Regulation of Markets

Types of market regulations

Regulators can use different types of controls to promote competition and remove anti-competitive behaviour.

Price regulation

Regulators can set a maximum price that monopolies can charge. Using the RPI-X+K formula, regulators force monopolies to charge below the profit maximising price.

The X in RPI-X is efficiency. Regulators set a price that is below the inflation rate, forcing firms to become more efficient if they are to continue to make profit. This ensures that firms pass the efficiency gains onto consumers.

However, due to the quick improvements in technology, it is difficult for regulators to know where X is. They only have asymmetric information, and their efforts may not be effective.

The K in RPI+K is capital. Regulators allow firms to grow and make profit but force them to invest it back. This allows efficiency gains to be passed onto consumers.

Regulators can also set a price cap at P=MSC (marginal social cost). This ensures that monopolies are allocatively efficient. The price cap acts as a proxy for competition.

Failing to act according to these price caps and regulations can result in huge fines which can affect the firms’ profits.

However, it could be difficult for regulators to know where a firm’s allocatively efficient point is due to asymmetric information. Additionally, inflation can eat away at profits in the long run if the price doesn’t adjust to inflation.

Profit regulation

Instead of regulating prices, regulators can control the maximum level of profits. In the US, this is known as the ‘rate of return’ regulation. Prices are set to allow firms to cover their operating costs and earn a ‘fair’ rate of return based on the capital employed.

It is used to prevent firms from setting too high prices and it encourages them to invest. However, firms could employ too much capital and allow it to depreciate so that regulators can increase rates. Additionally, firms do not earn more if their costs are reduced, thus it provides little incentive for firms to reduce costs and improve efficiency.

Quality standards and performance targets

Regulators can establish quality standards to ensure that consumers are not exploited through poor-quality goods and services.

Regulators can also impose different targets on firms ranging from price, quantity, consumer rights, and cost of production. This can help firms improve their service towards consumers and gain more consumers.

In practice, this could lead to firms meeting their targets, but not improving.

Merging policies

To prevent the abuse of monopoly power, regulators can stop monopolies from forming in the first place. Regulators do this by blocking mergers and takeovers or by forcing a monopoly to demerge.

By blocking mergers and takeovers, regulators prevent firms from gaining monopoly power and prevent consumers from getting exploited. By forcing firms to demerge, regulators promote more competition within a market and eliminate monopolies.

Market regulation and market failure

Market failure occurs when there is an inefficient distribution of goods and services in a free market. It can occur because of monopolies, negative externalities, or a lack of provision of public goods.

The government can impose laws and regulations to correct and avoid market failures. The regulations established can prevent demerit goods, goods with negative externalities, the abuse of monopolies, and the exploitation of labour.

Other examples of regulations imposed to correct market failure include:

• US Motor Vehicle Air Pollution Control Act. This limits the amount of pollution and emissions engines can create.

• Cartel and the Competition Act 1998. This prevents anti-competitive agreements and the abuse of a dominant position by a firm.

Advantages and disadvantages of market regulation

There are many advantages and disadvantages to a regulated market.

Advantages

Some advantages for regulating a market are:

• Prevent exploitation: a regulated market can help prevent the formation of monopolies that will exploit consumers with higher prices or poor-quality products.

• Encourages competition: a more contestable market allows for consumers to benefit from choice and lower prices.

• Encourages firms to be more efficient: regulating the price firms can set, can encourage them to be more efficient in making profits. It can also lead to them passing on the efficiency gains onto consumers.

Disadvantages

Some disadvantages for regulating a market are:

• Asymmetric information: to impose effective controls, regulators require a lot of information about the market as a whole and specific firms. Due to inaccurate or limited information, regulators could set ineffective controls which could result in government failure.

• Regulatory recapture: this refers to when regulators serve the interests of those it is meant to be regulating rather than those it is supposed to be protecting. Regulators fail to regulate the market through lobbying or corruption.

• Theory of second best: this refers to when the government corrects one market failure but creates a larger market failure elsewhere. In these cases, the industry would have been better off if regulators never got involved.

We encourage you to read the Deregulation of Markets explanation to understand why some markets aren’t regulated.