Market-based mechanisms can be used to regulate activities and can be cost effective and minimise regulatory interference in the day to day operation of companies. Such mechanisms may involve standards that include control and command mechanisms. Examples include aspects of competition law, regulation by contract, tradable permits and disclosure regulation. Below are examples.
Paul G Scott “Competition Law and Policy” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). One of competition law’s primary concerns is prohibiting firms with market power from using that power to eliminate rivals or protect themselves from competition. Such firms do not vanquish their rivals through superior performance. Rather they aim to decrease the competitive viability of actual or potential rivals.
Courts and commentators have coined various terms to describe such use of market power. They include predation, abuse of market power, foreclosure and monopolisation. This chapter uses the term “monopolisation”. Competition law contains anti-monopolisation provisions. Their raison d’être is to prohibit unilateral conduct that results in the deterring of rivals’ competitive behaviour by taking advantage of, using or exercising that market power. In so doing, the anti-monopolisation provisions preserve a competitive environment that gives firms incentives to spur economic growth. Thus, anti-monopolisation provisions are essential if there is to be an effective competition law.
Paul G Scott “Competition Law and Policy” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). Competition is the process by which more efficient firms win and society’s limited resources are allocated as efficiently as possible. It leads to cheaper prices for consumers. Competition sharpens firms’ incentives to cut costs, improve productivity, stimulate production and process innovation. So competition spurs firms to decrease cost, improve the quality of their products and services, invest in new products and services, educate consumers and engage in a range of other activities that benefit consumer welfare. These are presumptively good things. In New Zealand the focus is on economic efficiency.
Paul Scott and David de Joux “Uncertainty and Regulation: Insights from Two Network Industries” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). The aim of the operational separation was to increase competition by limiting Telecom's incentives to discriminate between access seekers to its bottleneck infrastructure. It was decided that the Minister of Communications and Information Technology would supervise the separation, and it would be based on the example of the separation of British Telecom in the United Kingdom. Lengthy negotiations followed, which were finally concluded in 2008. Telecom was to be divided in three arm's length groups: Access Network Services (now Chorus); Telecom Wholesale; and Telecom Retail. "There is a requirement for these three groups to operate on a stringent arms length basis, with clearly defined non-disclosure requirements between the groups." The regime also applied Equivalence of Inputs standards to all regulated fixed access services. Further, discrimination between access seekers was strictly prohibited.
The Separation Undertakings also included "significant commitments (from Telecom) to migrate its public switched telephone network customers to a new voice platform …, and invest in rolling out Fibre-to-the Node (FTTN) to 84 per cent of New Zealand's population by December 2011". While this will reduce the length of the copper loops sufficiently to enable speeds of 10 Mbps, it will not enable very-high-speed digital subscriber line services.
The 2006 reforms have seen positive results, despite four Telecom requests for variation of its Undertakings. Following closer monitoring of the market by the Commission, it appears that since 2007 there has been "an increase in competition resulting in increased investment, greater choice, lower prices and better quality across the spectrum of telecommunications services in New Zealand". Perhaps more significantly, New Zealand has climbed in the OECD ranking of broadband penetration from 22nd to 17th position.
Paul Scott and David de Joux “Uncertainty and Regulation: Insights from Two Network Industries” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). Following the constitutional and foreign exchange crisis of July 1984, the Fourth Labour Government decided to undertake a large programme of economic reform which led to what is now known as "light-handed regulation". This regulation system was characterised by three main points: reliance on general competition law and on the courts to enforce regulation; strong information disclosure obligations; and the threat of further regulation should the market perform unsatisfactorily.
Telecommunications had been a public monopoly for the major part of the 20th century. Embarking on a fast-paced reform the government created a new State-Owned Enterprise (SOE), Telecom Corp of New Zealand (Telecom), on 1 February 1987 and transferred all telecommunications and assets to it two months later. By 1 April 1989 the monopoly was fully removed, and "by this time, Telecom New Zealand Limited was doing business in one of the most open telecommunication marketplaces in the world". No specific regulation had been adopted; instead, the market, and notably the terms upon which competitive firms could connect to the network, was to be regulated by the Commerce Act 1986.
Telecom was finally privatised on 12 September 1990. The sale involved what became known as the "kiwi share". It imposed several social welfare obligations upon the new owners of Telecom:
… the price of residential telephone rentals would not rise faster than the Consumer Price Index (CPI) unless profits were unreasonably impaired (the 'price cap' obligation), rural residential rental prices would not exceed urban residential rentals (the 'universal service' obligation) and residential customers would continue to be offered a tariff with no charges for local calls (the 'free local calling' obligation).
Paul Scott and David de Joux “Uncertainty and Regulation: Insights from Two Network Industries” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). In 1993, the government established the Electricity Market Company to support the electricity market framework for wholesale trading. This saw the start of an online secondary market in trading ECNZ's hedge contracts. It also designed the Metering and Reconciliation Information Agreement (MARIA) which recorded and reconciled flows to meet the needs of parties contracting in the wholesale and retail market. In 1994 the Electricity Information Disclosure Regulation came into force. These required disclosure of separate audited financial statements for natural monopoly and potentially competitive businesses, prices and other main terms and conditions of contracts, financial performance measures based on standard asset values, efficiency and reliability performance measures and line changes.
In 1995, the government announced it would split ECNZ into two competing SOEs (ECNZ and Contact). Contact would receive ECNZ's Maui gas contract. It would also sell some of ECNZ's assets.
In 1996, the competitive wholesale electricity market started. M Co acted as market administrator while Transpower was the scheduler and dispatcher.
Further reforms came with the Electricity Industry Reform Act 1998. This required full separation of distribution (lines) businesses from supply (retail and generation) businesses. The reason was to encourage competition in generation and retailing and to prevent cross-subsidisation of generation and retailing from lines customers. The Act allowed for price control of lines businesses if they did not deliver best possible prices to consumers. The Act also strengthened the disclosure regulations and stipulated the decision in principle to split ECNZ into three SOEs.
In 1998, the government decided to sell Contact Energy, which it did in 1999. In 1999, the government split ECNZ into three competing SOEs: Genesis Power Ltd, Meridian Energy Ltd and Mighty River Power Ltd. New disclosure regulations also came into force in 1999.
Paul Scott and David de Joux “Uncertainty and Regulation: Insights from Two Network Industries” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). With price (and profit) control, regulation aims to produce larger output (and lower prices) than would occur with an unregulated monopoly. It also leads to reduced profit and a lower rate of return on investment.
While sound in theory there are always problems with price regulation. Theoretically effective regulation would result in prices being at marginal cost. However, this will not wash. It will not cover the cost of constructing the network. To stay in business, the monopolist needs more funds. It needs more funds to meet the minimum investment to support a given level of output.
It is also difficult to determine the optimal level and growth of service. If regulation allows a company to charge excessive prices, the company will expand at more than the optimal rate. Also when regulation allows the rate of return to exceed the cost of capital firms are incentivised to over-expand fixed assets and shift to capital intensive means of production.
Conversely, if regulation allows for too low a price, consumers will over-consume. If the price offers producers too low a rate of return on capital, this will thwart innovation and necessary expansion.
Indeed, basing price regulation on costs can cause problems. A monopolist has little incentive to reduce costs if the price regulation it is permitted to charge is based on cost. Regulation can thus reduce the profit incentive for efficiency. Thus, the need for regulation is to correct what is called a "market failure". This is the conditions which prevent a market performing with optimal efficiency. This requires knowledge of the asset valuations on input methodologies. As with all regulation based on these concepts, the regulators require accurate information about the regulated firms, which requires information disclosures to the regulators.
Susy Frankel, Meredith Kolsky Lewis, Chris Nixon and John Yeabsley “The Web of Trade Agreements and Alliances, and Impacts on Regulatory Autonomy” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). Patents are known to be imperfect solutions to the market failure associated with the creation of knowledge, since they create market "rents" in the form of the ability for the holder to charge higher prices and, in the case of pharmaceuticals, sometimes monopoly prices for goods whose marginal production cost is close to zero.
In theory, the optimal amount of patent protection is relatively straight forward. It is a trade-off between incentivising dynamic efficiency that leads to a "new" product versus the inefficiency of adversely impacting on the efficient use of knowledge. Therefore, the optimal length of a patent is where the marginal revenue from extra innovation equals the marginal costs associated with the inability to disperse any particular innovation.
Alec Mladenovic “Networked Industries: Electricity and Telecommunications” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). As part of the new period of economic reform, the Labour Government announced its first decisions for restructuring the electricity industry in 1986. These included removing the government monopoly over generation by opening up the market to new entrants, changing the current structure of generation and transmission, and setting up an inter-departmental committee to address changes in the distribution and supply sectors.
Alec Mladenovic “Networked Industries: Electricity and Telecommunications” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). This new era of competition, however, was to prove particularly litigious, with the relationship between Telecom and Clear especially acrimonious and a major test for the efficacy of a light-handed regulatory approach in telecommunications. Most notably, the consequences of a drawn-out court case involving these two companies over an interconnection dispute – lasting from 1991 to 1994, and reaching the Privy Council (at the time New Zealand’s final appellate court) – has been suggested as being the main reason for accusations that light-handed regulation in telecommunications was a “failure” and for providing the impetus for the significant regulatory reforms that ensued.
Under the threat of regulatory action by the Minister, Telecom and Clear finally settled their dispute over interconnection in March 1996 by signing a five-year interconnection agreement. In June 1996, the government endorsed its ongoing commitment to light-handed regulation of telecommunications and made clear it expected interconnection to be provided on terms that enhance efficiency and provide the benefits of competition to consumers. These two events instilled a higher degree of certainty into the industry, which encouraged a number of new entrants to enter into interconnection agreements with Telecom during the next two years.
Alec Mladenovic “Networked Industries: Electricity and Telecommunications” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). The first stage of introducing competition in the electricity retail market, by removing the energy companies’ statutory monopoly rights to local distribution and electricity retailing (and the obligation to supply), was implemented on 1 April 1993 under the Electricity Act 1992. This initial step enabled retail competition for small consumers only. The reason for staggering the introduction of retail competition was to prevent the possibility of small consumers incurring the costs of a cross-subsidy on the assumption that competition for larger consumers was likely to be more intense. The second stage implemented on 1 April 1994 opened up retail competition for all consumers.
Alec Mladenovic “Networked Industries: Electricity and Telecommunications” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). Comprehensive reform of telecommunications was initially undertaken during 1987–1989. Similar to the electricity industry, the central aim was to improve economic performance and provide consumer benefits through competition. As at 1 April 1987, the telecommunications operations of the New Zealand Post Office were absorbed into a new state-owned enterprise to form Telecom Corporation of New Zealand Limited (“Telecom”). By April 1989 all regulatory barriers protecting Telecom from competition had been removed. And in 1990 the state relinquished its ownership involvement in the provision of telecommunications services following the full privatisation of Telecom.
Paul Scott “Competition Law and Policy: Can a Generalist Law be an Effective Regulator?” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). All this changed in Telecom Corp of New Zealand Ltd v Clear Communications Ltd, however, which concerned the access price to Telecom's network. The High Court held Telecom did not breach section 36 by charging an access price based on the Baumol-Willig rule or Efficient Component Pricing Rule (ECPR). The potential problem was that the ECPR allowed Telecom to charge its opportunity cost in connecting a rival. The benchmark price could be at such a level to permit an integrated monopolist to maintain its monopoly profits in the output market. This could enable Telecom to receive any monopoly rents that were contained in Telecom's charges.
A numerical example will show how the ECPR works. A vertically integrated monopolist sells a retail product. The monopoly or output price of the retail product is $100. It also manufactures a vital input to the retail product at a price of $10 per unit. It has other incremental costs of $30 per unit of output sold. Thus, the costs per unit are $40. The monopolist earns a price-cost margin of $60 per unit.
Under the ECPR, a monopolist will charge $70 to an equally efficient competitor who seeks access to the vital input. The new entrant as it is equally as efficient will have incremental costs of $30. Thus, when charged $70 it will have a price-cost margin of zero if the monopolist continues to charge the pre-entry price of $100 for the retail product (costs include a competitive rate of return). The retail product price will stay at $100 and the monopolist retains its profit of $60 per unit. This is so whether the final product is sold by the retailer or new entrant.
Thus, the $70 price for the input represents the opportunity cost for the monopolist; that is, $10 cost of manufacturing the input and the foregone price-cost margin of $60.
Mark Bennett and Joel Colón-Ríos “Public Participation in New Zealand’s Regulatory Context” in Susy Frankel and Deborah Ryder (eds) Recalibrating Behaviour: Smarter Regulation in a Global World (LexisNexis 2013). The standard regulatory concern from an economic point of view is to ensure competition and efficiency in the market. The relationship between these economic concepts is complex, but basically competition between sellers increases efficiency in markets. The Commerce Commission has observed that:
Economic efficiency is generally enhanced in markets that are competitive. Firms that are subject to competitive pressures from other firms that are supplying the market, or from the threat of new entry, have an incentive to meet the demands of their customers (allocative efficiency), at minimum cost (productive efficiency), as they would otherwise lose market share to more responsive and efficient competitors. Such firms also face an incentive to invest and innovate over time, in order to achieve and maintain a competitive advantage over their rivals (dynamic efficiency).
The electricity regulation literature often focuses on allocative efficiency, where resources are used to meet consumer demand, which is "maximised where price is equal to marginal cost". Therefore, one of the major concerns in electricity regulation is that of natural monopoly, where it is economically efficient for a single firm to provide services or products to a market, giving the largest supplier a cost advantage over competitors and new entrants. Indeed, utilities are often said to be the paradigmatic industry requiring regulation for this reason, because the costs of building the networks over which the utility service is distributed to consumers are very high, and there are economies of scale and scope that favour provision by large companies.
Brent Layton “Regulating the Building Industry – A Case of Regulatory Failure” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). The government using its ability to borrow at lower cost than other parties because of its ability to tax to meet commitments may lower costs of funding repairs and remedial work and therefore be more efficient. However, a decision to relieve parties of liabilities they have willingly incurred, or accepted in the normal course of events, and place them on tax payers means a reallocation of risks and returns which has a high potential to generate inefficient outcomes over time. This is because, if such interventions become widely anticipated, parties are likely to alter behaviour so they take on more high-risk activities than they would if they bore all the risks of their own actions. In short, socialising risks creates what economists refer to as “moral hazards”. The outcome is more risks are taken on by the community than it would be efficient to do, given the likely costs of incurring these risks. The allocation of resources towards risky activities becomes inefficiently high in the sense that economic welfare could be improved if fewer risks were taken.
Chris Nixon and John Yeabsley “The Challenges and Opportunities of Conformity in the Wider Asia – Pacific Context: Tiny Steps on a Long Road” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). (e) Loss of political control
One of the main trade-offs required is to assess how much political control will be lost for improved economic performance. Key vested interest groups within countries are likely to oppose such moves because of fears of the erosion of their rights and privileges. Further integration will also challenge the mindset of various government agencies who eye neighbouring countries as competitors. These mindsets will have to change over time before the benefits of complete integration to the region are fully realised.
Graeme Austin “The Regulation of Consumer Credit Products: An Examination of Baseline Assumptions” in Susy Frankel (ed) Learning from the Past Adapting to the Future: Regulatory Reform in New Zealand (LexisNexis, 2011). What would a policy discussion look like if there were greater engagement with the issue of the “safety” of consumer credit products? A useful starting point is a thought experiment developed by Professors Elizabeth Warren and Oren Bar-Gill. Suppose that the safety of ordinary consumer products were regulated in the same way as consumer credit. Warren and Bar-Gill note that, in the United States, it is almost impossible to buy an unsafe consumer product − such as a toaster. The safety of these kinds of products is regulated more directly. But credit products that are unsafe in some consumers’ hands are quite readily available. In the New Zealand context, Warren and Bar-Gill’s point can be illustrated by the regulation of children’s nightgowns: in New Zealand, we regulate the safety of children’s nightgowns, not just the information that accompanies their sale. While the information provided to consumers is relevant in most consumer contexts, the sale of (some) unsafe children’s nightwear is not conditioned on the adequacy of nightwear specifications to which consumers might have access prior to purchase. With certain types of nightwear, parents are simply not permitted to make an informed trade-off between safety and price. To be sure, for some products, consumers regularly make such trade-offs − choices between different models of motor vehicle are a familiar example. Here, however, consumer choice is exercised only after manufacturers pass a baseline safety threshold. In contrast, consumer credit products might be quite unsafe in the hands of certain consumers for a variety of reasons: taking on more debt than one can bear can lead to deleterious effects on physical and mental health, for example. But for most practical purposes, the sale of such products is conditioned primarily on the provision of the prescribed information.
“Information disclosure” and “consumer safety” paradigms reflect different baseline assumptions, and envisage different kinds of market intervention and different approaches to interference with contractual freedom in this context. These paradigms emphasise different kinds of reasons for regulatory intervention in consumer markets. The “information disclosure” paradigm responds to information asymmetry problems by stipulations as to the quality and quantity of information available to consumers. The “consumer safety paradigm” largely concerns the products themselves; it can lead to proscriptions against bringing certain products to the market even when it is possible to provide consumers with sufficient information about a product’s risks. Measures that address informational asymmetries aim to make the process of contracting work better; many consumer safety measures, in contrast, aim to prevent some contracts from being entered into at all.