Markets, Regulation and Law

Luxury, fashion and sports regulation

Luxury, fashion and sports are important when it comes to regulation. For example, in the USA for the sports there are two main rules:

Salary cap

The salary cap is a budget constraint for the total amount of money teams can spend on players’ contracts. The US deals with three different models:

• Football league implements a hard salary cap: teams cannot spend above the cap under any circumstances.
• No basketball league salary cap at all.
• In the middle, operates under a soft salary cap: the cap can be exceeded with certain exceptions and/or penalties.

Luxury tax

The luxury cap is a penalty that the team has to pay if it has spent above the cap. This tax is progressive, and if a team has paid the luxury repeater tax in previous years, it must pay a higher tax rate called “tax.” The revenue gained from the tax-paying teams gets redistributed to non-tax paying teams.

We are questioning the effects of the regulation, if it’s efficient, and if the rules pursue an efficient goal.

Importance of financial regulation

Why do they have a salary cap? Financial regulation is important because it is a matter of competition and rivalry. If you allow teams and companies to spend whatever money they want to run a competition based on their pocket, there is the risk that only the richest company will run for the championship; there won’t be a significant turnover in terms of teams that are able to compete for the final championship. So, with financial rules, you strengthen and promote competition.

Ensuring competition

Why should a league be concerned about ensuring competition? The main concern of a league is the revenue it is able to collect. The main source of revenues in their balance sheet is TV rights. When the teams are going to sell their product all over the world to increase the audience, they have to ensure that there is a competition. No one will spend time watching a game when there is a huge gap among the teams; it is not challenging. In the NBA, it is difficult for a team to win the championship for several years because the players will ask for a higher salary, making it difficult to keep all the players within the roster and to meet the salary request. Competition allows you to sell the product abroad and in your country in terms of TV rights to capture the interest of the audience. Financial constraints, such as the salary cap, help to ensure a level playing field (e.g., the NBA teams can’t decide the salary of a player; there are rules to follow).

Internet and mobile phone scenario

There are three main players:

• Providing internet access (e.g., Vodafone) → broadband providers
• Content providers (e.g., Netflix, Amazon)
• Mixed players: both content and internet providers (e.g., Sky)

When it comes to internet competition, it may happen that broadband providers “zero-rate content”: they offer to their users the possibility to enjoy some content without consuming data. So, there is a big competition between broadband providers and also between content providers regarding this zero-rating.

Economic regulation

In legal and economic literature, there is no fixed definition of the term ‘regulation.’ Economic regulation is the pattern of government intervention in the market. Regulation involves the employment of legal instruments for the implementation of social-economic policy objectives.

Types of regulation

• Structural regulation concerns the regulation of the market structure.
• Conduct regulation is used to regulate the behavior of producers and consumers in the market.

Antitrust law vs. regulation

Antitrust law doesn’t consist of a direct intervention in the market but is made by a set of rules that aim at ensuring competition among companies; it ensures that competition runs efficiently in the market. Antitrust controls that companies’ behavior is efficient and fair in the market. It safeguards the process of competition without intervening to secure the results. If the process is safe and efficient, the outcome will be efficient. Antitrust is different from regulation as it operates ex post without fixing ex-ante what is unfair (monopoly sometimes can be positive). If there is market failure, the only weapon is regulation. If there is no market failure, the best solution is antitrust.

Market failure rationales

The only justification for regulatory interventions is market failures. Outside market failure, there are many other rules that regulate other scenarios, but do not belong to market failures.

Imperfect competition

Imperfect competition will cause prices to deviate from marginal cost. Monopolies and natural monopolies arise when economies of scale available in the production process are so large that the relevant market can be served at the least cost by a single firm. Therefore, it is less costly to society to have production carried out by one firm than by many. We should intervene with regulation to set and control terms and conditions price. Where a natural monopoly exists, the use of competition law (antitrust) may be undesirable. To promote a more efficient and equitable allocation of scarce resources, these natural monopolies are either put under control of the state, as happened in many European countries, or highly regulated, as is the practice in the United States. In the former case, these firms are instructed to maximize welfare instead of profit; in the latter case, regulation consists of stopping entry and enforcing price or profit rules that promote an efficient allocation of resources.

Unstable markets

Unstable markets are characterized by dynamic inefficiencies with respect to the speed at which these markets clear or stabilize. These instabilities waste scarce resources. Imbalances within an economy occur at the level of separate markets and on a macro level. In separate markets, destructive or excessive competition may arise, often as a result of long-term over-capacity. Over-capacity situations may also arise when the production capacity is adjusted to demand at peak moments or periods. Examples are electricity: the relationship between demand and supply tends to change significantly according to specific hours or periods. You may have a huge increase in demand with a consequence difficult to match with supply. Since electricity could not be stored, it is difficult to match that capacity. Regulation intervenes to set a specific price so that the demand for electricity in that specific period will be lower, thanks to the increase in price.

Missing markets

Missing markets imply the demand for socially valuable goods and services for which the total value (willingness to pay) exceeds the production cost, but where prices or markets do not arise. Missing markets may be the result of information problems and transaction costs. Each type of goods requires a different kind of regulation.

• Search goods: for which the quality of a product can be determined prior to purchase. They do not belong to a market failure scenario.
• Experience goods: for which quality only becomes apparent after consumption of the good. They belong to a market failure scenario.
• Credence goods: for which the quality cannot even be established after consumption. They belong to a market failure scenario (e.g., medical treatment, consultants, lawyers). It’s a matter of trusting the service you are receiving. Customers may fear that the price for that good is not fair, leading to the situation of information asymmetry. They will not buy a product because they believe there is a significant gap between the real value and the price of the product/service. In particular, adverse selection arises from asymmetry.

Information asymmetry and adverse selection

Adverse selection: high-quality goods are driven from the market by low-quality goods. In the market of "lemons," the buyer believes that the price the company is asking for the product/service is too much according to his perceptions.

Moral hazard

Moral hazard usually occurs after a transaction or a contract or deal. People are unable to assess the behavior of someone else. Parties take advantage of their information lead (one party gets the benefit and the other party incurs the cost). An example is an insurance company; they cannot predict nor check if they are going to insure a good or a bad driver. As a consequence, they cannot discriminate, but they charge just one price to everyone, and so good drivers will pay more and bad drivers will pay less.

Bounded rationality

Human beings' cognitive capabilities are limited. The decision behavior of human beings cannot conform to the ideal of full rationality.

Akerlof (1970): the market for lemons (i.e., second-hand cars) is an explanation of adverse selection. It regards second-hand cars and not first-hand cars. The production of information is costly, but the dissemination is not. Due to asymmetry information, buyers and sellers don't have equal amounts of information. When it is not possible to establish the relevant quality dimensions of particular goods or services in advance, purchasers will be prepared to pay an average price corresponding with the average expected quality. This will benefit the seller if the car is a “lemon.” But sellers of high-quality products will not be prepared to sell at that asking price and will withdraw from the market. The end result is that the quality of goods and services will decline, as will the price buyers are prepared to pay. The interventions of regulation in this situation are trademarks, feedbacks, and contracts of provision; this will reduce the information gap and help the exchange.

Transaction costs

According to the Coase theorem, an inefficient allocation of resources can arise in the presence of externalities (i.e., cost or utility effects for third parties outside the market interactions where these external effects develop).

Undesirable market results

Even if the competitive market mechanism allocates scarce resources efficiently, the outcomes of the market processes might still be considered unjust or undesirable from other social perspectives. The correction of undesirable market results can be considered desirable for other than economic reasons, such as considerations of justice, paternalistic motives, or ethical principles. However, these values are not measurable.

Price regulation

Price regulation is the main tool of public intervention in the market.

The natural monopoly problem

The main cases where you can find public intervention are natural monopoly. The market does not achieve production and allocative efficiency if technology is such that the industry structure is one of natural monopoly. A natural monopoly arises if technology and demand are such that it is cheaper for one firm to serve the market than for several firms to serve the market. The average total cost curve (ATC) is shown to be everywhere declining and hence the marginal cost curve (MC) is beneath the average total cost curve.

Possible sources of declining unit costs are many:

• Economies of scale and density
• Economies of scope

The tendency towards natural monopoly is most pronounced when economies of scale and density are combined with economies of scope: the former reduce the number of firms producing each service individually, the latter encourage each firm in the market to produce a range of services.

Assume that the firm can charge only a single price (that is, price discrimination is not allowed). If the firm is not regulated, it will maximize profits by setting marginal revenue equal to marginal cost, leading to price PM and output QM, known as market outcome (high price, low outcome).

• Productive efficiency requires producing at the minimum point of the average total cost curve: clearly, the market outcome does not satisfy this condition.
• Allocative efficiency requires that production occurs where the marginal cost curve crosses the demand curve: again, the market outcome does not satisfy this condition. Relative to the social optimum, social welfare has been reduced by areas A, B, C, and D (the deadweight loss).

Price regulation can theoretically lead to the social optimum if regulators specify that price be set equal to PE, where the E subscript denotes ‘efficient.’ Then allocative efficiency is met and the outcome has moved towards productive efficiency. However, a firm that charges PE and produces at QE will not generate sufficient revenue to cover costs of production; in particular, the firm will be short by the amount of its fixed cost. Thus, the regulator must alter the regulatory mechanism so that the firm remains in the market: to ensure that the market is served, the regulator might offer the firm a subsidy equal to its fixed costs.

If provision of a subsidy is not politically feasible, the regulator may alternatively specify that the firm charge PF, the price where the average total cost curve crosses the demand curve (the F subscript indicates ‘feasible’). At this price, the firm charges the lowest price possible, subject to the constraint that it covers all costs (lower prices and higher outcomes compared to the first scenario). This regulatory mechanism also increases social welfare by areas A, B, and C, relative to the market outcome. Society is still losing area D, but this may be acceptable relative to the political cost of providing the firm with a subsidy equal to the firm’s fixed costs.

Pricing strategies

To sum up: How can I adapt my strategy and find a price that is close to the feasible optimum one? When it comes to price schemes, we should study two situations: the first one in which we have a single product firm and the second in which we have a multiproduct firm.

Pricing schemes available for achieving the social optimum:

Rate of return

It is a regime of cost-plus pricing: the regulatory agency sets prices in such a way that the utility covers the cost of production and earns a ‘fair’ rate-of-return on its investment.

• CONS: Firms have no incentive to operate efficiently and minimize costs (the more the company invests, the more the price they may charge, it knows that it will be able to recover increasing costs with a subsequent increase in price).
• PROS: This regulation is promoting the quality of infrastructure, goods, and services. Firms may have an incentive to over-invest in capital equipment: the more they invest, the greater their excess return (so-called Averch-Johnson effect).

Price-cap

Price-cap regulation is a form of economic regulation that sets a limit on the prices that a company can charge. The regulator sets a cap, including an adjustment factor X, for a specified period (3-5 years), that the firm can charge for a defined basket of goods and services.

• PROS: It is characterized by incentive regulation: any cost savings are retained by the firm, so firms are incentivized to minimize cost. Companies are led to spend less.
• CONS: Since companies are led to reduce costs, they are also led to reduce investments and therefore the quality.

Additional benefits:

• It reduces regulatory administrative costs.
• The regulated market is decoupled from other markets, eliminating the inefficient incentives firms subject to rate-of-return regulation face in regards to entering markets in which they are not competitive.
• It requires less information regarding technological change to implement.

In order to take account of rates of inflation, the regime allows firms to vary its price in any year by an amount that is linked to the overall level of inflation: a price-cap permits a utility to increase its level of prices by the previous year’s rate of inflation, as measured by the retail price index (RPI), which is then varied by a percentage that is the adjustment factor (the value of X) that reflects the real cost reduction that the regulator expects (expected efficiency saving). If the firm is subject to a cap of RPI-5 and if inflation in the previous year were 3%, it would have to lower nominal prices by 2%.

In calibrating the cap (i.e., choosing the value of X), the regulator will try to achieve a balance between costs and revenues over the specified period as a whole: while under the rate of return regulation, the firm can recover whatever costs it has historically incurred, with a price-cap the regulator is making a projection of costs into the future and setting overall prices so that they will cover those expected costs.

The adjustment factor is a problem because it changes and with it you can overcompensate or undercompensate the company, providing bad incentives.

Problems in price regulation

• Information asymmetry: The determination of the value of X. The shorter the interval between the setting of the price caps, the closer RPI-X is to rate-of-return regulation. This is because, when reviewing the value of X, the regulator’s perception of the scope for performance improvements is influenced by how well the incumbent has done in the recent past as indicated by its rate of profit.
• As in rate-of-return regulation, an inappropriate design of price caps may fail to prevent cross-subsidization. When a company delivers more than one product, there is the risk that the company uses prices and revenues from the market in which the company is a monopolist to feed the competitive price of the other services it sells (so the company is taking money from the monopolistic market in order to charge low prices on the competitive market, therefore appearing more competitive in the competing market).

It is important, therefore, to determine a suitable composition of the basket of goods and services that are subject to the price cap.

General issues in regulation

Regardless of the form of price regulation, asymmetric information inevitably leads to regulators being poorly informed relative to those they regulate. The policy maker is not aware of the structure of costs of the company, he is just trying to find some proxy that allows him to intervene. He is not the manager of the company and he is regulating several companies in the market. There is a huge gap between the policy maker's knowledge and the company's knowledge.