Regulation of firms

Governments or their appointed agencies may attempt to influence the conduct of firms through regulation. Regulation involves legislation to restrict the behaviour of firms and other organisations, and to set standards of operation or impose conditions on their activities.

Regulation might involve penalties and sanctions for 'breaking any rules', as well as incentives to improve - the so called 'sticks and carrots' approach. In extreme cases, firms may be forced to stop trading.

The conduct of firms appears to be closely related to the market structure in which the firm operates. Monopolies and oligopolies may face little or no competition, and hence they are the most likely to engage in uncompetitive practices, or offer poor quality.

In theory, competition provides a check against 'inefficient' pricing, and low quality. By inefficient pricing economists mean prices that exceed the marginal cost of supply -  when prices equal marginal cost the price (and corresponding output) is said to be allocatively efficient.

Areas in which regulation is common:

  1. Health and safety standards, such as safety at work.
  2. Granting licenses to control the sale of potentially harmful products.
  3. Consumer protection legislation, to set minimum accepted levels of behaviour, and terms and conditions of supply.
  4. Protection of employees to ensure that they are not exploited, and receive minimum standards of welfare and pay.

  5. Setting controls on emission levels.

  6. Completely banning products (prohibition) if they are considered harmful to health or wellbeing – such as illegal drugs, dangerous weapons, and unauthorised pharmaceutical and medical products and medical procedures.

  7. Controlling the abuse of monopoly power through competition policy - which may include controlling mergers, restricting anti-competitive behaviour, and opening up natural monopolies to competition.

  8. Regulating the privatised industries. In the UK, as with the majority of advanced economies, special regulators are appointed to regulate each privatised utility, including energy, water and transport - many of which are natural monopolies.

Types of regulation to improve competition

In markets with few or no competitors, prices could be set at high level, output might be restricted, with low quality products or poor services. If it is not possible to make the market fully competitive by changing the structure of the market, then regulators can control the 'outcome' of uncompetitive markets - in other words, directly regulate price, profits or quality.

Price regulation

Competition authorities can cap the prices of firms if it considers that they are set too high. Clearly, setting high prices is possible when competition is limited - as with monopolies and oligopolies.

A price cap can be set at or near to the price that would generate the most allocatively efficient output. This would occur where the firm sets a price that just equals the marginal cost of supply, as shown below:

Diagram showing a profit cap where MC=AC

However, in practice, determining the price that achieves allocative efficiency is likely to be difficult, given that governments or regulators have imperfect knowledge.

Also, the firm can still make super-normal profits - even after the effect of the cap.

Diagram showing a profit cap where MC=AC

Pricing formulae

The price capping process might involve tying price increases to the rate of inflation, minus a figure to encourage efficiency gains. In the UK and in other economies using a pricing formula which includes a figure for inflation has been widely used to regulate utilities such as gas and electricity.

For example, the UK regulators use the formula RPI-X to regulate prices, where the RPI - the Retail Price Index - is a frequently used index of inflation, and 'X' represents a figure by which the regulator encourages efficiency gains. Hence, if the previous year's RPI is 4%, and 'X' is set at 6%, then the price of the regulated utility must be reduced by 2%. The larger the 'X' factor, the greater the expected efficiency gains.

The UK also uses the RPI+K formula when regulators believe that the firm (or industry) needs to set price increases above inflation to enable additional revenue to be earned to invest in improvements to infrastructure.

Revenue and profit regulation

It is also possible to directly regulate the amount of revenue a firm makes, or the level of its profits. This is a common approach to the regulation of natural monopolies in the energy and water sectors. Revenue and profits regulation are often referred to as the 'incentive approach' to regulating utility companies.

A revenue cap operates in a similar way to a price cap, and sets a limit on what revenue can be earned. This can include and adjustment to encourage firms to be more efficient.

Rate-of-return regulation attempts to move the prices of regulated utilities [which are generally natural monopolies] towards the price that would exist if the market was perfectly competitive, while allowing them to recoup their service costs. Regulators typically consider all the costs included in supplying a good or service [such as the cost of energy supply] including capital costs, depreciation and operating costs and any relevant taxes, and uses this as a basis for calculating the revenue that would be needed to cover all costs.[1] It may also allow a reasonable rate of return on the capital employed in the business.

However, critics argue that this approach encourages firms to inflate their costs, for example, by undertaking unnecessary investment in order to increase costs. However, regulators can try to limit artificial cost inflation by undertaking 'efficiency audits' and through regulatory lag. [2] Regulatory lag refers to the principle that cost or price controls are in place until the next review - perhaps 3 or 4 years. Hence, the regulated company cannot instantly change prices following a cost increase, which may act as an incentive to absorb costs, and try to make efficiency savings.

Quality standards

In addition to price, revenue and profit regulation, regulators can set quality standards on producers. Such standards are usually 'minimum' acceptable standards, and producers may exceed these.

In broad terms, quality refers to the flow of service, or the level of value, that consumers derive from a product. Two aspects of quality can be regulated - quality of the product, and quality of the service.

Examples of quality of product standards include water purity levels (for water) and carbon emission levels (for energy suppliers). Examples of quality of service standards includes reliability of service (for train operating companies), and quality of billing provision or handling complaints (all types of provider.)

However, quality is a highly subjective concept, and much harder to define and measure than price or revenue. [3]

Regulators can also use quality ratings to enable consumers to compare quality.

What happens if quality targets are not met?

Producers not meeting quality targets could be fined, and forced to make improvements, or risk losing any license to trade they have. Producers could also be forced to compensate consumers for low quality standards, and offending producers could be 'named and shamed' in the media.

Increasing contestability

Market contestability refers to the ease with which producers can enter and leave a market. When a market is perfectly contestable, there are zero entry and exit costs.

To be able to freely enter a market, no barriers to entry will exist, and to leave a market freely, there will be no barriers to exist

In terms of regulation, increasing the levels of contestability in a market requires the removal or reduction of barriers to entry and exist.

Given that some barriers are 'natural' or structural barriers, such as the benefit of economies of scale, regulators tend to consider 'strategic' or artificial barriers as the major impediment to contestability. Strategic barriers include:

Excess capacity

If incumbents build excess capacity it is likely to be interpreted by potential entrants as a threat because the excess capacity could be quickly deployed to increase output, reduce marginal cost and reduce price.

Advertising expenditure

Excessive advertising can be regarded as a deliberate strategy to deter entry. For example, if an incumbent regularly spends $1m on advertising new entrants might have to try to match that level of expenditure to achieve a given level of brand awareness to achieve sales revenue to, at least, cover costs.

Expenditure on R&D

Similarly, expenditure on research and development can be seen to be a symbolic statement to potential entrants that sufficient budgets are available for developing new products in the future.

Price discrimination

Pricing is clearly an opportunity for incumbents to deter potential entrants. Price discrimination, where consumers in sub-markets are charged different prices for the same product, can be used as a barrier to entry. For example, if a new entrant wishes to a enter a market via a low price strategy it is possible for an incumbent to reduce price in that sub-market, while maintaining a higher price for other sub-markets. The success of this depends upon the elasticity of demand of consumers in the different submarkets.

Where possible, regulators can impose controls on firms to limit the use of such barriers.

Promoting small businesses

Promoting small businesses is likely to increase competition in a given market, as well as increase the level of contestability.

This could involve targeted support in terms of cheap loans, subsidies, tax relief, and business and marketing advice.

Deregulation

Deregulation is the process of removing barriers to entry in previously highly regulated industries.

Historically, heavily regulating industries as associated with industries under public control, and where regulations were in force for protect the monopoly status of the public owned (nationalised) industry.

For example, in the UK, state-run bus services and airlines were privatised in the 1980s to encourage new entrants, and increase competition.

The intended effect of deregulation is to increase contestability in the market, increase the level of innovation, and make efficiency improvements across the industry. As a consequence, prices may be kept in check (and pushed nearer to the allocatively efficient level) and quality improved.

However, critics of 'excessive' deregulation argue that the market can become like the 'wild west', with quality and safety compromised in the chase for 'price sensitive' customers.

Advantages and disadvantages of regulation

Advantages

    Regulation provides a number of benefits, such as:

  1. Helping achieve the socially desirable quantity and quality of output of goods and services, such as through price capping.

  2. Providing a ‘light touch’ alternative to nationalisation.

  3. Regulations can be updated to reflect new evidence and new theories, as well as deal with emerging problems, such as global warming, and the CODID-19 pandemic.

  4. Regulations can also be updated to reflect the evolving needs of consumers.

  5. 'Surrogate’ competition can also be introduced where no real competition exists – such as setting pricing formulae for energy companies who effectively may be natural monopolies.

Disadvantages

    Regulation also has several disadvantages, including:

  1. Government decisions may suffer from information failure, which may include setting inappropriate targets or overly strict regulations.
  2. Regulations may inhibit innovation and stifle entrepreneurship.

  3. Intervention may create unintended consequences, such as regulations regarding the production of medicines, which may create barriers to entry and protect existing pharmaceutical companies.

  4. Regulation may require a complex and costly legal system in order to implement the regulations, and make judgments if they are broken.

  5. Firms may also incur additional costs in terms of compliance.

  6. Regulators may also be subject to political bias, which can distort their judgment.

  7. Finally, regulators can suffer from regulatory capture, where those that are being regulated - such as the large energy companies - are able to 'win-over' regulators, who then adopt a more 'friendly' and less thorough approach to regulation.



Moral hazard

How can firms suffer from moral hazard?

Moral hazard
Government failure

Why do governments fail?

Government failure
Privatisation

What are the benefits of provatisation?

Privatisation

[1] Source: viewed 10th August, 2021 https://en.wikipedia.org/wiki/Rate-of-return_regulation

[2] Regulation Body of Knowledge, Viewed July 20, 2021  https://regulationbodyofknowledge.org/wp-content/uploads/2013/03/Berg_Introduction_to_the.pdf

[3] The Role and Measurement of Quality in Competition Analysis 2013, https://www.oecd.org/competition/Quality-in-competition-analysis-2013.pdf