“Why Johnny Can’t Regulate”: A Reply to Ergas

Abstract

Henry Ergas is a talented, erudite and articulate economist, and a long-time critic of the ACCC/AER. In a recent paper in this journal2 he raises the possibility that public utility regulation is doomed to end in failure. He draws on the vignette of primary-schooler Johnny, who wants to grow up to be a regulator. Is Johnny's career destined to end up with nothing but disappointment?Of course, this raises the question as to what public utility regulation is designed to achieve. Ergas addresses this issue at the outset, by allowing that, due to transactions costs, a Coasean bargain contract between the customers and a monopoly supplier would be subject to the risk of ex-post opportunism - both on the side of the supplier (who might threaten to shade quality or raise the price ex-post) and on the side of the customers (who might seek to expropriate the sunk investment of the supplier by collectively agreeing to lower the price to the supplier). Given these risks, either side may fail to make valuable sunk investments, or, as Ergas puts it, either side may make investments which are inefficient due to the threat of opportunism: 'each side would invest in costly precautions so as to ward them off. But ... those investments, seen from a societal perspective, are merely a waste, reducing welfare.3Ergas is thereby led to ask: can the government directly step in to re-create the Coasean bargain on behalf of small customers? He rightly points out many problems in this, including problems of aggregating customer preferences, problems of monitoring and enforcing by customers of the government in its interactions with the supplier, and problems of time-inconsistency and opportunism.Perhaps these problems can be resolved by delegating certain powers to an independent authority. Such delegation might make it easier for customers to monitor, might improve the information-collection ability, and might resolve the commitment problems. After all, delegating monetary policy to an independent central bank as a means of overcoming the time-inconsistency problem has been a success. Might not the same principle apply to an independent regulatory authority? Ergas goes to some lengths to distinguish the role of a central bank from the role of an independent regulator. According to Ergas, an economic regulator is likely to have much wider range of instruments at its disposal and more vaguely specified objectives. Moreover, the incentives for time- inconsistency are much stronger for a regulator than for a central bank. He also suggests that newly established central banks seek to invest in a reputation for being tough on inflation, whereas newly established regulators seem to do the opposite:This [need to establish a reputation] would suggest that the initial period following the transition to regulatory independence would be associated with regulator's credibly signalling a strong aversion to expropriating sunk investments. But in no major country has that been the case ... If anything, utility regulators seemed to preference delivering price reductions to consumers, as evidenced by tough price caps and steep falls in regulated revenues.4As an aside, we may note that any tendency for new regulators to favour customers is still consistent with the regulator seeking to establish a reputation for protecting sunk investments - but with rather more focus on the sunk investments of the customers. If the primary reason why the regulator is established in the first place is a concern that - in the absence of the intervention of the regulator - the customers will be unwilling to make sunk investments for fear of expropriation by the monopoly supplier,5 it makes sense for a regulator to counter that fear, proving its mettle by being tough on the monopoly supplier. Such actions may improve the climate for investment by those customers who need to invest in reliance on the monopoly service.'Last but not least', Ergas expresses concern that regulatory decisions are affected by the wider political context, citing as examples changes to the merits review process in electricity and ministerial powers of discretion in NBN. …