Requirement for Regulation in Privatized Industries
Requirement for Regulation in Privatized Industries
Privatization is likely to lead to incentives for firms to pursue productive efficiency. However, this will not ensure allocative efficiency, unless regulation is introduced to ensure that competition takes place. Another policy would be to pursue a policy of deregulation. In this case, the government actively removes various regulations, for example by removing entry barriers to encourage increased competition. Once an industry is privatized, government no longer has direct control over the objectives and strategies of these firms. As a consequence, there is often a need for regulation. For effective regulation, the regulator needs information on future changes in costs and market conditions.
In a stable market this task is relatively straightforward. In a dynamic market, where market conditions are changing constantly, it may be difficult to build up a detailed picture. Regulators attempt to balance the interests of consumers by promoting competition, while at the same time regulating prices to ensure that the shareholders of privatized firms receive a reasonable return on capital invested. There are two main ways of regulating prices known as rate of return and price cap regulation respectively.
Rate of return regulation
This ensures firms receive a minimum rate of return on any capital employed. In this case, the regulator fixes a required rate of return on capital (R), which can be expressed as:
R=(Total revenues-Total costs)/(Capital employed)
This means that firms are guaranteed R. The regulator allows firms to set a price which covers costs and a mark-up to allow capital equipment to be updated. Under this type of regulation, price reviews can be frequent. Therefore, it is more likely that a relationship between regulator and firms can build over time. As a consequence, there is a danger of regulatory capture. Regulatory capture occurs when the regulator ends up representing the interests
Privatization is likely to lead to incentives for firms to pursue productive efficiency. However, this will not ensure allocative efficiency, unless regulation is introduced to ensure that competition takes place. Another policy would be to pursue a policy of deregulation. In this case, the government actively removes various regulations, for example by removing entry barriers to encourage increased competition. Once an industry is privatized, government no longer has direct control over the objectives and strategies of these firms. As a consequence, there is often a need for regulation. For effective regulation, the regulator needs information on future changes in costs and market conditions.
In a stable market this task is relatively straightforward. In a dynamic market, where market conditions are changing constantly, it may be difficult to build up a detailed picture. Regulators attempt to balance the interests of consumers by promoting competition, while at the same time regulating prices to ensure that the shareholders of privatized firms receive a reasonable return on capital invested. There are two main ways of regulating prices known as rate of return and price cap regulation respectively.
Rate of return regulation
This ensures firms receive a minimum rate of return on any capital employed. In this case, the regulator fixes a required rate of return on capital (R), which can be expressed as:
R=(Total revenues-Total costs)/(Capital employed)
This means that firms are guaranteed R. The regulator allows firms to set a price which covers costs and a mark-up to allow capital equipment to be updated. Under this type of regulation, price reviews can be frequent. Therefore, it is more likely that a relationship between regulator and firms can build over time. As a consequence, there is a danger of regulatory capture. Regulatory capture occurs when the regulator ends up representing the interests