What is the role of the regulator?

In this article, Alan Sutherland asks how regulators should act in order to support positive outcomes for customers and wider society in the long term.

It is all too easy to describe something in terms that make it seem difficult. But in this context, what do we mean by ‘difficult’? Is it something we are unable to do? Or, perhaps, something we don’t want to do? It is such human dilemmas that are at the heart of economic regulation. All of us are, as human beings, very good at procrastinating. We can all find excuses as to why something we do not want to do either cannot be done or should not be done. 

In a market, a participating firm has no choice, it has to observe, to analyse, to understand. It may have more or less time, but its success, or even its survival, depends on responding to the actions of its competitors, the expectations of its customers or even understanding what some new technology might mean. Think Xerox, Kodak or Polaroid!

A natural monopoly business – one whose function cannot easily (or should that be profitably) be replicated – does not experience these same pressures. There is no immediate existential threat. Economic theory suggests that monopolies can be good and bad. They can be good in that they can often access economies of scale and should be able to incur unit costs that are much lower than could be achieved if there were multiple suppliers. They can be bad because they could set prices for services that we all need at levels that would allow them to earn a significant economic rent – some amount higher than a fair return for what they have done and the risks they have managed. Economic theory often concludes by asserting that the pricing power of monopolies needs to be curtailed.

But is this right? Do we want to curtail pricing power, or do we want to encourage more responsive, more innovative and more customer-oriented behaviours? I would argue the latter.  

If the job is simply to curtail pricing power, the challenge that faces the economic regulator is relatively straightforward. It is not too difficult to do the analysis, to diagnose the issues that have to be addressed, and to set charges that should allow the regulated entity to earn a fair return for its efforts. But how does an economic regulator create the conditions that will lead to those better behaviours and, ultimately, outcomes? 

The dynamics of competitive markets

Observing more closely what actually happens in a competitive market might help – in other words, taking the time to understand the underlying dynamics of markets. 

In a very competitive market, participants tend to be ‘price takers’. There is a market price that consumers of a particular good or service are prepared to pay. That price is what it is. 

A decision to participate in the market accepts the prevailing market price. Such acceptance does not, however, say much about how the entity will participate, how it will gain and retain a share of the market, how it will meet the expectations of its customers, or how it will provide a return to its investors that meets their expectations. These are all questions that the market participant’s management will have to address. And those who have invested in this market participant will inevitably hold the management to account for just how well they answer these questions. 

It is immediately clear that a market participant’s success ultimately depends on just how well it understands what is happening in its marketplace. Are there new technologies available? Are customers’ tastes changing? Can I just keep doing what I am doing – even if a little better each year?

Can we mimic these market pressures?

So, what do these observations of the dynamics of a market tell us about the appropriate role of an economic regulator? 

If an economic regulator just focuses on setting a fair price – where the monopoly earns a fair return for its efforts – there is little reason for the regulated monopoly to fear the future, or to ask itself the difficult questions that a participant in a competitive market has to ask itself. From a societal point of view, this has to be a problem! For a market participant the failure to ask these questions can be existential as the Kodak, Polaroid and Xerox examples illustrate. What is the pressure that keeps the natural monopolist honest? Surely this should fall to an economic regulator, if the job is to mimic the pressures of the market place.

The logical conclusion then is that the economic regulator needs to do much more than set prices. The regulator has somehow to replicate these same, quite normal, day to day pressures that market participants experience. 

The regulator should therefore ask, on an on-going basis, questions such as:

  • Could (should) costs be lower?
  • Is the quality of the product as good as it should be?
  • Is the level of investment appropriate?
  • Is the industry/the service provider sustainable?
  • What might society/customers expect in the future? Is the service provider reasonably placed to respond well?
  • What is happening elsewhere that could impact costs, customer perceptions or the future trading of the service provider?

Quite obviously, these questions are quite different to (and demonstrably more complex than) those that need to be answered in setting prices for a regulatory control period of four to six years. They imply a quite different regulatory process – far from the linear price setting (‘do no harm’) game of regulatory ping pong. 

In the much more simple game of price setting, both regulator and regulated take it in turns to respond to what the other has said or done. Asking these fundamental questions around the dynamic pressures of a market place, or, more prosaically debating these issues, could be likened to a game of ping pong, but only if there are multiple balls in play all of the time.  

To be successful, the economic regulator has to play the role of investment analyst (costs and future revenues), discerning customer, futurologist and observer of relevant societal trends. The engagement with the regulated entity cannot be narrowly focused on appropriate prices and the avoidance of economic rent. The regulator’s focus has to be on understanding whether the regulated entity cannot or does not want to do what would be right for its customers if it were subject to the pressures of direct competitors (all of whom could similarly be price takers). 

Whether something is difficult or inconvenient to the management or investors in a regulated monopoly should not impact the ultimate consumer or wider society – at least, not if the economic regulator is doing what they should.
 

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