Theories of Regulation

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The development and techniques of regulations have long been the subject of academic research. 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,2 interest group theories that describe stakeholders’ interests in regulation,3 and theories of government opportunism that describe why restrictions on government discretion may be necessary for the sector to provide efficient services for customers.4 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,5 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 theories of regulation generally conclude that regulators should encourage competition where feasible, minimize the costs of information asymmetries by obtaining information and providing operators with incentives to improve their performance,6 provide for price structures that improve economic efficiency,7 and establish regulatory processes that provide for regulation under the law and independence, transparency, predictability, legitimacy, and credibility for the regulatory system.8

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.9 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.10

Footnotes

  1. See Rationale for Regulation and Regulatory Instruments.
  2. Market Structure and Competition addresses market power issues.
  3. Institutional Design Issues, Ethics, and Stakeholder Relations address issues relevant to the effects of stakeholders in regulation.
  4. Limits to regulatory power and institutional mechanisms designed to limit opportunism are examined in the Regulatory Process chapter. Incentive regulation techniques reviewed in the Quality, Social, Environmental chapter include restrictions on regulatory discretion that are intended to limit opportunism.
  5. See Regulatory Instruments.
  6. See Market Structure and Competition, Financial Analysis, and Price Level Regulation for techniques for overcoming information asymmetries.
  7. See Tariff Design.
  8. See Regulatory Process.
  9. See Regulatory Instruments. See Productivity Commission of Australia (2003) for a case study in how information issues affect regulatory policy.
  10. Price Level Regulation covers incentive regulation and Tariff Design notes multipart pricing.