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Regulation of Markets

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Economics

Can you imagine a world without laws and regulations? No doubt it would be chaotic. Thus, to avoid chaos within a market, the government puts in place market regulations to exert oversight and prevent certain undesired or unfair actions.

What is market regulation?

Market regulation refers to the rules imposed by the government to change the behaviour of firms and correct market failure.

In the UK, the government uses the Competition and Markets Authority (CMA) to investigate mergers, anti-competitive practices and regulate firms in different markets.

The CMA can enforce financial penalties, prevent mergers, and force businesses to demerge. They promote competition within markets to benefit consumers and protect consumer laws.

Six UK regulators sit under and answer to the CMA. They oversee previous nationalised sectors. The regulators are:

  • Office of Rail and Road (ORR).

  • Office of Communications (Ofcom).

  • The Water Services Regulation Authority (Ofwat).

  • Civil Aviation Authority (CAA).

  • Office of Gas and Electricity Markets (Ofgem).

These regulators can investigate the industry as a whole or focus on a few specific firms.

The financial market is fudamental and thus also regulated. Three bodies regulate it:

  • The Financial Policy Committee (FPC) regulates risk and supports the government's economic policy.

  • The Prudential Regulator Authority (PRA) promotes the safety of banks, investment firms, etc.

  • The Financial Conduct Authority (FCA) ensures competition and protects consumers’ interests.

Firms can hold a dominant position, as it is not illegal. When firms use the power they hold to exploit consumers and stifle competition, regulators get involved to control these monopolies.

Types of market regulations

Regulators can use different types of controls to promote competition and remove anti-competitive behaviour.

Price regulation

Regulators can set a maximum price that monopolies can charge. Using the RPI-X+K formula, regulators force monopolies to charge below the profit maximising price.

The X in RPI-X is efficiency. Regulators set a price that is below the inflation rate, forcing firms to become more efficient if they are to continue to make profit. This ensures that firms pass the efficiency gains onto consumers.

However, due to the quick improvements in technology, it is difficult for regulators to know where X is. They only have asymmetric information, and their efforts may not be effective.

The K in RPI+K is capital. Regulators allow firms to grow and make profit but force them to invest it back. This allows efficiency gains to be passed onto consumers.

Regulators can also set a price cap at P=MSC (marginal social cost). This ensures that monopolies are allocatively efficient. The price cap acts as a proxy for competition.

Failing to act according to these price caps and regulations can result in huge fines which can affect the firms’ profits.

The Royal Mail had a price cap on the price of second-class stamps. They increased the price above the price cap and were fined £1.5 million by Ofcom.

However, it could be difficult for regulators to know where a firm’s allocatively efficient point is due to asymmetric information. Additionally, inflation can eat away at profits in the long run if the price doesn’t adjust to inflation.

Profit regulation

Instead of regulating prices, regulators can control the maximum level of profits. In the US, this is known as the ‘rate of return’ regulation. Prices are set to allow firms to cover their operating costs and earn a ‘fair’ rate of return based on the capital employed.

It is used to prevent firms from setting too high prices and it encourages them to invest. However, firms could employ too much capital and allow it to depreciate so that regulators can increase rates. Additionally, firms do not earn more if their costs are reduced, thus it provides little incentive for firms to reduce costs and improve efficiency.

Quality standards and performance targets

Regulators can establish quality standards to ensure that consumers are not exploited through poor-quality goods and services.

Regulators can also impose different targets on firms ranging from price, quantity, consumer rights, and cost of production. This can help firms improve their service towards consumers and gain more consumers.

In practice, this could lead to firms meeting their targets, but not improving.

Train services could change their timetables to ensure trains arrive on time. In this example, trains haven’t improved but they have met their targets.

Merging policies

To prevent the abuse of monopoly power, regulators can stop monopolies from forming in the first place. Regulators do this by blocking mergers and takeovers or by forcing a monopoly to demerge.

By blocking mergers and takeovers, regulators prevent firms from gaining monopoly power and prevent consumers from getting exploited. By forcing firms to demerge, regulators promote more competition within a market and eliminate monopolies.

The CMA prevented Asda and Sainsbury’s from merging, which would have led to higher prices for consumers.

Market regulation and market failure

Market failure occurs when there is an inefficient distribution of goods and services in a free market. It can occur because of monopolies, negative externalities, or a lack of provision of public goods.

The government can impose laws and regulations to correct and avoid market failures. The regulations established can prevent demerit goods, goods with negative externalities, the abuse of monopolies, and the exploitation of labour.

The National Minimum Wage Act is a form of regulation imposed to reduce monopoly exploitation of their employees. Through this act, workers earn a fair wage and it reduces a firm’s monopoly power.

Other examples of regulations imposed to correct market failure include:

  • US Motor Vehicle Air Pollution Control Act. This limits the amount of pollution and emissions engines can create.

  • Cartel and the Competition Act 1998. This prevents anti-competitive agreements and the abuse of a dominant position by a firm.

Advantages and disadvantages of market regulation

There are many advantages and disadvantages to a regulated market.

Advantages

Some advantages for regulating a market are:

  • Prevent exploitation: a regulated market can help prevent the formation of monopolies that will exploit consumers with higher prices or poor-quality products.

  • Encourages competition: a more contestable market allows for consumers to benefit from choice and lower prices.

  • Encourages firms to be more efficient: regulating the price firms can set, can encourage them to be more efficient in making profits. It can also lead to them passing on the efficiency gains onto consumers.

Disadvantages

Some disadvantages for regulating a market are:

  • Asymmetric information: to impose effective controls, regulators require a lot of information about the market as a whole and specific firms. Due to inaccurate or limited information, regulators could set ineffective controls which could result in government failure.

  • Regulatory recapture: this refers to when regulators serve the interests of those it is meant to be regulating rather than those it is supposed to be protecting. Regulators fail to regulate the market through lobbying or corruption.

The alleged capture of HMRC by Vodafone who negotiated to waive a tax bill of £7 billion.

  • Theory of second best: this refers to when the government corrects one market failure but creates a larger market failure elsewhere. In these cases, the industry would have been better off if regulators never got involved.

We encourage you to read the Deregulation of Markets explanation to understand why some markets aren’t regulated.

Regulation of Markets - Key takeaways

  • Regulation refers to the rules imposed by the government to change the behaviour of firms, correct market failure, and protect the environment.
  • Regulators can regulate an industry by controlling the price, profit, quality standards, performance targets, and merging policies.
  • To avoid or correct market failure, the government can impose regulations that prevent demerit goods, goods with negative externalities, the abuse of monopolies, and the exploitation of labour.
  • Some advantages of a regulated market are that it encourages competition, efficiency and prevents exploitation.
  • Some disadvantages of a regulated market are regulatory recapture, asymmetric information, and the theory of second best.

Regulation of Markets

A government can regulate many different things. For example, the price of a good or service, the profit a firm can make, and mergers. Quality standards and performance targets are other measures that are regulated too.

Markets need to be regulated to avoid market failure and to prevent monopolies from exploiting consumers.

The National Minimum Wage Act, Cartel and the Competition Act, and the US Motor Vehicle Air Pollution Control Act are examples of government regulation.

Final Regulation of Markets Quiz

Question

Why do markets need to be regulated?

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Answer

To prevent anti-competitive behaviour, consumer exploitation, and market failure.

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Question

Which of these is not an example of government regulation?

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Answer

The National Minimum Wage

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How can a market be regulated?

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Answer

Profit caps

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What are the benefits of a regulated market?

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Answer

Prevents exploitation by monopolies, encourages competition, gives consumers choice, and encourages firms to be more efficient.

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What are some drawbacks of a regulated market?

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Answer

Regulators can be captured and fail to regulate the market properly due to lobbying or corruption.

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Which of these are UK regulators?

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Answer

Office of Rail and Road (ORR)

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What are the three regulators in the UK’s financial market?

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Answer

Financial Conduct Authority (FCA)

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What does RPI-X mean?

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Answer

It refers to regulators setting a price that is below the inflation rate, to force firms to become more efficient if they are to continue to make profit. 

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What does RPI+K mean?

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Answer

It refers to regulators allowing firms to grow and make profit, but forcing them to invest it back.


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Question

Explain what regulatory recapture means.

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Answer

It refers to when regulators serve the interests of those it is meant to be regulating rather than those it is supposed to be protecting. 

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Question

Explain what the Theory of Second Best shows.

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Answer

It shows when the government corrects one market failure but creates a larger market failure in the same industry. The market would have been better off if regulators never got involved.

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Who are the Competition and Markets Authority (CMA)?

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Answer

They are regulators who investigate mergers and anti-competitive practices, and regulate firms in different markets. 


They also enforce financial penalties, prevent mergers, and force businesses to demerge.


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Question

Define ‘market regulation.’

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Answer

Market regulation refers to the rules imposed by the government to change the behaviour of firms, and correct market failure.

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Explain how regulators can regulate a firm’s profit.

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Answer

Regulators can set prices to allow firms to cover their operating costs and earn a ‘fair’ rate of return based on the capital employed.

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Explain how regulators suffer from asymmetric information.

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Answer

Regulators require a lot of information about the market and firms within that market if they are to set effective controls. Because of limited or inaccurate information, regulators can set ineffective controls which can have no effect in the market or lead to government failure.

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