Economics for Effective Regulation
63 Pages Posted: 9 Mar 2017
Date Written: March 9, 2016
Economics for Effective Regulation (EFER) is a new methodology for regulatory economic analysis. This paper discusses how it can help the FCA meet its new challenges. Specifically, the FCA’s strategic objective is to ‘make the relevant markets work well’. To achieve this objective, it often needs in-depth analysis of outcomes at the level of the market, as well as of the drivers of poor market outcomes and what can be done about them. Relative to its predecessor, the FCA needs to meet higher standards for assessing the effects of its interventions to comply with its new competition obligations and legal requirements for the cost benefit analyses (CBAs) that it is required to publish when consulting on new policy.
EFER is a market-based approach to the design of regulation. It produces a combined assessment of all the main problems facing regulators who want to make markets work well: information asymmetries, externalities, market power, and behavioural distortions, as well as any unintended consequences of previous interventions that arose from market responses to changes in the regulatory environment.
EFER has three key stages: problem diagnosis, intervention design and impact assessment. In this paper, we describe these stages, explain how they support effective regulation, and provide tools for applying the framework in practice. The tools will help regulators identify the underlying problems in the markets and the harm that arises as a result. They will also help regulators assess what interventions could best remedy the problems.
This new methodology draws on recent advances in academic research and regulatory best practice to extend conventional approaches to regulatory economic analysis in a number of ways. In particular, it:
• incorporates more explicit and structured consideration of behavioural biases and competition problems—both of which are increasingly recognised by regulators as playing an important role in driving poor market outcomes;
• recognises that severe cases of poor outcomes in markets frequently arise because of the interactions of multiple underlying problems, which need to be analysed and tackled together for regulation to be effective;
• stresses the importance of considering market participants’ likely dynamic responses to significant interventions in markets; and
• tackles some challenging questions for cost benefit analysis (CBA), such as measuring the indirect effects (costs or benefits) of interventions or analysing welfare impacts on consumers, and recognises where textbook approaches to these issues are impossible and pragmatic alternatives are needed.
These extensions can make the analysis more complex. As a result, many of the elements in EFER are likely to be proportionate only for major interventions. Finally, and at the risk of stating the obvious, while the contribution that economic analysis makes to regulation is significant, strategy and policy must also be influenced by supervisory insights, governmental and EU considerations, and the tools and insights of competition enforcement.
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