Chapter 4: Objectives of Economic Regulation
4.1 Background
52. The Government's primary objective, in reviewing the regulatory provisions of the Commerce Act, is to ensure that economic regulation in New Zealand provides for the long-term benefit of consumers within New Zealand.
53. The presumption of the Commerce Act is that competition is the most effective means to achieve long-term consumer welfare in most cases.5 It is generally agreed that competitive markets deliver benefits to consumers over time by incentivising firms to deliver the goods and services consumers want and to improve prices and quality. In order to make profits in a competitive market, firms must invest and innovate, lower their costs and prices and/or improve quality.
54. Thus most of the Commerce Act is designed to maintain and promote competition by prohibiting or restricting anti-competitive conduct (Part 2) and restraining business acquisitions which substantially lessen competition unless there are net public benefits (Part 3).
55. However, there are some markets where there is little or no scope for competition. This occurs particularly in markets with natural monopoly characteristics; that is, where there are economies of scale, sunk costs and barriers to entry such that it is only economic for one firm to supply the market. Such markets typically occur for basic infrastructural or utility services where substitutes are not readily available.
56. In these markets the basic dynamic of competition, or the threat of competition, is absent. The effect of this is that a natural monopolist will have the incentive and scope to raise price and restrict the quantity and/or quality of the good or service offered. In other words, an unregulated natural monopoly could earn very substantial profits, or "monopoly rents", since consumers will be willing to pay prices well above cost as there is no alternative supply. This is especially true in the case of "essential services" such as electricity, where electricity lines businesses have strong natural monopoly characteristics. These "monopoly rents" are considered by many to be unfair and potentially inefficient, especially when they occur in the supply of essential services.
57. As such, economic regulation seeks to mimic, in a market with little or no competition, the outcomes that would occur in a market with workable competition. That is, both the pro-competitive provisions in Parts 2 and 3, and the regulatory provisions in Parts 4, 4A and 5 strive to achieve the same outcomes. The difference lies in the instruments used to realise that goal.
4.2 Possible efficiency and distributional outcomes
58. There are a number of outcomes that may result from economic regulation. These are grouped below in terms of efficiency outcomes and distributional outcomes. Efficiency effects relate to how efficiently the economy uses its limited resources and incentivises investment and innovation. Distributional effects relate to the share of benefits to consumers and producers arising from regulation.
Efficiency outcomes
59. With lower prices, output in the regulated market will expand, improving the efficiency of resource use in the economy (allocative efficiency). The size of this effect will depend on how price-responsive demand for the product is. In markets for essential services such as electricity, demand is not very responsive to price and so the allocative efficiency gain is likely to be small.
60. The monopolist might produce more or less efficiently than it did prior to regulation (productive efficiency) — this will depend in part on the level of efficiency the monopolist was producing at prior to regulation and the share of any efficiency gains regulation allows the monopolist to keep as increased profit. Note that in a competitive market, a firm that fails to minimise costs will be unable to compete. A well-designed regulatory regime seeks to replicate this outcome.
61. The monopolist may face stronger or weaker incentives under regulation for investing in new assets, maintaining existing assets, and/or innovating (dynamic efficiency). Dynamic efficiency means ensuring that there is an appropriate level of investment and innovation to meet future consumer demand.6 Dynamic efficiency may improve if regulation is designed in such a way that it encourages the regulated firm to invest. On the other hand there may be diminished incentives for investment and innovation because of a lower rate of return for the monopoly on such investment. A competitive market provides strong incentives to invest and innovate efficiently, since innovation provides an opportunity to command a premium over competitors, at least for a period of time. A well-designed regulatory regime seeks to replicate this outcome, and in particular to avoid disincentivising investment.
62. There will be costs incurred by the regulator (in administering the regime) and the regulated business (in complying with the regime).
Distributional outcomes
63. As a consequence of economic regulation, consumers (both households and downstream businesses) should face lower prices and/or improved quality (i.e. increasing consumer surplus) while the monopolist receives less for the regulated product (i.e. reducing producer surplus). That is, producers will be prevented from appropriating or keeping monopoly rents, resulting in a redistribution of economic rent from producers to consumers.
Graphical representation of monopoly impacts
The following simplified diagram illustrates the problem of monopoly. In the absence of competition, the monopolist raises prices above costs and restricts output.
Consumers are worse off as a result of the higher price (the loss measured by the two shaded areas).
The higher price benefits the monopolist, who sells less but receives more per unit (the darker shaded rectangle).
There is an allocative efficiency loss (deadweight loss) equivalent to the lighter shaded triangle (this simple representation does not capture productive or dynamic efficiency effects).
Note also that the more inelastic (steeper) the demand curve (which is characteristic of demand for basic infrastructure services) the smaller the allocative inefficiency from monopoly pricing, and, hence, the smaller the allocative efficiency gains from regulation.
Weighing up efficiency and distributional effects
64. There are clear economic benefits and costs arising from regulation. The economy potentially benefits from improvements in the allocation of resources, any lowering of production costs and improvements in the incentives for appropriate investment. On the other hand, there are direct costs to the economy from devoting resources to administering and complying with regulation, and potential indirect costs such as weakened incentives for investment and innovation.
65. In practice, measuring these economic effects can be difficult. The Commerce Commission has done this as part of its inquiries into whether sectors should be regulated (i.e. gas pipelines and airports inquiries). In recent evidence in relation to the decision on gas pipelines, the Commission has indicated that its methodology is likely to show that there will be net economic costs from regulating in virtually all cases.
66. Whether the redistribution of wealth from producers to consumers should be regarded as a benefit of regulation is more contentious. One argument is that since these wealth effects are a redistribution or transfer from one group (producers) to another (consumers), the respective gains and losses offset each other with no net gain to the economy and so should not influence the decision to regulate.
67. Another argument is that the redistribution matters for economic performance. The presence of monopoly profits could encourage wasteful "rent-seeking" behaviour as the monopoly seeks to protect or capture these rents, or it could mean reduced incentives for investment and innovation in businesses downstream of the monopoly. It could also be argued that distribution matters for social cohesion reasons and for the sustainability of economic growth (although this argument would need to be judged in the context of wider Government policies affecting income distribution and social protection).
68. It could also be the case that distributional outcomes matter simply because society considers that the outcomes from leaving a monopoly unregulated are unfair. This is a value judgement that Ministers are best placed to make a final decision on — taking account of factors such as the nature of the consumers and producers in the market, the materiality of impacts on consumers (e.g. share of total household budget) and the impact of other current or potential government policies to mitigate impacts on consumers.
4.3 Alternative objectives for economic regulation
69. The potential benefits and costs arising from regulatory intervention will depend on the specific circumstances of the sector in question. This means it is not possible to make an a priori judgement that regulation will lead to better outcomes for New Zealand compared to the outcomes from leaving the sector unregulated. The key question is how should the Act guide Ministers and the Commission in terms of how they should weigh up the various factors?
70. Four broad alternatives are:
- Economic efficiency or total surplus standard;
- Framing the test so that improving economic efficiency is the primary purpose of regulation but that distributional outcomes also matter;
- Framing the test so that improving consumer welfare is the primary purpose of regulating but recognising that impacts on economic efficiency also matter; or
- Consumer surplus standard.
71. The table below compares these alternatives.
| Test |
Impacts on economic efficiency considered? |
Distributional outcomes considered? |
Comment |
| Economic efficiency standard |
Yes |
No |
Counts only net efficiency gains — assumes transfers from producers to consumers offset each other in terms of overall community welfare. |
| Economic efficiency primary objective |
Yes |
Yes |
Assumes that generating efficient market outcomes is the primary objective for regulating.
Test asks whether there is a net efficiency gain, if not, it requires a judgement on whether distributional outcomes are substantial enough to justify incurring net efficiency costs.
Requires consideration of the value of distributional outcomes. |
| Consumer welfare primary objective |
Yes |
Yes |
Assumes that generating consumer welfare improvements is the primary objective for regulating.
Counts consumer gains as a benefit and requires a judgement on whether any efficiency costs necessary to bring about this gain are acceptable.
Assumes distribution outcomes are a benefit. |
| Consumer surplus standard |
No |
Yes |
Counts only the benefits that consumers receive from lower regulated prices. |
72. If net economic efficiency is found to be increased by regulation, a judgement would not generally be needed to balance off efficiency and distributional objectives, as the middle two tests would be effectively equivalent.
73. In the situation where economic efficiency is found to be reduced (which has been argued by the Commission, and others, is likely in most cases):
- a test with consumer outcomes as the primary objective, will lean toward regulating unless the efficiency costs are considered "too high";
- a test with economic efficiency as the primary objective, will lean toward not regulating unless the distributional outcomes are considered of sufficient value to justify regulating.
74. In the Ministry's view, both economic efficiency and distributional objectives are important and should be considered in the judgement on whether or not to regulate in any particular circumstances.
75. Note that there is a question of whether regulatory provisions should be designed to limit/minimise or eliminate/prohibit monopoly rents. However, because the costs of regulatory error tend to be asymmetric (i.e. the cost of errors leading to too-tough control terms and potential under-investment are likely to outweigh the costs of errors allowing higher than normal rates of return) the rest of this document focuses on the objective of limiting, rather than eliminating, monopoly rents.
Current position
76. The current framework under Part 4 lacks a clear purpose statement and there is some dispute over the test that should be applied. In practice, the Commission uses a "Net Acquirers" Benefit test. This test, which is based on the wording of s 52 of the Act, focuses on benefits to acquirers of the good or service to calculate benefits to acquirers after netting off estimated efficiency costs. The resulting estimate of Net Acquirers' Benefit is then compared with estimated efficiency costs through an estimated transfer-cost ratio. This test has a consumer benefits/wealth transfer flavour.
77. There have been "control inquiries" into whether regulatory control should be declared in respect of airport activities and gas pipeline services.
78. In both instances, there were negative net public benefits of control (i.e. negative efficiency effects) but positive benefits to acquirers of the services (i.e. positive welfare effects).
79. In the Airports Inquiry the Commerce Commission recommended control of Auckland International Airport but the Minister decided that control was not desirable because the benefit to acquirers was relatively small, especially relative to the efficiency costs of control.
80. In the Gas Pipelines Inquiry, the Minister agreed with the Commerce Commission's recommendation and decided that some gas pipeline services should be controlled because the gains of control to consumers were sufficiently large to outweigh the loss in overall economic efficiency resulting from control.
81. Thus, Government policy to date has been to treat consumer welfare effects as a benefit (i.e. to regulate for distributional reasons), as long as the effect on overall economic efficiency is acceptable relative to the gains to consumers.
Questions for submitters: Chapter 4
Q1. Do you agree that a regulatory regime needs to be available to address issues in markets with monopoly characteristics?
Q2. Do you consider that the sole or primary objective of a regulatory regime should be economic efficiency or consumer protection (distribution), or do you consider that both should be taken into account?
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