Economics of Regulation - Theories of Regulation

Theories of Regulation

The development and techniques of regulations have long been the subject of academic research, particularly in the utilities sector. Two basic schools of thought have emerged on regulatory policy, namely, positive theories of regulation and normative theories of regulation.

Positive theories of regulation examine why regulation occurs. These theories of regulation include theories of market power, interest group theories that describe stakeholders' interests in regulation, and theories of government opportunism that describe why restrictions on government discretion may be necessary for the sector to provide efficient services for customers. In general, the conclusions of these theories are that regulation occurs because:

1. the government is interested in overcoming information asymmetries with the operator and in aligning the operator's interest with the government's interest,
2. customers desire protection from market power when competition is non-existent or ineffective,
3. operators desire protection from rivals, or
4. operators desire protection from government opportunism.

Normative economic theories of regulation generally conclude that regulators should

1. encourage competition where feasible,
2. minimize the costs of information asymmetries by obtaining information and providing operators with incentives to improve their performance,
3. provide for price structures that improve economic efficiency, and
4. establish regulatory processes that provide for regulation under the law and independence, transparency, predictability, legitimacy, and credibility for the regulatory system.

Alternatively, many heterodox economists working outside the neoclassical tradition, such as in institutionalist economics, economic sociology and economic geography, as well as many legal scholars (especially of the legal realism and critical legal studies approaches) stress that market regulation is important for safeguarding against monopoly formation, the overall stability of markets, environmental harm, and to ensure a variety of social protections. These draw on a diverse range of sociologists of markets, including Max Weber, Karl Polanyi, Neil Fligstein, and Karl Marx as well as the learnt history of government institutions involved in regulatory processes.

Principal-agent theory addresses issues of information asymmetry, which in the context of utility regulation, generally means that the operator knows more about its abilities and effort and about the utility market than does the regulator. In this literature, the government is the principal and the operator is the agent, whether the operator is government owned or privately owned. Principle-agent theory is applied in incentive regulation and multipart tariffs.