Deregulation and evaluating market-based supply-side policy

Overview

Deregulation lower firms’ costs, deregulation raise the contestability of a market and main risks of deregulation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is deregulation?

   Model answer

   Deregulation is the removal or relaxation of rules and legal restrictions that limit how firms may operate, who may enter an industry, and what they may charge. It includes ending statutory monopolies, abolishing licensing requirements that keep entrants out, simplifying planning and reporting requirements, and reducing restrictions on working practices. The aim is to lower firms’ costs and to make markets more contestable so that competitive pressure forces efficiency.

2. 2

   Give three examples of deregulation in practice and say what each was intended to achieve.

   Model answer

   Opening bus and coach routes to any operator that met safety standards was intended to end local monopolies and force fares down through competition. Ending the exclusive right of a single supplier to sell electricity, gas and telephone services was intended to let new entrants compete on price and service. Relaxing planning restrictions on building and on converting commercial premises to housing is intended to increase the supply of homes and reduce the cost of premises for firms.

3. 3

   How does deregulation lower firms’ costs, and what happens to the aggregate supply curve as a result?

   Model answer

   Compliance with rules absorbs management time, requires paperwork and legal advice, and sometimes forces firms to use more expensive methods or materials than they would otherwise choose. Removing unnecessary requirements reduces these costs so that firms can supply any given output at a lower price. On a diagram with the general price level on the vertical axis and real national output on the horizontal, short-run aggregate supply shifts right, and to the extent that lower barriers also encourage entry and investment, long-run aggregate supply shifts right too, so real output rises and the price level falls.

4. 4

   How does deregulation raise the contestability of a market, and why does that matter for efficiency?

   Model answer

   Regulations such as licences, exclusive franchises and heavy approval requirements act as barriers to entry that protect incumbents from challenge. When they are removed, the credible threat of new firms entering forces incumbents to keep prices close to costs and to cut waste, even if entry never actually occurs. The result is lower prices, less organisational slack and stronger pressure to innovate, all of which raise productive efficiency and therefore the economy’s capacity.

5. 5

   What are the main risks of deregulation?

   Model answer

   Regulations often exist because an unregulated market produces outcomes society will not accept, so removing them can allow pollution, unsafe products, dangerous working conditions or the mis-selling of financial products. Where an industry is a natural monopoly, deregulation may simply transfer market power to a private owner who restricts output and raises price. Deregulation can also produce short-term competition followed by consolidation, leaving consumers facing a small number of large firms once the entrants have been driven out.

6. 6

   How can some regulation raise, rather than reduce, the long-run productive capacity of an economy?

   Model answer

   Rules that require safe workplaces reduce injury and absence, so the effective supply of labour is larger and more productive, and rules that limit pollution protect the natural resources and the health on which future production depends. Prudential rules on banks reduce the risk of a financial crisis that would destroy capacity for years. Well-designed standards can also create a common platform on which firms compete, lowering transaction costs, so the question is not whether to regulate but whether each individual rule delivers benefits that exceed the compliance cost it imposes.

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