly, regulators of developing countries are more vulnerable to corruption. In China, for instance, most large-sized monopolies are state-owned. This means they are inextricably connected with government departments and often leads to problems, like soft budget constraint.
 

In their co-authored volume of works titled A Theory of Incentives in Procurement and Regulation (1993), Laffont and Tirole stated, “good regulation theories should reflect the information structure, constraints and available tools in front of regulators and firms. Information structure and feasible regulatory plans should reflect observable costs and contract costs as much as possible; available tools and constraints must conform to industrial structure and laws which should be analyzed domestically, rather than simply defined by the outside.”


While applying new regulatory economics to analyze China-related problems, scholars must pay particular attention to the principles.
 

The author is from the School of Economics at Renmin University of China.

 

The Chinese version appeared in Chinese Social Sciences Today, No. 669, Nov. 19, 2014

 
The Chinese link: http://sscp.cssn.cn/zdtj/201411/t20141119_1405555.html 
 

Translated by Chen Mirong
Revised by Tom Fearon