The public sector may be identified in different ways, as stated in Chapter 1. The first conception dealt with the legal-rational interpret
ation of the public sector. Let us return to this classical concept of the state and the public sector. The public sector as a system of state
introduced laws and regulations of conduct in both public and private organizations as well as households has not figured as much as the resource allocation or resource redistribution approaches. When the state or the system of national and local governments are viewed as a set of institutions with their own employees, then the public sector is highly visible. But when the state is considered as the creator of normative systems - regulations - then it is far more difficult to identify the vast system of laws and directives - the invisible state - that govern all kinds of behaviour. Regulations are not of one kind.
Why is the state so active in providing legislation that directs conduct in various spheres of human activity?
TYPES OF PUBLIC REGULATIONS
One may distinguish between two fundamental kinds of public regulation. First, there is the old type of economic regulation that involves entry conditions as well as price controls. The theory of natural monopoly has been regarded as providing the reasons for the establishment of institutions that result in legal monopolies, as argued in the theory of public utilities (Eatwell et al., 1987). It remains to assess whether there really is some justification for economic regulations.
Secondly, a large set of product regulations stipulate how various kinds of goods are to be both produced and delivered. They may involve directives that prohibit the use of certain dangerous materials or the sales of products that are potentially harmful to the consumer.
According to the research into the occurrence of public regulations, product regulations outnumber economic ones, although there are difficult problems inherent in the calculation of the number of laws and directives in a society (see Derthick and Quirk, 1985).
It is often stated that the invisible state is huge - what aspects of life, private or public, are not the target for some type of regulation?
MODElS OF PUBUC REGULATION 119
Public regulation may be oriented towards national or local govern
ments themselves, private organizations (firms or those that are non-profit-making), banks and the financial markets, the relation
ships between public authorities and citizens or the interaction between persons in the private sector, processes of production, employment and provision as well as the behaviour of courts and legal institutions.
How exactly one measures the degree of regulation in a sector of society is far from clear, but there is a general consensus that modem society is overregulated and is in need of regulatory reform, such as deregulation of markets - in the case of various transport systems for example (trucking and air flights, etc.). However, it has proved very difficult to halt the process of increasing regulation (Mitnick, 1980;
Wilson, 1980; Noll and Owen, 1983; Weiss and Klass, 1986). This applies in particular to product regulations, whereas the regulatory reform movement in various manifestations has been more successful in removing or deregulating economic regulations concerning market structure and price determination.
The foundation for public regulation has been laid by welfare economics and its theories about externalities and economies of scale (Chapter 1). The reasoning for economic regulations is to be found in the theory of natural monopoly in relation to economies of scale and economies of scope in production (Berg and Tschirhart, 1988; Sherman, 1989). When there are considerable economies of scale or scope in the production of goods that require large fixed costs - so-called sunk costs - there tends to be market failure (Chapters 1 and 8). Product regulations are motivated by the occurrence of external effects that do not show up in the market price and thus have to be internalized by
means of, for example, a tax that equates marginal cost with social cost
or marginal value with social value (Spulber, 1989).
The regulatory reform movement usually focuses on the public regulation of production and markets in the private sector. These regulations bring two kinds of costs that in the end will have to be picked up by the consumer or citizens. Direct costs tend to be small as it is not very costly to operate a regulatory commission, but indirect costs can be very high as regulations may give rise to inefficiencies in both production and consumption. However, the need for regulatory reform of the public sector itself is no less apparent if one examines the system of public regulations from an efficiency standpoint. Local governments tend to be constrained by a number of state directives in the form of laws or conditions entailed in programme transfers from national government to local governments.
The same also applies to the structure of state authorities at various levels, where the bureaucratic principles of subordination could result in a lack of flexibility and of adaptive capacity at lower levels of state hierarchies.
120 THE PUBUC SECTOR
NORMATIVE REGULATION MODEL
The case for public regulation of market allocation is stated most succinctly in the theory of monopoly. The standard monopoly situation arises when there are economies of scale or economies of scope in production. When there exist economies of scale, the phenomenon of sub additivity arises, meaning that the cost of one firm producing a set of goods is lower than the joint costs of several firms producing the same output. Economies of scope refers to the multiproduct case where one firm may produce a set of various products less expensively than if there were a whole set of firms producing the same output. A.E. Kahn
in The Economics of Regulation argues that public regulation is required when:
a natural monopoly is an industry in which the economies of scale - that is, the tendency for average cost to decrease the larger the producing firm -are continuous up to a point that one company supplies the entire demand . . . their costs will be lower if they consist in a single supplier. (1988: 123-4, 11) A position of natural monopoly invites state activities as there is too little output at too high a cost (Figure 5.1). Maximizing social welfare, the state may decide to transform the natural monopoly into a legal monopoly, determining both output and price.
Thus, by setting the price equal to marginal cost, output will rise from qm to qW and consumer surplus increase to include the dead
weight loss in monopoly allocation, that is, the area ceg. At this level of output the firm suffers a loss since, though average cost continues to fall, it is the case that marginal cost is lower than average cost at the level of output. Regulating price and determining output is not sufficient in public regulation introducing a legal monopoly by means of barriers to entry. The cost to the firm must also be covered somehow, either by means of a deviation from the efficient price equating marginal cost with demand or by means of a financial contribution that covers the loss at marginal cost price setting.
This is all economic theory, stating a case for public intervention in terms of a welfare maximization framework. It tacitly assumes not only rational behaviour on the part of the two parties in the interaction, the regulator and those regulated; in addition, there is the innocent assumption that both parties act sincerely and in the interest of the public or the consumers. Public regulation is based upon the notion of a benevolent sovereign taking the necessary steps to increase consumer welfare by means of authority, working in the public interest. But what happens once this crucial public interest hypothesis is relaxed, and bounded rationality, opportunist behaviour and strategic decision
making in order to enhance self-interest enter the model of public regulation (Posner, 1974)?
The new models of regulation start from assumptions about the interacting parties that do not prejudge the question of how close the
p(Qm)
.� Q) a ct
p(QW)
MODElS OF PUBUC REGULATION 121
AC
average costMC
marginal cost MR marginal revenueFigure 5.1 Monopolies, prices and quantities
Quantity
outcome will be to the welfare economics ideal. Modelling the behaviour of the regulators and the regulated on the basis of the standard economic-being assumption, the Chicago school produced a whole set of new ideas about how the invisible state could be modelled (see George Stigler's edited volume Chicago Studies in Political Economy, 1988).
POSITIVE REGULATION MODELS
The standard regulation models from textbook economics suggest a number of solutions to the problem of allocating goods and services in a monopoly market. Although there is no single best solution, regulation theory arrives at a number of proposals for decreasing the efficiency losses and for increasing consumer surplus. However, regu
lation theory assumes somewhat naively that all these improvements will be automatically implemented, once they become known to the actors in the regulation game. Here is the starting point for so-called positive regulation theory, which models the real life behaviour of the regulators and those regulated. There is a set of different positive theories modelling the regulation game on the basis of the assumptions of the economic being.
Positive regulation models are highly policy relevant, because what matters in the conduct of public policy is real life possibilities and not ideal solutions. The practicality of a large invisible state regulating both the private and the public sectors depends on the extent to which institutions may be created that together with the motivation structure
122 THE PUBUC SECTOR
of the actors involved in the regulation game afford mechanisms that contribute to the implementation of desirable but realistic end states.
As Vickers and Yarrow show in their Privatization: An Economic Analysis (1989), the whole issue of regulation strategies is of crucial importance in making decisions about the private and public sector demarcation in privatization questions. The selling-off of public enter
prises has to be based on a sound policy about market structure, competition and demand. Often public enterprises at national government level or public utilities at local government level offer services characterized by low elasticity of demand. This may well call for a regulation approach in order to undo negative effects of privatization such as monopoly behaviour. Again, we come back to the basic problem with the invisible state: can regulation policies be made workable?
THE CAPTURE MODEL
Stigler in The Citizen and the State (1975) questioned how one could be sure that public regulation works in the public interest. It is not enough to specify what the optimum solution is in public regulation of monopoly, as we also need a theory about the motivation that would lead both regulators and those regulated to implement the solution identified as in the public interest. If one assumes that both regulators and those regulated act in accordance with their own self-interests, then why would the optimum solution be the strategy in a regulation game?
The capture model states the opposite, namely that one may expect the regulators and those regulated to end up in a common strategy after playing the regulation game a couple of times. Both would agree on a regulation policy that would remain stable over time, with maximization of their joint interests in stable and predictable outcomes.
The outcome would tend towards the natural monopoly solution involving substantial dead-weight losses and huge monopoly profits.
How could the regulator force those regulated away from their best position, when there is asymmetric information that works to the benefit of those regulated? Who knows the exact shape of the cost curves in an industry? What about elasticity of demand? If one resorts to so-called Ramsey prices recognizing that marginal cost price setting will not work, then who could calculate the optimum Ramsey prices?
Determining output and price by means of regulation is a difficult task, as the regulator can only use indicators that are at best fairly reliable tools but at worst carry simply straightforward erroneous information. The regulator is dependent upon those regulated to provide them with basic information, as they act within the confines of bounded rationality. There is no guarantee that there will not be opportunist behaviour and strategic steps in the interaction process
MODELS OF PUBLIC REGULATION 123 between those regulated and the regulators. In order to minimize these disruptive tendencies it may be to the advantage of the regulators to settle for less than optimum solutions to output and price determination. To quote Stigler:
Until the logic of political life is developed, refonners will be ill-equipped to use the state for their reforms, and victims of the pervasive use of the state's support of special groups will be helpless to protect themselves. Economists should quickly establish the licence to practice on the rational theory of political behavior. (1975: 132-4)
Williamson (1975) identified a number of difficulties in economic contracting which apply to the regulation game, where the state entrusts an agency or board with the task of controlling a set of private firms. The Williamson difficulties - bounded rationality, small numbers problem, opportunist strategies - appear both in the relationship between the government and the regulating board and in the interaction between the regulator and the regulated firms. Public regulation typically takes the form of a concession introducing legal monopoly rights - barriers to entry - for the firms in exchange for public influence over basic economic parameters such as quantity supplied and unit price charged. In order to handle the difficulties which tend to show up in any kind of economic contracting Williamson argued that hierarchy instead of voluntary exchange was to be preferred.
Hierarchy replacing voluntary exchange in industrial organization opened up a new way of viewing the firm structure along lines suggested by Ronald Coase's 'The Nature of the Firm' (1937). In order to minimize transaction costs inherent in the voluntary exchange approach the firm would employ authority instead of contracting to reach its objectives. Vertical integration may be a sound way to proceed in economic organization (Williamson, 1986) and the modem corporation (Mueller, 1986), but it will not aid the search for first-best (Pareto-optimal ) solutions involved in public regulation.
The capture model implies that the special interests of both the regulator and the regulated will dominate over the public interest.
Moreover, it also predicts that the special interests of these two groups will converge towards some stable solution not far removed from the monopoly solution. The regulators are simply swamped by those regulated as the latter have a systematic information advantage over the former and because the former lack any credible motivation to reverse asymmetric information in order to reach outcomes that the latter would resist.
Public regulation in its various modes - price control, subsidies, output specification, public utility status, public authority - invites opportunistic behaviour on the part of those regulated. Since all cost calculations are made by the regulated firm or bureau, it can always ask for prices that will cover its costs. A legal monopoly removes all
124 THE PUBUC SECTOR
traces of competitive price setting, thus the regulators would have to look very closely at the costs for which the regulated ask compen
sation. But how is such an information base to be assembled, when there is asymmetric information built into the very interaction between the regulators and those regulated? Why would the regulators really start looking into a sector of the economy that is regulated to such an extent that they could disclose and prohibit all kinds of opportunism?
Both the information problem and the motivation problem militate against the transformation of so-called natural monopolies into legal monopolies, because the second-best solutions suggested by regulation theory are very difficult to implement in the public sector. Controlling price and quantity is not easily achieved when there is a monopoly or a strong price leader among a set of oligopolists.
Actually, government may have better options than the remedy of legal monopolies suggested in the normative theory of monopoly.
What is crucial in a market is not the sheer number of actors, but the degree of real or potential contestation between these. A market could be fiercely competitive with only two major actors. And a market could even be competitive with only one actor as long as there was the potential of market entry by another actor. What matters is contest
ability. This means that government could use the public sector to enhance contestation in various sectors of the economy instead of shutting competition out by means of the introduction of legal monopolies. In terms of infrastructure, where the public sector tends to be very much active in various institutions, this would mean the search for competitive forms of supply such as bidding, contracting, franchise, the separation between transmission, production and distribution in electricity and railway systems. Much of what looks like a natural monopoly, such as electricity distribution, could be turned into competitive supply simply by allowing various actors to rent one and the same transmission system. Even public provision could become competitive by such strategies: for example, by inviting several actors to bid for the use of the railway track system. The government should enhance entry conditions into a sector and not close it off by means of a legal monopoly as, for example, in telecommunications.
Empirical tests of the capture model have resulted in mixed evidence. Some economists claim that the dead-weight loss remains high even though there is public regulation of a sector such as various infrastructures. They also state that the regulatory scheme is ineffec
tive, meaning that the existence of a regulatory body has no impact on price and quantity (Stigler, 1988). Some political scientists as well as economists deny both these assertions, arguing that public regulation could make a difference (Wilson, 1980). Of the two types of public regulation, it seems as if economic regulation, that is, entry closure by means of a legal monopoly, performs worse than simply product regulation in the evaluation of public regulatory institutions.
MODELS OF PUBUC REGULATION 125
The capture model may be generalized into a general principal
agent framework that models the interaction difficulties when two parties contract for a considerable time period and the nature of the contract remains underspecified due to contingencies, strategies and randomness. Let us outline some of the characteristics of the principal
agent approach which apply to public regulation.
PRINCIPAL-AGENT PROBLEMS IN REGULATION
Public regulation, or the specification of rules for conduct in the private sector, involves the problems typical of economic relationships within the private sector. At the heart of public regulation is the ambition of the principal to monitor the efforts of the agents in terms of a set of goals decided upon corresponding to the private sector contract.
Whenever there are considerable transaction costs due to the nature of the economic interaction between two parties as well as the coordi
nation difficulties involved in collective action, then principal-agent problems arise.
The principal-agent problem of designing an agreement or system of contracts that motivate the agent to act in the interests of the principal as well as of monitoring the behaviour of the agent in relation to the agreement is not confined to private insurance institutions, to which the principal-agent model was first applied. Principal-agent diffi
culties are constitutive of public sector institutions, policy-making as well as public regulation.
To employ a principal-agent framework for the analysis of government action involves a clear rejection of the notion of the public interest as the motivational basis in the public sector. The only interests that exist within a principal-agent framework of public policy-making and public regulation are those that belong to either the principal or the agents. The interests of principals and agents would include selfish, altruistic, personal or social interests, as there is no scope for the public interest as the driving force of the public sector. In the principal-agent framework the activities of the agent are determined by both the effort of the agent and an unobservable random factor.
Making the agent in the political body serve the wishes of the population results in all the difficulties of having an agent serve the principal. Typical of democracies is the distance between the electing body and government, which gives rise to all the kinds of principal
agent interactions encountered in the analysis of the private sector (Ross, 1973; Ricketts, 1987). In elections the population as the principal interacts with parties and politicians, which results in uncertainty about what action the principal wishes the agent to take as well as problems with regard to how the action of the agent could be costlessly monitored.
The public choice school suggests a number of models of the