When is regulation more efficient than competition?

Carmine Guerriero

When is regulation more efficient than competition? This column provides a theoretical framework for thinking about these issues and explores its implications using electricity data from the US. It argues regulation can be more efficient than competition when investment inducement is salient, and that deregulation can be inefficiently implemented when consumer groups are too politically powerful.

“Competition is not only the basis of protection to the consumer but is the incentive to progress. However, […] destructive competition […] may impoverish the producer and the wage earner" (Herbert Hoover, States of the Union Address, December 2, 1930).

Economists have long maintained that competition generates important efficiency gains. Two are the main arguments in support of free-markets:

competition delivers higher allocative efficiency – i.e., a higher level of output – than regulation can;

when the information is asymmetric, competition is better suited to constrain the behaviour of effort averse managers because it confronts their choices with those of competing colleagues (Baggs and de Bettignies 2007).

Yet, despite the economists' dissatisfaction with regulation, societies often regulate markets far from being in danger of failure (Shleifer 2010). Starting from this paradox, some works have claimed that regulation could be better suited to foster cost-reducing investment (Vives 2008) and have documented that the recent worldwide deregulation wave has delivered modest welfare improvements (Fabrizio et al. 2007). This raises two key questions:

Is it the case that a benevolent government should choose between competition and regulation, trading-off allocative distortions and investment inducement?

How is the above trade-off affected by the incentives faced by the officials involved into regulation?

Competition versus regulation

In a recent paper (Guerriero 2010), I provide a theoretical framework for thinking about these issues, and I explore its empirical implications using US electricity data.

In the model, I build on a wide literature on incentives, competition and regulation (Laffont and Tirole 1993, and Armstrong and Sappington 2006) and I compare two market institutions in a world in which firms can commit a cost-reducing investment before privately learning their cost. The latter can be either high or low. Under the first institution, two firms undercut each other in order to serve all the market at the price offered by the opponent.1 If the offered price is the same, they split the demand. Under the second institution, the market is served by a regulated monopoly.

The solution of the model shows that, due to the pricing interaction and conditional on the cost distribution, competition assures that the firm with the lowest cost serves the market more often. Yet, because of the asymmetry in the information between society and the firm and in the empirically relevant case of inelastic demand, regulation produces higher expected rents and, in turn, stronger incentive to invest.2 There are two paramount consequences of this pattern:

The likelihood that competition is adopted is higher when society is less concerned about cost-reducing investments and the extent of asymmetric information along with the informational rents left by regulation. Also, when investment boosts mainly the firm's profits, a tension between consumers and shareholders arises and competition is more likely to prevail the stronger is the consumers' political power. 3

Because the probability that the firm has low cost is higher under regulation, but the low cost firm serves the market more often under competition, the relation between the expected cost and the prevailing market conduct is undecided.

Testing theory with evidence from the US

In order to test these predictions, I look at the deregulation of the US electricity market and analyse a panel of 503 plants owned by investor-owned utilities operating in 43 states between 1981 and 1999. Until the beginning of the 1980s, Public Utility Commissions have set prices in order to assure a specific return on investment after recouping all operating costs recognised as reimbursable during rate reviews. After experimenting incentive rules helped to sever the price-cost link and communicate stronger incentives to minimize costs, more radical reforms were enhanced in the mid-1990s. As a result of this reforming effort, many investor-owned utilities now own only a small fraction of the generation capacity and retail rates follow the prices from auction-based wholesale markets (Fabrizio et al. 2007).4

Consistent with the model, deregulation was implemented in states where politicians were more pro-consumer and investment inducement was less salient because generation costs were historically lower. Focusing on the last point, the likelihood of deregulation falls by 11.4 percentage points as a result of a one-standard-deviation rise in the past – three years before the reform – own state's mean of the marginal fossil fuel costs, and by 7.6 percentage points for each standard-deviation rise in the ratio of the past own state's mean of the marginal fossil fuel costs over those of neighbouring states. Also, fully considering that reforms depend on technological and political forces suggests that deregulation brought a cost reduction stronger than that documented before.

Building on the model, this evidence suggests that the firms serving the deregulated markets were the most efficient but also the most prone to suffer investment shortages due to the declining profits. This interpretation is confirmed by Joskow (2008), who documents that the new generating capacity entered service in the last two decades was mainly built by firms in non restructured markets. Also, reforms enhanced only to accommodate the consumers' political pressure have been followed in the last 5-6 years by a series of re-regulation moves. All in all, the US electricity market case highlights two crucial ideas:

regulation can be more efficient than competition when investment inducement is salient, and

deregulation can be inefficiently implemented when consumers' groups are too politically powerful.

Saving regulation from economists

The work just discussed goes into the direction of a growing body of literature debunking many of the economists’ myths about the absolute power and efficiency of free-markets.5 This research effort is particularly relevant in a post-crisis period like the one in which we are currently living – a period in which a deeper understanding of the functioning of regulatory policies can avoid that incorrect rules are designed or too much is left to the autonomous activity of market agents in the name of an ideal mistake-proof invisible hand.

References

Armstrong, Mark, and David EM Sappington (2006), “Regulation, Competition, and Liberalization”, Journal of Economics Literature, 44:325-366.

Baggs, Jen, and Jean-Etienne de Bettignies (2007), “Product Market Competition and Agency Costs”, Journal of Industrial Economics, 55:289-323.

Fabrizio, Kira, Nancy Rose, and Catherine Wolfram (2007), “Do Markets Reduce Costs? Assessing the Impact of Regulatory Restructuring on US Electric Generation Efficiency”, American Economic Review, 97:1250-1277.

Guerriero, Carmine (2010), “The Political Economy of (De)Regulation: Theory and Evidence from the US Electricity Market”, ACLE Working Papers, 2010-06.

Joskow, Paul (2008), “Lessons Learned From Electricity Market Liberalization”, Energy Journal, 29:9-42.

Knittel, Christopher R (2006), “The Adoption of State Electricity Regulation: the Role of Interest Groups”, Journal of Industrial Economics, 54:201-222.

Laffont, Jean-Jacques, and Jean Tirole (1993), A Theory of Incentives in Procurement and Regulation, MIT Press.

Pinotti, Paolo (2010), “Trust and Regulations: Addressing a Cultural Bias”, Unpublished.

Shleifer, Andrei (2010), “Efficient Regulation”, in Daniel Kessler (ed.), Regulation vs. Litigation, NBER and University of Chicago Press, forthcoming.

Vives, Xavier (2008), “Innovation and Competitive Pressure", Journal of Industrial Economics, 56:419-469.

1 Under mild extra-assumptions, the results also hold under Cournot competition.

2 The equilibrium under competition is the same as if information was complete because the pricing interaction is strategically similar to a second price auction. Hence, truth-telling is optimal.

3 This also explains the switch from a municipal regulation with its typical hold-up problems to a state one assuring a fair rate of return on investment. Knittel (2006) shows that these reforms were implemented where capacity shortages were more severe and residential penetration rates lower.

4 Even if between 1993 and 1998 all states held hearings on possible restructuring, only 23 states and the District of Columbia enacted restructuring legislations between 1996 and 2000.

5 Crucially Pinotti (2010) shows that the rise of the regulatory state can efficiently overcome the risk that market participants are coerced by a subgroup of untrustworthy agents; once this cultural bias is considered the negative relation between regulation and economic development disappears.