RPI

1
RPI X Regulation

• Nick Crafts
• (University of Warwick)

2
Regulation of Privatized Industries

• Regulate to prevent abuse of market power in
  cases of natural monopoly or high entry barriers
• British approach based on price capping whereas
  traditional American version used rate of return
• RPI X aims to stimulate cost reduction as well
  as preventing high price cost margins

3
Productivity and Prices

• In a competitive market pmcLAC (including a
  normal rate of return on capital)
• In the absence of productivity growth, over time
  output prices would rise at the same rate as (the
  weighted average) of input prices
• More generally, output prices in a competitive
  market rise at the rate of growth of input prices
  minus productivity (TFP) growth

4
Price Capping

• If prices are allowed to rise at RPI-X, the
  industry will be able to maintain normal profits
  providing it achieves TFP growth equal to the
  national average, TFPUK, X
• If TFP growth is greater than (less than) TFPUK
  X, the formula implies supernormal (subnormal)
  profits

5
RPI-X vs Rate of Return Key Arguments

• RPI-X
• Strong incentives for cost reduction and
  innovation
• BUT
• Quality may suffer
• Prices exceed costs on average

• RATE OF RETURN
• Prices stay in line with costs
• Quality assured
• BUT
• Likelihood of excessive investment
• Weak incentives for productivity improvement

6
The Averch-Johnson Problem

• Rate of return regulation which allows the firm
  to earn a rate of return above the cost of
  capital encourages the firm to accumulate an
  excessive capital stock
• The equity value of the firm will be proportional
  to the capital stock and, provided the allowed
  rate of return is above the cost of capital, the
  share price will be positively related to the
  capital stock
• Have to rely on the regulator to identify
  unnecessary projects and disallow them from the
  cost base

7
The Water Industry

• Regulation is a hybrid
• Its the Averch-Johnson problem that we should
  fear in the long-run .. especially given
  populist pressures
• Excessive capital stock encouraged by
• de-luxe quality directives
• ensuring no supply interruptions
• no peak load pricing
• Key question is marginal benefit (willingness
  to pay) less than long-run marginal cost?

8
RPI-X Regulation Further Points

• Optimal length of price reviews trades off gains
  from cost reduction against losses from excessive
  prices . is shorter the lower is the sensitivity
  of costs to cost-reducing effort and the higher
  is price elasticity of demand
• Mitigating regulatory risk with sunk costs
  through credible commitment by regulator is
  desirable
• Uncertainty lowers advantages of price caps if
  need to ensure non-negative profits
• Setting X well requires good way of estimating
  potential for productivity improvement

9
Managerial Effort and Productivity Growth

• Implementing productivity improvements/cost
  reductions requires managerial effort, i.e. has
  disutility for managers
• Monitoring managers in context of asymmetric
  information encounters free rider problems in
  private sector and may offer no reward in public
  sector
• Competition is antidote to agency problem

10
Privatization and Managerial Effort

• Asymmetric information does not go away
• Private shareholders may improve
  monitoring/incentivizing of managers
• Competition may increase
• Regulator may have to try and compensate for
  weaknesses of shareholders and/or competition

11
Privatization and Productivity Performance (Green
and Haskel, 2004)

• TFP growth raised by the privatization process
  not by private ownership per se
• Productivity growth increased in some cases as X
  factor made more demanding (e.g. water)
• Regulation central to quality implications of
  RPI-X incentive structure
• Overall picture is dominated by levels effect of
  eliminating inefficiency

12
Total factor productivity in the UK public sector
(annual rate of increase, )
72/3-78/9 78/9-86/7 86/7-99/00
British Airways 3.0 3.3 4.2 Privatised 1987
72/3-78/9 78/9-86/7 86/7-93/4
British Coal -2.8 0.1 9.0 Privatised 1994
72/3-78/9 78/9-86/7 86/7-94/5
British Gas 8.2 2.0 1.5 Privatised 1986
72/3-78/9 78/9-88/9 88/9-97/8
British Steel -5.0 3.8 1.8 Privatised 1988
72/3-78/9 78/9-84/5 84/5-94/5
British Telecom 0.6 3.2 3.0 Privatised 1984
13
Comparative Productivity electricity, gas and
water sectors, 1979-95 (UK 100)
Labour Factor Productivity
Total Factor Productivity
14
Regulated Prices in the UK
15
Conclusions

• Productivity performance in privatized utilities
  may be affected by the incentive structures of
  the regulatory framework
• In practice, not clear that RPI-X has generally
  been a strong driver of TFP growth
• Introducing competition where possible delivers
  stronger incentives to improve productivity

16
GROUP WORK

1. When would you expect regulation to have a
   powerful impact on the productivity performance
   of a privatized business?
2. How should a regulator decide the precise value
   of X at a price review?

17
Regulation and UK Productivity Performance

• Nick Crafts
• (University of Warwick)

18
Costs and Benefits of Regulation

• Regulation that corrects market failures provides
  gains from a more efficient allocation of
  resources
• Regulation also incurs costs so it is relevant to
  ask how benefits compare with costs
• The costs of regulation may be felt in terms of
  lower GDP per person

19
Questions

• In what ways can regulation affect productivity
  outcomes?
• How good are measures of regulation?
• Is the UK lightly regulated?
• Does regulation actually have a big impact on
  labour productivity growth?

20
Regulation and Productivity

• Compliance costs have direct productivity
  implication
• Additional adverse impacts if disincentives to
  investment and to innovation
• May create barriers to entry that reduce
  competition
• Impact has not been well quantified

21
Compliance Costs

• Administrative Costs 3 to 4 GDP and Policy
  Costs 7 to 8 GDP (BRTF, 2005)
• Direct measurement effect will be to reduce
  measured TFP by an equivalent amount of
  productive resources diverted away from producing
  output
• No time series evidence on compliance costs but
  difficult to believe these direct effects have
  reduced annual TFP growth much in recent past

22
Regulation as a Tax

• Investment and innovation are key determinants of
  labour productivity growth
• Appropriable returns underpin incentives to
  investment and to innovate
• Regulation may reduce net present value of
  projects
• For example, employment protection and ICT
  expenditures (Gust and Marquez, 2004)

23
Regulation as Barrier to Entry

• For example, costs of setting up new business,
  licensing rules, planning restrictions
• Empirical evidence of cross-country comparisons
  shows tighter regulation reduces entry and raises
  price-cost mark-ups (Cincera and Galgan, 2005
  Griffith et al., 2006)
• Retailing productivity growth example of
  regulatory barriers having seriously adverse
  impact in Europe compared with US (McGuckin et
  al., 2005) in ICT era

24
Competition and Productivity Growth

• Absence of competition allows managers to be
  sleepy if ineffective control/monitoring by
  shareholders
• Competition is strongly positive for productivity
  outcomes in UK firms without dominant shareholder
  (Nickell et al., 1997)
• Competition promotes better management practices
  (Bloom and van Reenen, 2006)
• Patenting performance of UK firms suggests
  inverted U-shaped relationship with price-cost
  margin which peaks at about 20 (Aghion et al.,
  2005)

25
Policy Impact on Rate of Technology Adoption
Firm Type
Maximizing
Agency Problems

Competition Policy
Positive
Negative
Industrial Policy
Positive
Negative
Maximizing Firms Competition Policy lowers
expected profit from innovation Industrial
Policy raises expected profit from innovation
Agency Problem Firms Competition Policy cuts
rents and raises cost-reducing effort Industrial
Policy pays subsidies and lowers cost-reducing
effort
26
Regulation and the Growth Rate

• If regulation is a disincentive to investment and
  innovation, they will be lower as a result
• Endogenous growth models predict that the rate of
  growth will be adversely affected
• This would be the most serious consequence of
  excessive regulation rather than the diversion of
  resources through conventional compliance costs

27
Measuring Regulation

• Evidence on compliance costs quite limited
• Investigators looking at relationship between
  regulation and productivity performance have used
  indices constructed by OECD, World Bank and
  surveys of expert opinion conducted by IMD, World
  Economic Forum etc.
• Both product market and labour market indices
  available
• BUT how good are they?

28
Measures of Regulation

• Subjective vs Objective
• Comprehensive?
• Take account of enforcement and litigation?
• Include extraneous aspects?

29
IMD Survey Questions

• Business Regulations
• Regulation intensity does not restrain the
  ability of companies to compete
• Labour Regulations
• Labour regulations do not generally hinder
  business activities

30
OECD Regulation Indices

• Product Market Regulation (Conway et al., 2005)
  index designed to reflect the extent to which the
  regulatory environment is conducive to
  competition including indicators of state
  control, barriers to entrepreneurship
• Employment Protection (OECD, 2004) index
  designed to reflect legislation as employer-borne
  tax on employment adjustment including difficulty
  of dismissal and extent of severance pay

31
Is the UK Lightly Regulated?

• OECD measures say yes
• Subjective indicators more equivocal, cf. IMD
  scores where UK has been slipping down the league
• Overall, within OECD UK closer to relatively
  liberal group including Australia, Canada,
  Denmark, Ireland, USA than the relatively
  strict group including France, Germany, Greece,
  Italy, Portugal and Spain

32
Business Regulations, 2005 (0-10) (Source IMD,
2005)
33
Labour Regulations, 2005 (0-10)
34
Product Market Regulation (0-10)
1998 2003
France 4.17 2.83
Germany 3.17 2.33
Italy 4.67 3.17
Spain 3.83 2.67
UK 1.83 1.50
USA 2.17 1.67
35
Product Market Regulation and Productivity Growth

• Regulation that creates barriers to entry raises
  mark-ups and reduces innovation, investment and
  productivity growth (Griffith and Harrison, 2004
  Griffith et al., 2006)
• At the macro level de-regulation has been
  associated with better TFP growth (Nicoletti and
  Scarpetta, 2003)
• Product market regulation is negatively
  correlated with the contribution of ICT-using
  services to aggregate productivity growth
  (Nicoletti Scarpetta, 2005)
• UK shows up well on OECD measures compared with
  other European countries

36
Multifactor productivity acceleration and product
market regulation
Difference in average MFP growth rate between
1990-2000 and 1980-1990 Adjusted for hours worked
Correlation coefficient -0.51 t-statistic -2.29
Product market regulation, inward oriented, 1998
Source Nicoletti Scarpetta (2005)
37
Regulation and the contribution of ICT-using
services to aggregate productivity growth
ICT using services, 1996-2001
Correlation coefficient -0.62 t-statistic -3.35
Product market regulation (inward-oriented), 1998
Source Nicoletti Scarpetta (2005)
38
Retail Trade Labour Productivity Growth ( per
year)
1990-5 1995-2001
US 2.0 6.5
EU 1.7 1.3
Germany 2.8 0.7
UK 1.2 3.7
France 2.1 1.9
Italy 1.3 1.1
39
Implications for Regulatory Impact Assessments

• The Competition Assessment component is important
• In practice, this is often cursory and there is
  scope for more timely liaison with OFT (National
  Audit Office, 1006)
• Traffic Light Scores 1 7 5
• Is the competition filter (5 yes out of 9) in the
  RIA too weak?

40
ICT Expenditure and Employment Protection
Legislation

• Are inversely correlated
• Firing costs delay adoption of ICT but do not
  generally deter investment
• Effective use of ICT often involves upgrading
  labour force skills and re-organization, i.e.
  labour turnover

41
Employment Protection Index (0-10)
1980 1990 1998 2003
France 6.50 7.05 7.00 7.00
Germany 8.25 7.60 6.50 5.60
Italy 10.00 9.45 7.50 4.85
Spain 9.55 8.70 7.00 7.50
UK 1.75 1.75 1.75 1.75
USA 0.30 0.50 0.50 0.50
42
IT Expenditures and Employment Protection
Legislation
IT Expenditures ( of GDP), 1999
Correlation -0.72
Employment Protection Legislation, Index, 1998
43
Reduction in PMR and UK Productivity Performance

• Nicoletti and Scarpetta (2003) results imply UK
  has had modest TFP growth advantage over France
  and Germany in the past 20 years
• This is reflected in decline in TFP (but not
  other) component of labour productivity gap.

44
A Decomposition of UK Labour Productivity Gap
(percentage points)
France/UK Germany/UK
1979
Labour Productivity Gap 31 30
Labour Quality 6 5
Physical Capital 17 9
TFP 8 16
2000
Labour Productivity Gap 21 17
Labour Quality 4 4
Physical Capital 17 12
TFP 0 1
Note In 1979 Germany is West Germany only.
45
Change in TFP Growth over 10 years from Adopting
Best Regulatory Practice ( points)
46
Conclusions

• Regulation does have implications for TFP
• In particular, this is true of regulation that
  inhibits competition
• Administrative costs of compliance are not the
  key issue