Economic Rationale for Regulatory Intervention

A regulation can be defined as a form of government intervention in a market. It involves rules and their enforcement. It may occur proactively in forecasting future market changes or reactively as a result of a market occurrence, such as a financial crisis.

The challenge of dealing with systematic risk and the risks financial institutions take drive regulators.

Economic Rationale for Regulation

1. Inadequacy of Market Solutions

   The fundamental theorem of welfare economics postulates that it is impossible to redistribute resources without making a portion of market agents better off and another worse off. Moreover, efficient market allocation is only achieved if inappropriate equilibrium market prices are reached. Regulation is required to safeguard consumer protection and privacy rights to reach an economically efficient market solution.

2. Presence of Informational Frictions

   Informational frictions are market inefficiencies that cause poor outcomes in the market. Examples of informational frictions are inaccessibility and inadequacy of information. Informational frictions result in issues that require regulations. A good example is asymmetrical information, which may give a market participant an advantage over the other participants in the course of their interactions. Therefore, regulation is set up to establish a level playing field in the distribution of information in the market.

3. Market Externalities

   Market externalities can be described as the spillover effects of production and consumption activities. These ripple or spill-over effects affect other market players who are not directly involved in a specific transaction, action, or market decision.

   Market externalities are categorized into negative and positive externalities. A positive externality (for example, home improvements) results in spillover benefit, while a negative externality (for example, the systematic risk created by environmental pollution) causes spillover cost. Market regulation is therefore required to control market externalities.

4. Presence of Weak Competition

   Weak competition is harmful to consumers due to high prices, limited choices, and lack of innovation. Weak competition is related to occurrences of a dominant firm having too much power or individual firms conspiring to keep the market prices high.

5. Achievement of Social Objectives

   Typically, social objectives are achieved by the provision of public goods—usually financed by the government—that the market could not provide. Consumption of public products by one individual does not decrease another consumer’s accessibility to them. Examples of public goods and services include police protection and education.

   Firms can also be subjected to regulatory obligations in order to achieve social goals. For instance, a regulation requiring telecommunication firms to extend their services to remote villages can be imposed. This way, the population in such areas will enjoy access to telecommunication services.

Question

Which of the following is least likely to be the rationale for the establishment of regulations in the economy?

1. Informational frictions such as privatization of information.
2. Substantial divulgence of operating and financial information by firms trying to attract investors’ attention.
3. Systematic risks created by the financial market industry.

Solution

The correct answer is B.

Substantial divulgence is not a reason for regulation. Rather, it may be the consequence of control or a sign of a conducive business environment. It is informational frictions that increase the need for rules.

A and C are incorrect. These are some of the factors that prompt the establishment of a regulatory system.

Reading 10: Economics of Regulation

LOS 10 (a) Describe the economic rationale for regulatory intervention.