Regulation 1. General 2. Second Best 3. Industry Capture

Regulation

1. General

2. Second Best

3. Industry Capture

Traditional View• Departures from marginal cost.

• Key idea is that MC = MB

• Mathematically:Benefits = W(Q) = Willingness to pay for Q.

Costs = C(Q) = Cost of producing Q.

• Maximize U = (Benefits - Costs):U = W(Q) - C(Q)

dU/dQ = W - C = 0

Mgl WTP = Mgl Cost

It’s all about QUANTITY!

It’s all about QUANTITY!

Departures• If the price of a good

equals someone's willingness to pay, then if we price at marginal cost, then we should move to an optimum.

• All of us are aware of the standard monopoly model that shows departure from optimum.

• We have the WRONG quantity

DemandMR

Q

P

MC

Departures• This is a fairly standard

diagram. The efficient choice of production is at point C. DemandMR

Q

PBecause the firm has monopoly power, it produces output Q1 and sells for price P1. At this point, the willingness to pay is P1 > MC. If we could get the producer to increase production, well-being would be improved. Q1

P1

MCC

A

Although you have excess profit, the welfare loss has to do with the wrong QUANTITY

Although you have excess profit, the welfare loss has to do with the wrong QUANTITY

Departures

DemandMR

Q

P

In this type of situation, regulator could come in, and force monopolist to price at P2 rather than P1.

Q1

P1

MC

This makes for a horizontal MR curve up to where it intercepts the demand curve. Monopolist will produce at D, rather than at A, and will reduce welfare loss triangle from gold to pink.

Key feature here is the sense of knowing what the marginal cost is. There are some fairly tricky information problems here as well.

P2

pink

A

D

Second Best• One of the arguments against

regulation has to do with so-called "second best considerations." Says that if you have more than one imperfection, moving toward MC, MAY not improve welfare. Here's an example.

• Suppose we have a monopolist who is also a polluter. The pollution imposes social costs on society, although the monopolist does not act on them.

• We get a diagram that shows the problems

Demand

MR

Q

P

MC

MSC

Second Best• Suppose that the monopolist

faces constant marginal production cost, but that the more he produces, the incremental amount of pollution increases.

• The monopolist does not face these costs, but society does. We can calculate the amount of output, and the implied amount of pollution that the monopolist comes up with.

Demand

MR

Q

P

MC

MSC

QMON

PMON

QMKTQOPT•Now, suppose the regulator comes in and,

again, imposes marginal cost pricing.

Second Best

• This increases both the amount of output and the amount of pollution.

Demand

MR

Q

P

MC

MSC

QMON

PMON

QMKT

• The general sense of the theory of the second best, then, is that when there are many imperfections, addressing one of them does not necessarily improve well-being.

?

QOPT

Industry Capture

• Are the regulators beneficent?

• What if the industry “captures” the regulatory process?

• There are lots of trade associations; for example, American Medical Association, American Hospital Association.

Peltzman on Regulation - Capture

Starting premise: Regulatory process constitutes a transfer of wealth. Treats the process as if taxing power rests on direct voting.

Regulator seeks “votes”, in particular a majority, M.

(1) M = nf - (N - n) h

n = # of potential voters in beneficiary group

f = probability that beneficiary will grant support

N = total number of potential voters

h = probability that (non-n) opposes

Seek to get majority n/N.


Peltzman on Regulation (2)

(2) f = f (g)

g = per capita net benefit

(3) g = [T - K - C(n)]/n

T = total transferred to beneficiary group

K = $ spent by beneficiaries to mitigate opposition

C(n) = cost of organizing direct support of beneficiaries and efforts to mitigate opposition

(1) M = nf - (N - n) hSeek to get majority n/N.


T = transfer

K = $ to mitigate opp.

z = K/(N – n)


Assume that K and T are chosen. What is optimal tax rate t?

T is raised by taxing the “others.”

(4) T = t B(t) (N - n) t = T/[B(t) (N - n)]

B = wealth

Opposition is generated by tax rate, and mitigated by education expenditures per capita z, so:

(5) h = h (t, z)

(6) z = K/(N - n)

(7) fg > 0; fgg < 0

(8) hz < 0; hzz >0

(9) ht > 0; htt < 0.



T = transfer


z = K/(N – n)


So, office holders must pick:

n = size of group they will benefit

K = amount they will ask group to spend for mitigating opposition.

T = amount transferred to beneficiaries.

Substitute all of these into (1):

)(

,))((

)()(

nN

K

nNtB

ThnN

n

nCKTnfM

(1) M = nf - (N - n) hSeek to get majority n/N.



Note: from (4)

t B(t) = T/(N-n); z = K/(N-n)

(tBt + B) dt = T/(N-n)2 dn

dt/dn = tB/[(tBt + B)(N-n)], from substitution.

Similarly, for dz/dn

M/n = -(g + c)f + f- ht [tB/(B+tBt)] - hz z + h = 0 (10)

M/T = f - ht [1/(B+tBt)] = 0 (11)

M/K =-f - hz = 0 (12)

dn

dzhnN

dn

dthnNh

n

g

n

cnff

n

Mzt )()()

'('

ht, hz = mgl cost

f´ = mgl benefit


Making all of the substitutions:

( )1 , where ,

( )g

g

f g an C Ca m

N f h f m a n n

It works. What does it mean?

First, assume there are no organization costs, such that a = m = 0.

n

N

f g

f h

fg

gf

f

f hg

1 1



n

Ca

amfhf

agf

N

n

g

g

where,

)(

)(1


Making all of the substitutions:

With diseconomies of scale, m > a

Denominator falls, you’re subtracting a larger number and (n/N)

So, there is an optimal fraction, and it is less than 1.

As n/N , there is a bigger majority, BUT less to tax, and more opposition if you raise the tax.



M/T = f - ht [1/(B+tBt)] = 0 (11)


Let’s rearrange:

f (B+tBt) = ht (11)

[Mgl in prob.of support]

=[Mgl prod.raising revenues from losers]

[Mgl opp.from taxes]

T = transfer


z = K/(N – n)

f(B+tBt) = Rt = ht /


$ or R

tax rate t

(B+tBt) ht /f

tmax

ta

If you tax to maximize revenue (tmax), you compromiseyour majority by mobilizingopposition.

T = transfer


z = K/(N – n)

MR from taxation MC from opposition

Documents

Regulation 1. General 2. Second Best 3. Industry Capture