Lecture 1 Market Failures and Market Regulation
Definition of regulation by the OECD : “imposition of rules by government, backed by the use of penalties
that are intended specifically to modify the economic behavior of individuals and firms in the private sector”
So, regulation makes use of a set of legal tools to achieve pre-defined socio-economic goals
A (blurred, and not very useful) taxonomy:
• Economic regulation
• Social regulation
Social regulation involves the correction of externalities
Typical examples:
• environmental controls
• health and safety regulations
• restrictions on labeling and advertising
essential steps of regulation
a. Identifying a desirable state of the world
b. Comparing the state of the world with that benchmark identifying a market failure
c. Defining possible strategies to address the market failure
d. Selecting the best strategy (including option zero): impact assessment (cost-benefit analysis)
e. Implementing and enforcing the preferred strategy
f. Measuring outcomes / reviewing (back to “a”)
Broadly speaking, “regulation” includes:
• Rule-making (laws; regulations)
• Supervision: oversight of firms’ behavior by an administrative entity
• Enforcement: discovering, deterring, rehabilitating, or punishing people who violate rules they are subject to
Two ways to look at economic regulation
a) Rules as an input: determinants of market dynamics
b) Rules as an output: the market for regulation
c)
Do we need to regulate? And what is an economists dream
short run adjustment
,Long run
Surplus maximisation How common is perfect competition ?
Monopolistic competition short run
Monopolistic competition long run
,Cheap or cool? a trade-off
• Not really a Nirvana, then…
• However, consumer choice is also valuable, and an incentive to technological development
• So, still the best of possible benchmarks
Market failures
• In the competition paradigm, the allocation of scarce resources is determined by price mechanisms
• Marginal values/prices (tend to) correspond to marginal costs: allocating less or more resources would be
inefficient for the society
• Market failures prevent markets from properly
performing this allocative function
Market dominance
Determinants of market concentrations
• Economies of scale
o Average costs decreasing with production
• Network effects
o Attracting critical masses
• Abusive barriers to entry
o Margin squeeze; advertisements
• Legal barriers
o Licensing: see below
Natural monopolies
Asymmetric information
• Moral hazard
o Insurance contracts
o Distorted managerial incentives (and frauds)
• Adverse selection
o Why is insider trading prohibited?
o The cost of capital (SME Growth Markets)
Collective action problems
, • Dominant strategies, Nash equilibria and suboptimal outcomes
o Bank runs
o Inefficient (re)allocation of corporate
control
o Public goods
Positive externalities
• Underproduction of goods and services
o Painting your house façade and dressing
elegantly
o Vaccinations
o Audit services
Negative externalities
• Overproduction of goods and services
o Pollution
o Bans, taxation, and transactions
costs
o Limited liability (shares as put
options) and excessive risk-taking
Bounded rationality
• Sometimes, heuristics, shortcuts, and
biases can drive market participants’
choices
• Examples are countless, let us just consider a few:
o Overconfidence
o Framing
o Endowment effect (risk aversion)
o Anchoring
o Groupthink
o Confirmation bias
o Survivorship bias
Market mimicking
• Market failures deviate markets from their physiological dynamics
o In some cases, the deviation is so pervasive that the market is missing
o E.g. externalities and public goods
• The aim of regulation is to restore:
o Market functioning, where possible; or
o A market-mimicking outcome, otherwise
Definition of regulation by the OECD : “imposition of rules by government, backed by the use of penalties
that are intended specifically to modify the economic behavior of individuals and firms in the private sector”
So, regulation makes use of a set of legal tools to achieve pre-defined socio-economic goals
A (blurred, and not very useful) taxonomy:
• Economic regulation
• Social regulation
Social regulation involves the correction of externalities
Typical examples:
• environmental controls
• health and safety regulations
• restrictions on labeling and advertising
essential steps of regulation
a. Identifying a desirable state of the world
b. Comparing the state of the world with that benchmark identifying a market failure
c. Defining possible strategies to address the market failure
d. Selecting the best strategy (including option zero): impact assessment (cost-benefit analysis)
e. Implementing and enforcing the preferred strategy
f. Measuring outcomes / reviewing (back to “a”)
Broadly speaking, “regulation” includes:
• Rule-making (laws; regulations)
• Supervision: oversight of firms’ behavior by an administrative entity
• Enforcement: discovering, deterring, rehabilitating, or punishing people who violate rules they are subject to
Two ways to look at economic regulation
a) Rules as an input: determinants of market dynamics
b) Rules as an output: the market for regulation
c)
Do we need to regulate? And what is an economists dream
short run adjustment
,Long run
Surplus maximisation How common is perfect competition ?
Monopolistic competition short run
Monopolistic competition long run
,Cheap or cool? a trade-off
• Not really a Nirvana, then…
• However, consumer choice is also valuable, and an incentive to technological development
• So, still the best of possible benchmarks
Market failures
• In the competition paradigm, the allocation of scarce resources is determined by price mechanisms
• Marginal values/prices (tend to) correspond to marginal costs: allocating less or more resources would be
inefficient for the society
• Market failures prevent markets from properly
performing this allocative function
Market dominance
Determinants of market concentrations
• Economies of scale
o Average costs decreasing with production
• Network effects
o Attracting critical masses
• Abusive barriers to entry
o Margin squeeze; advertisements
• Legal barriers
o Licensing: see below
Natural monopolies
Asymmetric information
• Moral hazard
o Insurance contracts
o Distorted managerial incentives (and frauds)
• Adverse selection
o Why is insider trading prohibited?
o The cost of capital (SME Growth Markets)
Collective action problems
, • Dominant strategies, Nash equilibria and suboptimal outcomes
o Bank runs
o Inefficient (re)allocation of corporate
control
o Public goods
Positive externalities
• Underproduction of goods and services
o Painting your house façade and dressing
elegantly
o Vaccinations
o Audit services
Negative externalities
• Overproduction of goods and services
o Pollution
o Bans, taxation, and transactions
costs
o Limited liability (shares as put
options) and excessive risk-taking
Bounded rationality
• Sometimes, heuristics, shortcuts, and
biases can drive market participants’
choices
• Examples are countless, let us just consider a few:
o Overconfidence
o Framing
o Endowment effect (risk aversion)
o Anchoring
o Groupthink
o Confirmation bias
o Survivorship bias
Market mimicking
• Market failures deviate markets from their physiological dynamics
o In some cases, the deviation is so pervasive that the market is missing
o E.g. externalities and public goods
• The aim of regulation is to restore:
o Market functioning, where possible; or
o A market-mimicking outcome, otherwise
