Policy Sci DOI 10.1007/s11077-013-9192-z
Policy and regulatory design for developing countries: a mechanism design and transaction cost approach Eduardo Araral
Ó Springer Science+Business Media New York 2013
Abstract The first-generation literature on policy design has made considerable contributions over the last 30 years to our understanding of the process, politics and implications of policy design and instrument choice. This literature, however, has generally treated institutions as a black box and has not developed a coherent set of frameworks, theories and models of how institutions matter to policy design. In this paper, I unpack the black box of institutions using transaction cost and mechanism design to show how regulations can be better designed in developing countries when institutions are weak, unaccountable, corrupted or not credible. Under these conditions, I show that efficient regulatory design has to minimize transaction costs, particularly agency problems, by having incentive compatible (self-enforcing) mechanisms. I conclude with a second-generation research agenda on regulatory design with implications for environmental, food and drug safety, healthcare and financial regulation in developing countries. Keywords Transaction cost Mechanism design Infrastructure Institutions Policy/regulatory design Developing countries
Introduction Scholars in the last 30 years have made considerable contributions to understanding the process, politics and implications of policy design and instrument choice. For instance, political scientists have studied how the attributes of a policy problem affect democratic politics (Lowi 1979; Wilson 1986; Ostrom 1990; Schneider and Ingram 1993 and many others). Economists, on the other hand, have focused on the welfare implications of agency
E. Araral (&) Lee Kuan Yew School of Public Policy, National University of Singapore, 469C Bukit Timah Road, Singapore 259772, Singapore e-mail:
[email protected]
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problems (Weimer and Vining 2004), while political economists have studied the supply and demand for regulations (Stigler 1971; Buchanan 1980; Pelztman 1976; Laffont and Tirole 1993). Critical theorists point to the importance of text and context of policies, i.e., institutional narratives (Lejano 2006; Ricoeur 1991; Powell and DiMaggio 1991). Policy science scholars, on the other hand, have devoted their attention to the process and dynamics of design such as borrowing, tinkering and problem solving (Weimer 1993), while others point to the importance of instrument choice (Linder and Peters 1990). This literature can be aptly referred to as the first-generation literature on policy design and instrument choice because majority of them have been published in the late 1980s to mid-1990s. This literature has since tapered off in the late 1990s and the following decade and is seeing only its revival in recent years, for instance Howlett (2009), Lejano (2006), among others. While this first-generation literature has made considerable contributions in the last 30 years, it has at least one notable shortcoming: It has treated institutions as a black box and has yet to develop a coherent set of frameworks, theories and models of how institutions matter to policy design and instrument choice (but see, Weimer 1992). In this paper, I address the question of how institutions matter to policy design, specifically regulatory design. I open the black box of institutions using transaction cost (TC) and mechanism design (MD) and develop a more coherent set of framework, theories and models how institutions matter to regulatory design. Specifically, I illustrate how regulations can be better designed in developing countries where institutions are generally weak, unaccountable, corrupted or not credible. I argue that regulatory design, to be successful, has to minimize transaction costs—such as agency problems—by having incentive compatible (self-enforcing) mechanisms. The rest of the paper is organized as follows: In the next section, I discuss the relevant features of MD and TC for the study of regulatory design and then outline a framework that brings these two approaches into a coherent framework. In the third section, I illustrate the application of MD and TC with a focus on regulatory design for developing countries where institutions are weak, corrupted and non-credible. In the concluding section, I outline the implications of the paper for the second-generation research agenda on policy design and implications for studying the politics of policy design.
Mechanism design and transaction cost Mechanism design is a relatively new field in economics, associated with economics Nobel Prize winners Eric Maskin, Leonid Hurwicz and Roger Myerson. The Nobel Prize Committee for Economic Sciences (2007) described it as follows: Mechanism design theory provides a coherent framework for analyzing a great variety of institutions, or ‘‘allocation mechanisms,’’ with a focus on the problems associated with incentives and private information. The aim of MD is to find a solution (a mechanism) to a social problem in a way that will motivate agents to disclose their private information when they have incentives not to. In regulatory policy, the implications of MD have been extended mainly to the study of infrastructure regulation, for instance Estache and Martimort (1999) and Laffont and Tirole (1993). It has also been applied to study the relationship between a politician and a judge (Maskin and Tirole 2004) and more generally understand the implications of incomplete
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contracts (Maskin and Tirole 1999). Beyond this scant literature, MD is not yet well appreciated by scholars of policy design. Mechanism design has significant implications to policy design to the extent that it draws attention to generic problems of information asymmetry, adverse selection and moral hazard. While these problems are generally well known, their implications for policy design in a weak institutional context are much less understood. For instance, what is the best mechanism to achieve social goals given private information when institutions are weak, not credible or corrupted? This question has significant implications to a wide variety of policy issues confronting developing countries such as China—for example in food, drug and product safety, environmental regulation, banking and finance, education, health care, among others. MD allows us to more systematically answer these sorts of questions. However, MD has its limitations when extended to the policy design literature. For instance, it treats institutions as a black box; it does not explicitly deal with problems of opportunism; it ignores the politics of policy design; it assumes a comprehensive (as against incremental) approach and assumes that designers are faced with a blank policy canvass (as against inheriting a policy). The limitations of MD can be partly addressed with transaction cost (TC) analysis, a well-established concept in economics associated with Williamson (1985) and Coase (1960). Table 1 compares MD and TC as analytic approaches. TC was originally developed to answer the question why firms exist and to explain their boundaries and to help device governance mechanisms to minimize transaction costs. Transaction cost has four important concepts as follows: uncertainty, opportunism, bounded rationality and remediableness criterion. Unlike MD, TC more explicitly recognizes the problem of opportunism and thus implicitly the problems associated with weak institutions such as systemic corruption, weak accountability and credible commitment
Table 1 Comparison of mechanism design and transaction cost literature Mechanism design
Transaction cost
Theoretic focus
Principal-agent problem in achieving social goals
Theory of the firm/contract theory
Key questions
What is the best mechanism to achieve social goals given private information?
Why do firms exist? What explains the boundaries of the firm?
Aims
How to motivate agents to reveal their private information when they have incentives otherwise
How to device governance mechanisms to minimize transaction costs
Key concepts/ strengths
Information asymmetry, adverse selection, moral hazard, reverse game theory
Uncertainty, opportunism, bounded rationality
Applications to policy design
Regulatory design
Regulatory design, tradable permits, transaction cost politics, budgeting
Limitations when extended to policy design
Treats institutions as a black box; does not deal with problems of opportunism; ignores politics of policy design
Does not implicitly deal with principalagent problems; policy design is not simply minimizing transaction cost; limited to analysis of efficiency/ transaction cost implications and not other substantive policy outcomes such as equity, legitimacy, etc.
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problems. TC does not implicitly deal with agency problems unlike MD. The remediableness criterion states, ‘‘an outcome for which no feasible superior alternative can be described and implemented with net gains is presumed to be efficient’’ (Williamson 1996). TC has been applied to the study of infrastructure regulation (Estache and Martimort 2002), cost of doing business (World Bank 2013) and tradable environmental permits (Stavins 1995). In political science, TC has some foothold, especially in the treatment of political markets as a mechanism of exchange where TC matters, for instance North (1990), Dixit (2001, 1996) and Epstein and O’Halloran (1999). I argue that MD and TC combined offer a set of complementary conceptual tools to advance the policy/regulatory design literature. To understand how, it is first important to define what I mean by policy design and the ideal process of policy design. I refer to policy design as a process of choosing a set of policy instruments, for instance a mix of taxes, subsidies, standards regulation and insurance to achieve a policy outcome. Choice implies trade-offs—for instance choice between market-based instruments (price mechanisms) and regulatory instruments (command and control), while trade-offs imply bargaining, leveraging and hence involves politics. The ideal process of policy design and instrument choice requires, first, identifying the desired policy outcome(s). Given this outcome, we work backwards to find, usually in a negotiated/contested process, what is the most appropriate mechanism (policy design) to achieve this outcome subject to trade-offs among political, informational, administrative and financial constraints as well as given the institutional context. By appropriate, I refer to Williamson’s (1996) remediableness criterion referring to an outcome for which no feasible superior alternative can be described and implemented with net gains. Political constraints refer to the fact that policies are subject to bargaining among interest groups and to opportunistic behaviors such as rent seeking and credible commitment problems. Informational constraints imply that policy designers are boundedly rational and policy design is faced with information asymmetries between regulators and regulatees. It also implies that policy design as a process involves trial and error, calibration, borrowing, tinkering and problem solving. Administrative constraints refer to constraints in the implementation of a policy—the ability to implement, monitor and enforce policies. Mechanism design—using reverse game theory—can provide the analytic framework (which TC cannot) in thinking about the mechanism to achieve a social goal given problems of incentive and private information. MD, however, does not explicitly deal with the problem of opportunism, transaction costs and institutional context (which TC does), which are important to policy design. MD and TC are, therefore, complementary approaches to policy design and instrument choice.
Policy design framework Integrating transaction cost and mechanism design as a coherent analytic approach requires a framework. Building on Ostrom’s (1999) institutional analysis and development framework (IAD), I illustrate in Fig. 1 a stylized policy design framework (PDF) that integrates the key elements of TC and MD. In the PDF, we begin by identifying the desired policy outcomes, in this case efficiency, and then identify the appropriate mechanisms or policy instruments to meet these outcomes subject to political, informational, financial and administrative constraints and institutional context.
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Transaction Cost Variables Attributes of the policy problem (agency, adverse selection, moral hazard, etc.) Attributes of players (bounded rationality, opportunism, structure of policy networks, etc.)
Policy / Mechanism design ( centralized vs. decentralized regulation; regulated monopoly vs. unregulated competition; price cap vs. rate of return regulation
Policy outcomes (Efficiency)
Institutional context (capacity, accountability, commitment, transaction cost, etc.)
Fig. 1 The policy design framework
In this paper, I explore several policy design options as follows: centralized versus decentralized regulatory structure; regulated monopoly versus unregulated competition and price cap versus rate of return regulation. I argue that the efficiency implications of these mechanisms depend on at least three contractual or transaction cost variables: (1) the attributes of the policy problem (in this case agency, adverse selection and moral hazard problems), (2) the attributes of actors (bounded rationality, opportunism and structure of policy networks) and (3) the institutional context. Using the PDF, I explore the implications for designing industry, regulatory and contract structure given the problem of information asymmetry and the problem of opportunism arising from weak institutions. By industry structure, I refer to Laffont’s definition as the extent to which competition is allowed in an industry (i.e., regulated monopoly vs. unregulated competition). By regulatory structure, I refer to the mechanisms for regulatory enforcement (i.e., centralized vs. decentralized structure). By contract structure, I refer to the regulation of pricing (i.e., rate of return regulation, flat rates, cost plus pricing, etc.). By weak institutional capacity, I mean weak capacity to regulate, monitor and enforce regulations; commitments are not credible, and accountability is weak. Attributes of the policy problem Many scholars of policy design have studied the implications of the attributes of the policy problem. Lowi (1979) and Wilson (1986), for example, studied how different types of policies affect democratic politics and vice versa. Lowi’s model challenged the conventional thinking that politics create policies and instead argue, ‘‘policies create politics.’’ Wilson (1986), on the other hand, sought to explain how and why variations in policies lead to variations in politics. Wilson predicts that welfare policies will continually expand because those who benefit will mobilize (concentrated benefits), while those who pay (taxpayers) will not because the costs are dispersed among them.
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Schneider and Ingram’s (1993) model—one of the most cited models in the policy design literature—supports the conventional view that politics creates policies. Their main contribution is to highlight how the social construction or stereotyping of target groups affects policy design and how it affects democratic politics. However, few of these studies have systematically studied how the attributes of policy problems matter to policy outcomes given a weak institutional context. The welfare economics literature continues to treat institutions as a black box. For instance, while there is large literature on the implications of adverse selection, moral hazard and agency problems, very few studies have examined their implications when regulatory capacity is weak, corrupted or are non-credible. Policy actors and networks The role of policy actors and networks has been widely studied in the political economy literature as well as policy science literature, particularly the role of advocacy coalitions in policy reform (Sabatier and Jenkins-Smith 1993). Political economists from Chicago such as Stigler (1971), Buchanan (1980), Pelztman (1976) and Becker (1983) have argued that the network of actors (regulators, politicians, regulated firms, consumers) rationally use the political system to influence regulation where they have a stake at a level where marginal benefit is equal to marginal cost. The costs of organizing the industry, they argue, are the crucial determinant of industry (and generally interest group) influence. In contrast to the Chicago School, the Virginia School of regulation, associated with Buchanan (1980) and Tullock (1967), looks into the supply side models of regulation. Specifically, they look at how the networks of politicians and bureaucrats compete for rents associated with bribes and kickbacks. In their models, bureaucrats have the power to generate rents, for example by creating or maintaining a monopoly position, which are then sought after by the private sector. Politicians and bureaucrats, in turn, compete to become the grantors of rent. Within government, rent granters compete among themselves for the right to distribute rents and therefore receive favors from interest groups. On the other hand, Laffont and Tirole (1993) also criticized the Chicago School of regulation for two methodological limitations. First, it is not agency theoretic (i.e., they ignore information asymmetries). Since asymmetric information allows the regulated firm to enjoy rents, the absence of asymmetry reduces the incentive of the firm to influence regulatory outcomes. Second, it focuses mainly on the demand side of regulation in that all the action takes place on the side of interest groups. By assuming that the political and regulatory institutions as black boxes, they have ignored a crucial agency relationship between politicians and their agents in regulatory agencies. Institutional context While there is no disagreement among scholars that institutions matter to policy design, very little empirical work has been done to show how they matter to policy design. Lejano (2006) has argued for the importance of institutional narratives (the text and context) in policy design. Howlett (2009) has argued that policy aims and instrument choice especially in federal forms of government would have to be coherent and consistent if policy design is to be successful. Weimer (1994) has suggested that policy design scholars pay more attention to the work of scholars of new institutional economics for its particularly promising insights. For instance, Williamson (1981) was instrumental in highlighting the implications of
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uncertainty, opportunism and bounded rationality in the design of institutions and defining the boundaries of the firm. The implications of this work, however, have yet to be extended in the context of policy design. Following Laffont, the main contribution of this paper is to unpack the black box of institutions in policy design and show how it matters to the efficiency of policy outcomes.
Implications for regulatory design To illustrate the implications of MD and TC to regulatory design, I will explore the following questions in the context of a developing country. First, is it better to have a centralized or decentralized regulatory structure when regulatory capacity is weak? Second, is it better to use rate of return regulation or price cap when monitoring, auditing and judicial capacity is weak? Third, to reduce rent seeking and achieve more efficiency should there be more or less competition when regulatory capacity is weak? Finally, what is the ideal industry, regulatory and contract structure when the regulator cannot make credible commitments? I hypothesize, following Laffont (2005), that when regulatory capacity is weak (i.e., inadequate financial/human resources, undeveloped auditing system, inexperienced judiciary), it would be more efficient to have (1) a competitive industry structure to reduce rents and increase efficiency, (2) a centralized regulatory structure with capable staff and multi-sectoral bodies to regulate several industries than a decentralized system with weak, dispersed capacity and (3) a price cap regulation would be an ideal contract design structure if the regulator is weak and monitoring costs is high (i.e., costly to observe costs). Table 2 provides a summary of the ideal policy design and instrument choice given weak and strong institutional capacity. I elaborate on these in the sections that follow. Regulatory design implications when institutional capacity is weak Weak regulatory capacity is a key institutional challenge faced by most developing countries. This is often the case because: (1) regulators are generally short of financial and human resources; (2) auditing system is underdeveloped; and (3) the judiciary is inexperienced (Laffont 2005). Information asymmetry between the regulator and the operator often compounds weaknesses in regulatory capacity. The asymmetry arises when the operator has more information than the regulator, which it can use to its advantage, a
Table 2 Policy design implications given institutional capacity Ideal policy (mechanism) design given strong and weak institutional capacity Strong capacity
Weak capacity
Design of industry structure (structure of competition)
Low regulatory effort
High regulatory effort
Design of regulatory structure (monitoring and enforcement)
Decentralized regulatory structure
Centralized regulatory structure
Design of contract structure (pricing regulation)
Rate of return regulation Complex contracts
Price caps Simple contracts
Adapted from Laffont (2005)
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problem aggravated by inadequate training and experience of the staff of the regulatory agency. Lack of financial resources also hinders the ability of the regulator to monitor the efforts of the operator and ascertain between controllable and uncontrollable costs or observe the true level of total cost (Laffont 2005). As a result, Laffont suggests several consequences of weak regulatory capacity. First, greater information asymmetry between regulator and operator means more opportunities are available to the operator for rent seeking. Regulated firms can potentially reap excessive returns beyond those that could be expected from the high risks often associated with doing business in developing countries. Second, the distributional as well as political consequences of high rents can be significant for a developing country (Laffont and Tirole 1993). A weak institutional framework also makes it difficult to rely on contracts, thus discouraging parties from contracting. This is particularly damaging given the greater uncertainties about cost, demand and macroeconomic stability that exist in developing countries. Overall, Laffont argues that the effects of various institutional limitations can be large, and hence may override those concerns that are normally stressed in the regulation of utilities in developed countries. The solutions to these limitations, argues Laffont, are imperfect, contradictory and frequently divergent from those adopted in developed countries. Table 3 summarizes what type of industry, regulatory and contract structure might work when regulatory capacity is weak. Ideal industry design The ideal industry structure when regulatory capacity is weak, suggests Laffont, is to have a competitive industry structure, which can help reduce rents and increase efficiency. The trade-off, of course, is that a competitive structure is not costless; i.e., this might require a competition authority that in turn depends on institutional capacity. Armstrong and Sappington (2006), similarly, argue that a regulated monopoly may be inappropriate, and competition may be a more effective mechanism for reducing rents and increasing efficiency because a competitive market generally requires less regulation, and hence capacity constraints are less likely to be felt. Hall and Lobina (2005) have argued that limited regulatory capacity means that water and electricity sectors are best managed by the public sector. Mathematical modeling has been widely used to examine the welfare implications of regulated monopoly versus unregulated competition. An example is the work of Armstrong Table 3 Implications of weak regulatory capacity on industry, regulatory and contract design Regulatory challenge
Ideal industry design
Ideal regulatory design
Ideal contract design
Weak regulatory capacity (inadequate financial/human resources, undeveloped auditing system, inexperienced judiciary)
Competitive industry structure to reduce rents and increase efficiency
Centralized structure and multi-sectoral bodies to regulate several industries Sharing expertise and information with other countries Short-term contracting out regulation to third parties
Use price cap if regulator cannot observe cost Preference for simple contracts over complex contracts
Source: Adapted from Laffont (2005)
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and Sappington (2006) who suggest that unregulated duopoly delivers a higher level of expected social welfare than does regulated monopoly when the duopolists’ costs are perfectly correlated, i.e., there is no cost advantage among rival firms, and thus there is rent in the duopoly setting. While mathematical models of the neoclassical approach to regulation can help us better understand the welfare implications of infrastructure regulation and provide us with elegant prescriptions, they have a serious limitation: they ignore the political and institutional context of regulation, which can lead to ineffective regulatory reforms. For instance, Armstrong and Sappington (2006) caution that their conclusions from the simple models of regulated monopoly versus unregulated competition very much depend on institutional factors that can affect the optimal choice between regulated monopoly and unregulated competition. These institutional factors are summarized in Box 1. Ideal regulatory structure When regulatory capacity is weak, a centralized regulatory structure would be ideal where resources and expertise can be concentrated. The centralized agency can be responsible for regulating across a range of infrastructure industries. The centralized agency can build expertise by learning from other countries as well as contracting out some regulatory functions to third parties in the short run. Estache and Martimort (2002), however, cautions that centralized regulatory structures increase the likelihood of capture especially when institutions are weak or are faced with systemic corruption. Ideal contract structure Laffont (2005) suggests that the ideal contract structure when capacity is weak is to use price cap regulation especially when the regulator is unable to observe controllable and uncontrollable costs by the operator. Regulators should also use contracts that are simple and straightforward rather than complex contracts that they may not have the capacity to deal with. In price cap regulation, the regulator fixes ceiling prices for a basket of products using either average or weighted prices, and the firm is free to choose its prices at or below the ceiling. Price cap rules out the use of contractual data and is therefore sub-optimal. When the cap is too high, the firm becomes an unregulated monopolist. When it is too low, the viability of the firm will be in question. Determining the ‘‘right’’ price level is not easy especially when regulatory capacity is weak. Kirkpatrick and Parker (2004) also argue that while price cap regulation is successful in developed economies in improving performance, they are more difficult to apply in
Box 1 Institutional factors affecting choice of regulated monopoly versus unregulated competition Resource constraints faced by the regulator Potential role of regulation in pursuing distributional objectives Instruments available to the regulator Prevailing degree of regulatory independence and accountability Ownership structure of the incumbent industry producers and Importance of industry investment and innovation Source: Armstrong and Sappington (2006)
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developing economies. The reason for this, they argue, is that price caps (1) have higher levels of uncertainty which is not good for investment decisions, (2) creates incentives to cut quality and (3) creates greater risk of political pressure to change a decision. Indeed, in an empirical study of infrastructure contracts in Latin America, Guasch et al. (2004) find that price cap regulation increased the likelihood of contract renegotiation, increased the cost of capital and tended to reduce investments since the rewards were not available until a later date. They suggest that, under price cap, firms try to avoid risks since they ‘‘kept the efficiency gains when business was good and renegotiated when it was poor’’ and that gains were generally not shared with users. In contrast, they find that rate of return regulation reduces the incentive to cut costs. While price cap may not necessarily be the optimal solution, it nonetheless becomes the second best solution especially when the regulator is unable to observe controllable and uncontrollable costs by the operator. Finally, in deciding whether to adopt price cap or rate of return regulation, it is also important to consider the effect of the so called iron law of regulation. Following the principle of comparative advantage, the iron law of regulation suggests that the issue is not how regulation alters the costs of the firm in absolute terms but how it is altered compared with competition. This law therefore suggests that infrastructure regulation would have differential effects on the competitiveness of firms in the same industry. The reason for this is that firms in the same industry would have differences in technology, labor and energy usage, geographic advantage and so on such that an across the board regulation would have differential effects on the competitiveness of these firms. Regulatory design implications when commitments are not credible A second regulatory challenge common among developing countries is the problem of credible commitment. This problem can arise for a number of reasons (Laffont 2005; Gomez-Ibanez 2003). First, politicians may be tempted to renege on their contractual commitment and pressure the regulator to pursue short-term political interests that hurt the longer-term interests of customers. Second, it can lead to the so called hold-up problem which occurs when one party will not make an efficient investment because the other party cannot commit to allowing the investor a sufficient return on this investment. The firm may reduce its investment if the government cannot commit to allowing the firm to keep its returns from the investment. Third, if government is seen as unable to credibly enforce the contract (due to corrupted judiciary, for example), then the government also has limited ability to make the firm take on risks since the firm knows it can renegotiate the contract if the outcome is disadvantageous. Finally, commitment problems on the part of the government can lead to the problem of adverse selection in the bidding process since the contract may go to the firm that believes it has the highest chance of renegotiating rather than to the most efficient one. What then are the regulatory design implications to the problem of credible commitment? Levy and Spiller (1996) suggest that regulation is credible if stakeholders can trust that commitments made by both the government and the regulator will be kept. Regulation is predictable if regulatory decisions are consistent over time so that stakeholders are able to anticipate how the regulator will resolve issues. In this section, we explore the implications of the credible commitment problem in terms of (1) industry structure (or the extent to which competition is allowed), (2) regulatory structure (mechanisms for enforcement) and (3) contract structure (pricing). Danau and Vinella (2013) suggest that ‘‘under limited commitment, the optimal-fullcommitment allocation in a public–private partnership arrangement for infrastructure is
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Ideal industry structure (competition)
Ideal regulatory structure (enforcement)
Ideal contract structure (pricing)
Credible commitment problem
Integrated industry structure to reduce problem of hold-up Government ownership and debt financing in the case of regulated monopoly
Independent regulator Separation of powers, more veto points to reduce regulatory risks Pro-consumer regulator More role for consumer groups
Rate of return regulation instead of price cap (but only if regulatory capacity is strong) Involve politicians and regulators at the contracting stage Allow parties, through arbitration process, to fix ex ante their bargaining powers and default positions in case of renegotiation
Adapted from Laffont (2005)
implementable if and only if (1) the firm holds some minimum amount of own funds that can be destined to the project; (2) it is able to borrow funds for that specific project; and (3) the replacement cost is sufficiently high.’’ Moreover, they argue that implementation is made by (1) ‘‘instructing the firm to invest some intermediate amount of own and borrowed funds; (2) by conditioning the loan guarantee on the outcome of the potential renegotiation process between the government and the firm and (3) by setting duration of the arrangement neither too short nor too long.’’ Table 4 summarizes the policy/regulatory design implications to the problem of credible commitment. Industry structure When there is a significant credible commitment problem—for example the problem of hold-up—a vertically integrated industry structure would be ideal. If governments cannot make a credible commitment to investors that it will honor its part of the contract (for example providing bulk water supply or adequate energy generation capacity), then a vertically integrated regulated monopoly might make sense. Hall and Lobina (2005) have also argued that government ownership and debt financing should also be adopted in the case of regulated monopoly—for example water and energy. Contract structure In terms of the ideal contract structure, Laffont suggests the use of rate of return regulation instead of price cap regulation but only if regulatory capacity is strong. Politicians and regulators should also be involved in the contracting stage to avoid future disagreements. Furthermore, an efficient solution, according to the theory of incomplete contract, is for the parties to at least pre-commit or fix ex ante their respective bargaining powers and default positions in the case of future renegotiation (Aghion et al. 1994). Laffont suggests that in contract-based regulation, this may be best done through an arbitration process whereby bargaining power could, for example, be determined by setting up an expert panel or through the creation of a litigation fund (Garcia et al. 2005).
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Furthermore, operators and regulators alike agree to bind themselves ex ante to a set of rules—through either contracts or legal frameworks—and enforcement mechanisms. These rules and enforcement mechanisms often seek to ensure that the regulator is independent of political pressures and is transparent, predictable, legitimate and credible—the essential ingredients of a robust and hence effective regulatory regime. Regulatory structure When there is a commitment problem, the ideal regulatory structure is one in which the regulator is independent from the operator, and there is separation of powers to reduce regulatory risks. In addition, the regulator should also have a pro-consumer sentiment or at least consumer groups are given more roles and veto power as a hedge to the credible commitment problem. For a review of this literature, see Laffont and Martimort (1999). Many countries have created independent regulators in an attempt to increase confidence in contracts and thus to increase investment. There is some evidence that this strategy can work (Estache and Wren-Lewis 2009) but other scholars also offer caution (Laffont 2005). Stern (1997), however, argues that it is difficult to sustain independent regulation in the absence or underdevelopment of contract and commercial law, competition policy, legal process and clear separation of political powers. In the case of the energy regulatory agency in the Philippines, a developing country, the mechanisms for ensuring regulatory independence include (1) arm’s length relationship with private interests and political agencies; (2) a distinct legal mandate independent of ministerial control; (3) professional criteria is prescribed for board appointment; (4) executive and legislative branches are involved in appointment process to ensure checks and balances; (5) fixed term appointments and protection from arbitrary removal; (6) there is staggered terms of appointment; and (7) there is semi-autonomous budget and reliable sources of funding. Laffont (2005) cautions, however, that an independent regulator that is less constrained by government may be more open to collusion with the firm. He argues that it is possible to see greater investment under a captured independent regulator— alongside excessive returns—which is not welfare enhancing. Regulatory design implications when accountability is weak Several policy design implications follow when accountability is weak. The following are examples from the regulatory agencies on water and power utilities in the Philippines. First, stakeholders should be allowed to appeal a regulator’s decision to the courts, a process for appeal set in place, and there should be a requirement for detailed justification and non-political (judicial) reviews of decisions. Second, policy design should provide for transparent decision-making process such as publication and reasonable explanation of decisions, existence of consultative bodies and audit scrutiny. Third, when accountability is weak, it is helpful to have detailed specification of the regulator’s tasks as well as clear rules for setting deadlines. Fourth, there should be a provision for public hearing/feedback procedures as well as citizens charters and rights. Fifth, a process should be in place to hold regulators accountable such as the removal of regulators in cases of misconduct alongside requirements for commissioners or directors serving fixed terms and mechanisms for dealing with conflict of interest. Finally, mechanism for international arbitration should be in place along with a litigation fund to ensure that domestic regulators will not make arbitrary decisions.
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Conclusion and implications In conclusion, this paper has unpacked the black box of institutions and illustrated how they matter to regulatory design. First, I have argued that a weak institutional context has the effect of exacerbating the problem of information asymmetry between regulators and regulated firms, thus increasing incentives for rent seeking and other opportunistic behavior. I have shown how MD and TC can be used to design more efficient industry, regulatory and contract structure given problems of information asymmetry, opportunism and weak institutional context. This conclusion has important implications in the design of regulations for a large number of important policy issues involving information asymmetries, uncertainties and negative externalities. These include regulation of food, drug and product safety, education, banking and finance, anti-trust, environmental pollution, among others. These problems are particularly acute in developing countries. To be more efficient, policy design has to solve the problem of information asymmetry by having incentive compatible (selfenforcing) mechanisms rather than externally enforced contracts involving high transaction costs. Second, the policy design framework I have outlined in this paper has several implications. For one, it can help provide a coherent language for identifying universal components of theories, such as the problem of private information, uncertainty and opportunism, that have been studied in mechanism design, welfare economics, political economy and transaction cost. The PDF can also help stimulate new theoretic developments such as the application of mechanism design theory and its integration with the theory of transaction cost. Furthermore, the PDF can help organize empirical research in areas where well-specified theories are not yet formulated. For instance, how should regulations be set and met under a federal system of government (such as India) given the variability in the capacity of the different state governments? How should food and drug safety be regulated given incentive problems and private information on the part of regulated firms and rent seeking on the part of regulators? What should be the ideal industry structure to promote food safety in China? Should regulators pursue for more or less regulation? Should regulatory structure be centralized or decentralized when capacity is weak and regulators are faced with information asymmetries? Beyond efficiency, the PDF, MD and TC can also be extended to study the politics of policy design. For instance, Epstein and O’Halloran (1999) asked why the US Congress delegates broad authority to the executive branch in some policy areas but not in others. Their answer: transaction cost politics. They illustrate this with examples in the US context regarding airline safety regulations, base closure policies and tax policy, among others. They argue that legislators will prefer to make policies themselves as long as the political benefits they derive from doing so outweigh the political costs; otherwise, they will delegate to the executive. Dixit (1996, 2001) argues that TC is central to understanding economic policy in most developing countries because of the significant agency and credible commitment problems they typically face. Thus, a TC approach to politics can perhaps explain variations in the intensity of politics in different policy areas. For instance, in China, why is the politics of environmental regulation and food and drug safety so intense (as indicated by the degree of mass protests), but not the politics of banking and finance regulation? Could this variation in politics be explained by variations in TC, i.e., degree of uncertainty surrounding the problem and credibility of commitment (or trustworthiness) of regulators? Transaction cost
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theory, with its focus on the problem of uncertainty and opportunism, can perhaps explain the variations in politics in these policy areas. Overall, therefore, MC and TC can provide a meta-analytic tool to compare the efficacy of instrument choice and the politics of regulatory design across and within countries for a large number of policy areas. Hopefully, these tools can help lay the foundations for a second-generation research agenda on regulatory and policy design.
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