Economic Regulation: Beyond Efficiency?

Should economic regulators pursue other objectives, such as equity and social justice, in addition to efficiency?

The theme of the 2023 ACCC/AER economic regulation conference was ‘Beyond efficiency?’

Speakers during the conference’s opening plenary session were invited to explore whether economic efficiency should continue to be the sole objective pursued by the economic regulatory frameworks in Australia. Or, alternatively, should the remit of regulators be expanded to include other objectives besides efficiency in the name of tackling the major challenges of our time, including: climate change, technological disruption and digitisation, the transformation of services and business models, and the growing inequity in access to services and outcomes?

Some of the speakers at this session, and some conference delegates, were firmly of the view that it is now time for regulators to balance the pursuit of efficiency with other objectives, such as equity and social justice.

This bulletin presents a summary of the address given by Dinesh Kumareswaran, Director of Frontier Economics, during this first plenary session. Dinesh argued that regulators should pursue one objective, and one objective alone: the promotion of economic efficiency.

What is economic efficiency?

A common misconception is that efficiency means producing widgets at the lowest possible cost. This is a very narrow and misguided view, and not at all how economists (should) think about economic efficiency.

When economists talk about efficiency, what they really mean is maximising total societal welfare. Total societal welfare is a very broad concept that encompasses economic prosperity, satisfaction, fulfilment and wellbeing.

So, when you hear economists mention efficiency, remember that what they are really referring to is, as the United States Declaration of Independence puts it, “the pursuit of Happiness.”[1]

Economic theory categorises efficiency into three dimensions:

  • Allocative efficiency is when all resources in the economy are allocated to their best possible use. When this occurs, it is impossible to make someone better off without making someone else worse off.[2]
  • Productive efficiency occurs when firms are producing a quantity and quality of output that maximises total societal welfare today at least cost.
  • Dynamic efficiency occurs when firms are making investment choices that result in future production that maximises total societal welfare over the long run.

For more than 30 years, the regulatory frameworks that have been applied in Australia to natural monopoly industries have generally framed the objective of maximising total societal welfare in terms of promoting the long term interests of consumers with respect to price, quality and reliability of essential services.

During those three decades there has been consensus amongst Australian regulators that the most effective way to promote the long term interests of consumers is to set regulated prices or revenues in a way that incentivises allocative, productive and dynamic efficiency. As the Australian Competition Tribunal has observed:

…it is axiomatic in the principles of regulatory economics, that promoting allocative, productive and dynamic efficiency generally serves the long term interests of consumers.[3]

Why efficiency should remain the only economic regulation objective

A second common misconception is that economic efficiency is simply a means to an end. Invariably, those who espouse this view are unable to articulate clearly what the ‘end’ is.

When efficiency is understood properly to mean the maximisation of total societal welfare (happiness), it becomes clear that economic efficiency is in fact the end goal, rather than simply the vehicle to get there.

As explained below, there are at least three reasons why the promotion of economic efficiency should be the sole objective of regulators.

Reason 1: Clarity of purpose

One of the first lessons from public choice theory is that the Government should only intervene in markets if there is clear evidence of a market failure.

Evidence of market failure is not a sufficient condition for intervention—since regulation is almost never costless, and those costs may outweigh the benefits of regulation—but it is a necessary one.

Hence, if the Government is to intervene in a market through regulation, it must be crystal clear why regulation is required in the first place.

Economic regulation of natural monopolies was developed to address a very specific type of market failure. Given the lack of competitive constraint faced by such firms, if left unconstrained, natural monopolies would have a strong incentive to exercise their market power to set prices and output at a level that would diminish total societal welfare.

This reduction of total societal welfare—referred to in the economics literature as the deadweight loss from monopoly—is a form of economic inefficiency.

Economic regulation aims to protect against that loss of economic efficiency by trying to reproduce as closely as possible the efficient outcomes of a market that does not suffer from that market failure.

Remember, the golden rule is that the Government should intervene in markets only if there is a clear market failure. In other words, Government remedies should be targeted to clearly defined market failures, where it can be demonstrated that the Government intervention would result in a net benefit to society.

The market failure problem associated with natural monopolies has remained fundamentally unchanged over the past 30 years. If economic inefficiency is the problem, then the solution must be regulatory frameworks that are oriented towards promoting economic efficiency.

Of course, there are many different types of market failure that can occur, apart from the classic market failure associated with natural monopolies.[4] Economic regulation may have a legitimate role in addressing these different types of market failure. However, in every such case, the sole objective must be to maximise economic efficiency.

Reason 2: Effective institutions

There is overwhelming evidence that the most successful organisations (public and private) are those that single-mindedly pursue one objective, rather than multiple (often competing and unstated) objectives.

There are two reasons for this.

Firstly, all the resources of the organisation can be marshalled in the same direction, towards achieving a common purpose—rather than being diverted ineffectively in different directions.

Secondly, some objectives conflict with one another. In these circumstances, it may be impossible to achieve one objective without sacrificing another.

For example, the pursuit of equity and social justice (which some at the ACCC/AER regulation conference advocated for) typically involves redistributions from one group to another. This inevitably results in some groups being cross subsidised by others. Cross subsidies do not simply involve a transfer of welfare between groups; they also result in a deadweight loss to society (i.e., a reduction of total societal welfare).

Hence, the pursuit of equity and social justice is usually irreconcilable with the goal of promoting economic efficiency. The only way to do more of one is to do less of the other.

Therefore, regulatory agencies are likely to be more effective if they are focussed on a single objective (the promotion of economic efficiency), rather than pursuing efficiency and equity/social justice.

This does not mean that genuine social problems should be ignored. The point is that whether and how such problems should be addressed ought to be left to policymakers rather than regulators to determine.[5]

Reason 3: Sound governance

Ronald Reagan said the nine most terrifying words in the English language are: “I’m from the Government, and I’m here to help.”

A very close second must be: “I’m a regulator, and I have a great idea.”

Many regulators seem to have a penchant for ‘innovation’, new thinking and broadening the scope of their activities. Whilst improvements to the regulatory framework are sometimes necessary to respond to new challenges, it is vital that regulators resist the urge to go beyond their core role and step into the shoes of policymakers.

Good governance requires a bright line to be drawn between the roles of policymakers and regulators. This clear separation of powers is essential to:

  • Reduce the risk of regulatory scope creep. As explained above, Government intervention in markets should be targeted at addressing well-defined market failures. Unchecked expansion of regulatory action is the antithesis of targeted intervention and is likely to result in more harm to society than good.
  • Ensure accountability of decision-making. If the regulator is permitted to make policy, and policymakers are permitted to act as quasi-regulators (e.g., by exerting political influence on a supposedly independent regulator), then it becomes impossible to hold policymakers to account for poor policy outcomes, and equally impossible to hold regulators accountable for poor regulatory outcomes. A lack of accountability will inevitably lead to poor decision-making and worse outcomes for society.

If we as a society are unhappy with the direction of policy, we can remove the ultimate policymakers (i.e., elected representatives) via the democratic process. In principle, this limits the scope for bad policies. If regulators encroach on the domain of policymakers and we are dissatisfied with the policies they introduce, given that they are (at least in Australia) unelected officials, how do we vote them out?

The need for accountability and restraint on the power of decisionmakers is why most free, democratic societies such as Australia have a clear separation between the executive, legislative and judicial branches of Government.

If left unconstrained, governing institutions have a tendency to seek the accumulation of power and influence, often to the detriment, rather than service, of society. The solution to this problem is to separate the power of institutions so that they can each be held to account, while providing checks and balances on one another.

The desire for a clear separation of powers was the reason why, for example, three different market bodies—the Australian Energy Market Operator (system planner and operator), the Australian Energy Market Commission (rule maker), the Australian Energy Regulator (regulator)—were established to govern the National Electricity Market.

These three agencies were given separate (rather than overlapping) mandates, powers and obligations.

In principle, this is a good model for the governance of institutions. Because the regulator is not permitted to make the rules that it enforces:

  • It cannot make changes to the regulatory framework on a whim. This produces more stable, predictable regulatory rules and outcomes; and
  • It is easier to identify whether good/bad outcomes are due to the design of the rules or their implementation. This is an important discipline on the regulator’s decision-making.

Equally, because the rule maker is not responsible for enforcement, it is free to design and evaluate the rules dispassionately and on their merits.

Of course, under this model, regulators may have a legitimate role in identifying problems (market failures) and bringing those to the attention of policymakers. However, the relationship between the regulator and policymakers should remain at arm’s length, with the regulator simply raising awareness of an issue and then leaving it to policymakers to assess in an open and transparent way whether and how the issue should be addressed. In order to maintain the separation of roles, the regulator should not become an activist or advocate for policy change.

Conclusion

There is no doubt that regulators today must make decisions under considerable uncertainty about the future, in the face of new challenges such as climate change, technological disruption and digitisation, the transformation of services and business models, amongst others.

These challenges may require regulators to re-evaluate how best to achieve the most efficient outcomes for society as a whole and to adapt their frameworks accordingly. But there is no case for abandoning the efficiency objective, or adding new objectives that are unrelated to the problem that regulation is intended to solve. Doing so would likely produce worse outcomes for society at large, blur the distinct roles of policymakers and regulators, undermine clarity of purpose and reduce the accountability of decision-makers.

[1] This point was made by Dr Darryl Biggar during the closing session of the conference.

[2] This is a condition known as Pareto optimality in the economics literature.

[3] Applications by Public Interest Advocacy Centre Ltd and Ausgrid [2016] ACompT 1, para. 93.

[4] Other examples might include misleading and deceptive conduct arising from asymmetric information, negative externalities, coordination failures, and so on.

[5] The rule that the Government should intervene in markets if and only if there is a clear market failure applies just as much to policymakers as it does to regulators. This means that before intervening to address claimed equity or social justice problems, policymakers must (a) demonstrate convincingly, with evidence, that there is in fact a real market failure rather than an imagined one, (b) demonstrate that the intervention would be net beneficial to society as a whole and (c) be transparent with the public about what the equity and social justice objectives are and what Government actions are being taken to pursue those objectives. Policymakers should not intervene unless they are willing and able to do all these things.

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