ANNALS OF ECONOMICS AND FINANCE 5, 185–210 (2004) University of Toulouse (IDEI, ARQADE, GREMAQ-CNRS) This paper focuses on public utilities (telecommunications, electricity, gas, water, transportation (roads, railways, buses, ports, airports,. . . ) andpostal service) which are sometimes referred to as economic infrastructures.
It does not concern itself with the so-called social infrastructures such aseducation and health, or with the financial infrastructures. There is littledebate today regarding the fact that, when possible, public utilities shouldbe privatized (although several developing countries did not succeed indoing so).1 As a result, this paper will not cover issues of privatization. Itwill, instead, discuss the specific questions surrounding the regulation andliberalization of public utilities in developing countries. To that end, wefirst discuss the characteristics of developing countries that have a bearingon the analysis of regulation and competition policy.
An essential concept in this discussion is the marginal cost of public funds, that is, the social cost of raising one unit of funds. This cost in-cludes a deadweight loss2 because governments raise revenues by meansof distortionary taxes. It is estimated that this deadweight loss amountsto 0.3 in developed countries, meaning that it costs citizens 1.3 units ofaccount every time that the government raises 1 unit. The inefficiencyof tax systems in developing countries, coupled with the corruption thatis sometimes also present, makes it extremely difficult for governments toinvest in infrastructures and affects the cost of all types of public interven-tions, particularly, regulation and competition policy. According to WorldBank data, the deadweight loss in developing countries is well beyond 1.
It has been estimated at 1.2 in Malaysia and 2.5 in The Philippines, whilein Thailand it ranges between 1.2 and 1.5 (Jones, Tandon and Vogelsang, * I thank Xinzhu Zhang for many insights about the Chinese regulatory framework.
1See Laffont and Meleu (1999) for a positive theory of privatization for Africa.
2The deadweight loss depends on the type of tax used because the tax systems are Copyright c 2004 by Peking University Press All rights of reproduction in any form reserved.
1990; Mookherjee, 1998). In developing our analysis we take the high costof public funds as a given because, although tax reforms are necessary inmany developing countries, it is unlikely that they will be in place quicklyowing to the many financial, human and political variables involved.
An essential instrument of regulatory and competition agencies is the ability to audit costs. Yet, developing countries are hampered by a lack ofwell-developed accounting and auditing systems (Trebilcock, 1996). This isdue to the lack of proper training programs; to the political and social diffi-culties that hamper the payment of incentive salaries to auditors to rewardeffort and discourage corruption; to the lack of up-to-date technology suchas computerized systems (which makes it harder to discover cost paddingand evaluate real costs); and to the inability to impose high penalties incases of documented wrongdoing (because of the strong limited liabilityconstraints of most economic agents).
Many developing countries also suffer from widespread corruption due, in particular, to the low internal costs of side transfers. When two parties(such as a firm and an auditor or a bidder and the auction organizer)arrange a private deal, they must take into account the costs of beingdiscovered and the need to use indirect compensation (which is less efficientthan direct compensation). The cost of these side transfers is expected to belower than in developed countries because they are more difficult to identifyand, in addition, social norms may place a positive value on some types ofside transfers (for example, when they take place within families, villages orethnic groups). Accordingly, it is more difficult to fight corruption (Tirole,1992).
Inefficient credit markets and the sheer lack of wealth make limited li- ability constraints more binding in developing countries. It is importantto stress this point because many of the problems in regulation and com-petition policy result from difficulties in borrowing and attracting foreigncapital. It is also worth highlighting the complementarity of general com-petition policy and good banking sector regulation. When the bankingsector is inefficient and makes borrowing costly or impossible, an effectivecompetition policy may destroy the rents that allow firms to invest, or maycreate instability.3 Other characteristics that hamper public utility regulation concern the government. In particular, two characteristics of developed countries thatare often missing in developing countries are constitutional control of thegovernment and some degree of ability to enter into long-term contracts.
The lack of the checks and balances typical of well-functioning democracies(supreme courts, government auditing bodies, separation of powers, inde- 3Mishkin (1997) concludes that “developing countries may need to move slowly in financial liberalization in order to keep a lending boom from getting out of hand”.
pendent media4 makes the governments an easier prey to interest groupsand patronage. The lack of political democracy and well-functioning politi-cal institutions increases the uncertainty of future regulations and makes itdifficult for the government and the regulatory institutions to make credi-ble commitments to long-run policies. Consequently, the economic policiesof developing countries are even more sensitive to ratchet effects and rene-gotiations.
Another shortcoming of developing economies is the weakness of the rule of law. Poor enforcement of laws and contracts biases contracting towardself-enforcing contracts or leads to renegotiations.
Finally, it is essential to stress that the liberalization and deregulation of public infrastructures in developing countries often fails to attract thelevel of foreign capital that is necessary.
These features will be kept in mind throughout the discussion that fol- lows, and when necessary specific advise for dealing with these difficulties inregulating and promoting competition in public utilities will be presented.
Section 2 discusses the structuring of regulatory agencies that favor com- petition, and the trade-offs involved in choosing whether or not to engagein the vertical disintegration of incumbent monopolies between the com-petitive segments and the natural monopoly ones. Section 3 presents theregulatory rules required by the monopoly segments in developing coun-tries. The crucial issue of the management of the interface between themonopoly segments and the competitive segments is addressed in Section4 where access-pricing rules adapted to developing countries are discussedin greater detail. Section 5 is devoted to competition policy per se forthe segments opened to competition. Concluding comments are offered inSection 6.
A first consideration in structuring the government entity that will have responsibility for regulation and competition policy is whether these func-tions should be the purview of one integrated agency or separated ones. Inthis regard, recent experience in Australia and New Zealand is enlightening.
New Zealand employed a very novel approach to regulation, relying only on general competition laws enforced by the courts and by an industry-widecompetition authority. This approach was first used to regulate telecom-munications and then power. The notion of self-regulation by industry 4See Besley and Burgess (2001) for an empirical study of government responsiveness was also introduced. In this case, industry participants form councils tonegotiate the main rules and access conditions.
Although New Zealand’s experiment was not an immediate failure, the government recognized, after some years, that there was still a need forregulatory control of industries that are not competitive enough. Indeed,this proved necessary even in telecommunications, which is the most com-petitive industry of the ones we are considering here. The concern is thatlight control of the industry is not sufficient to contain abuse of dominantposition. The number of cases brought before the courts show that rapidtechnological change and the technology intensive nature of the industrymake it difficult to find a firm guilty of abuse of dominant position. More-over, the procedures involved make for very long delays. As a result, relyingsolely on competition laws has proved inefficient even when these laws arewell developed and enforced. On the basis of this experience, therefore, wecan conclude eschewing regulation is not the right option.
Integrating general competition policy and regulation into a single agency is only possible if the regulatory agency is a multi-industry one as in Aus-tralia. Australian regulation is organized around a federal multisectoralagency (the Australian Competition and Consumer Commission—ACCC),specialized agencies, and regional regulation. The ACCC is composed ofsectoral and functional bureaus and coordination entities. The Commis-sion deals with product safety, consumer protection, access, mergers andrestrictive trade practices in all the sectors under study in this report.
The ACCC was created in 1995 following the recommendations of the Himler Report. It has taken over a nonnegligible part of the duties of spe-cialized regulators by acquiring responsibility for promoting competition ina larger sense. For example, the regulatory body responsible for telecom-munications was closed after the creation of the ACCC. The Utility Reg-ulators Forum, created in 1997, is responsible for coordinating regulatoryactivities within the ACCC. The Australian case involves integration atthe federal level of regulation and competition, even if regional agencies arealso used. This system can be compared to the one prevailing in the UnitedStates where multisectoral ruling takes place at the state level, specializedregulation is the responsibility of the federal government, and competitionpolicy is dealt with separately.
Integrated regulatory agencies are attractive option for developing coun- tries because they face a significant shortfall in adequately trained person-nel. This is especially the case for the telecommunications, electricity andgas industries. While there are substantial economies of scope between theregulatory institutions of those industries, they seem much less importantbetween regulation and competition policy. To avoid creating a too pow-erful institution, we would generally favor a separate competition agencyand, except for very large countries, integrated regulatory agencies at the federal level. The only exception might be water which could remain atthe local level. Technological intensity requires federal regulation to reducecosts, but accountability requires more decentralized institutions.
Good advice on this structural issue must take into account political constraints, initial conditions and industry specifics. The variety of solu-tions implemented in developed countries and the experience of the differ-ent Latin American countries (Argentina, Chile, Peru, Brazil, Bolivia. . . )suggest that the trade-offs are complex. They involve balancing differenti-ation versus coordination; creative versus destructive competition betweenregulators (see Laffont and Pouyet, 2000); better enforcement by local au-thorities versus better control by the government; local corruption versusfederal corruption (see Bardhan and Mookherjee, 1999); industry specificexpertise versus sharing resources; and diversifying the risks of institutionalfailures versus coordination (Aubert and Laffont, 2000; Smith, 2000).
Box 1. The Structure of Regulatory Agencies in ChinaGeneral speaking, China has a mixed structure of regulatory agencies consist- ing of both industry-wide and sectoral agencies (ministries or departments) atboth central and regional levels. According to the law, the State Developmentand Planning Commission (SDPC) is the government body in charge of priceregulation of public utilities. Another major SDPC’s authority is to regulatemarket entry and investments in public utilities. In addition to the SDPC, thereare also some sectoral specific ministries that complement the SDPC includingthe Ministry of Information Industry (regulatory agency of telecommunications)and the Ministry of Railways etc. The later ones are generally the implemen-tation bodies.
Another structural feature of the Chinese regulatory agencies is the hierar- chical structure between the central and local regulatory bodies. First, thereare regional SDPCs along each layer of administrative governments. Similarly,there are some implementation bodies, either industry-wide or sectoral, at eachlocal government level that complement regional SDPCs. The separation ofpower between the SDPC and local SDPCs is that the former is usually incharge of the control of entry and investments for big projects and the approvalof price adjustment proposals submitted by local SDPCs while local SDPCstake care of smaller projects and make price adjustment proposals.
The general trend in the reform of regulatory structure is to delegate more and more of the regulatory power to regional governments. For instance, toprovide incentives for the regions to make investments in electric power, thecentral government has given to local governments the authority to approve en-try and investments in electric generation. It also allows the local governmentsto make price purchase arrangements with independent power producers, sub-ject to the approval of the SDPC. As a result of decentralization of regulatorypower, installed generation capacity has increased rapidly and substantially sothat China has in some sense solved the shortage of energy problem since 1998,which plagued the economy for a long time. It is also the case in telecommuni-cations where except for basic telecom services including fixed-line and mobilephone services, not only extensive deregulation has taken place nationally, butalso that when regulations remain, local regulatory agencies have gained muchmore discretion in terms of approval of market entry and investments and priceregulations. Similar delegations have also happened in the gas and transportsectors etc.
With respect to the structural choice between industry-wide versus sectoral regulators at the central government level, the trend is not clear at the momentsince until recently, the reform of regulatory agencies have focused on separatingmanagement from regulatory and policy making functions and the attempts toset up independent regulatory agencies in China’s context have begun onlyrecently. Indeed, the government just announced that an electric regulatoryagency will be created which is the first of its kind in China, at least judged bythe name and the status of it. But this event comes within a specific institutionalsetting, because unlike telecoms, railways, and transport etc., there is now nospecific regulatory body in charge of electric regulation in China.5 In otherwords there is in some sense a vacuum of power in the regulation of electricity.
So it is really hard to judge at this moment whether it will be another old styleimplementation agency just bridging this power gap or it is going to be a realinstitutional innovation which signals that the government has determined totake a sector specific agency approach which will eventually take the regulatorypower of electricity away from the SDPC.
The industries under consideration were formerly public natural monopo- lies providing public services such as telecommunications, electricity, gas ortransportation. Segments of these industries are now viewed as potentiallycompetitive. Some examples are long distance telecommunications serviceand electricity generation. These are, therefore, the segments opened tocompetition. Other segments continue to be considered natural monopo-lies. These include, for example, the electricity transmission grid, railwaytracks, and to some extent so far the local loop in telecommunications.
These industry segments remain regulated and may eventually face newforms of regulation (see Section 3).
Three types of market structures can be envisioned for these industries: (1) vertical disintegration, (2) vertical integration and (3) competition ininfrastructures. Under vertical disintegration the firm controlling the bot-tleneck (the natural monopoly segment) is not allowed to compete in theservices using the bottleneck as an input. For example, the local telephonecompany owning the local loop is not allowed to compete in long distanceservice using the local loop to access consumers. In the case of vertical in-tegration, the firm controlling the bottleneck becomes one more competitoramong many service providers using the bottleneck as an input. Finally, inthe case of competition in infrastructures, competition then takes place be-tween vertically integrated firms, each of which controls a restricted accesspoint and provides services.
The comparison between the first two cases raises the issue of the economies of scope that vertical integration makes possible, and the problems of fa- 5The Ministry of Water Resources and Electricity was restructured and disappeared in 1998 and the regulatory functions, were taken over by the State Economic and TradeCommission, another government agency which mainly takes care of the managementof SOEs.
voritism it raises. The bias in developing countries should be toward ver-tical disintegration because the economies of scope are likely to be inde-pendent of the characteristics of these countries (at least for given tech-nologies), while favoritism is more difficult to counter.6 Case 2 and case 3rest on a comparison of the fixed costs associated with competition in theprovision of the ”bottleneck” (like local telephony) and the gains one mayexpect from this competition (Auriol and Laffont, 1992). The comparison isdifficult for developing countries where the high cost of public funds makesmore expensive both the duplication of fixed costs and the informationrents resulting from a monopolistic provision of the bottleneck.
These comparisons are further complicated by the dynamics of the indus- try which may be moving towards case 3 as in the telecommunications in-dustry. Then, vertical disintegration may in fact slow down the emergenceof competition among vertically integrated firms providing both local andlong distance telephony. Recommending vertical disintegration may thenbe particulary inappropriate. However, for railways,7 gas or electricity,vertical disintegration of the track, the pipelines or the electric transmis-sion grid from transportation or the generation can be recommended ifcompetition in services is introduced.
In all these cases there is a choice between a single regulated entity that owns the tracks, the pipelines, or the grid, or shared ownership of thebottleneck by users who agree on rules for using it. The comparison is herebetween the inefficiency of regulation and the free-rider problems of jointownership. In a country where regulation is easily captured one may favorthe second alternative, despite the lack of consumer representation that itentails.
A particular problem for the gas industry is the market power of produc- ers, especially when there are foreign producers involved. The bargainingpower of consumers with respect to producers may be enhanced by the exis-tence of a vertically integrated network operator who also owns gas fields.
This argument is used in Europe with respect to the supply by Algeria,Russia and Norway, and also in Argentina where YPF (recently acquiredby Repsol) sells more than 60 percent of the gas produced.
More generally, there is a question about the affordable competitiveness of the market structure, given that developing countries also need to attractforeign capital.
6This should be balanced with another consideration which is the importance of trans- action costs which will be higher in case 1 due to the lack of enforceability of contractsand the lack of commitment which produces constant renegotiations. See also Ordoveret al. (1994). Another consideration in small countries and some industries such aselectricity, is that only a vertical structure provides a critical level of business attractingthe interest of foreign investors.
7Except maybe where competition by roads or (for large countries) competition be- tween vertically integrated firms interconnected with reciprocal access rules is possible.
Box 2: The Structure of IndustryThe general trend is to separate the monopolistic segment from competi- tive ones. In other words, vertical separation is taken to be the mainstreamrestructuring form of industrial structure. For instance, mobile services wereseparated from the incumbent, China Telecom, in the restructuring reform ofthe telecom sector in 1998. In electric power, the government just approveda new restructuring plan to separate generation from transmission and distri-bution even though transmission and distribution will remain to be integratedfor a while. As can be expected, this move is driven by the desire to facilitateefficient regulation and prevent favoritism.
However, the government didn’t approach the restructuring uniformly. In- deed, other forms of industrial structure such as vertical integration and com-petition in infrastructures have also been implemented or allowed to exist. Inthis regard, it is interesting to contrast the different restructuring approachesin electricity and telecommunications.
In the power sector, entry in generation was allowed to independent power producers since mid 1980s while the State Power Company owned not only themonopolistic transmission & distribution networks but also competitive gen-eration assets. Given the general situation of shortage of generation capacity,everything proceeded smoothly until excess capacity of generation and capacityconstraints of transmission appeared since 1998. Then, serious problems of fa-voritism have been claimed when the State Power Company no longer wantedto dispatch the power from independent power producers. Indeed, the powermarkets have become quite segmented among different regions and power ex-changes among provinces count for only about 20% of total transactions whichis considered not reasonable given the huge geographical differences, with East-ern China being the load center and having no generation assets and WesternChina being endowed with much of the resources for power generation (riversand coal mines). Worries about the serious favoritism problem, particularlywhen more stations such as the Three Gorges Project are going to generatepower soon, and the desire to build an integrated national market have con-tributed to speed up the restructuring reform in the power sector. Recently, thegovernment approved a new reform package in which separation of generationassets from transmission and distribution is one of the main contents. That isvertical separation will be adopted in the power sector.
In the case of telecommunications, however, a different approach has been adopted from the beginning. More precisely, competition in infrastructures wascreated in the telecom sector. This has been implemented in two ways. Onthe one hand, entry was liberalized in the competitive services and competitorsneed to buy access from the incumbent. For instance, beginning in 1994 whenChina Unicom was created, competition was introduced in long distance, mo-biles, and data services even though China Telecoms still kept the dominantposition in local services the access of which was needed by its rivals in com-petitive markets. It did cause some problems in creating competition in localservices, because China Unicom which can, as a matter principle, provide lo-cal services, has until recently only deployed network in three cities or regions,namely Tianjin, Chongqing, and Sichuan. Given the natural monopoly featureof local services, it should not come as a surprise. However, such institutionalarrangement did achieve an important policy goal, i.e., to increase the accessof telecommunications services. Indeed, the penetration rate of fixed lines hasreached 21 per 100 person, a remarkable achievement without any dispute byany standard. This puts China at a position that is ready for a leapfrog.
On the other hand, competition in infrastructures has also been introduced through restructuring of the existing operators. After the implementation of major restructuring in 1998 in which operation was separated from the gov-ernment functions and some services like mobile were divested, the Chinesegovernment initiated a new restructuring reform in 2001. The main theme thistime is to separate China telecom on a geographical basis, namely dividing itinto the South part which inherited the brand name and the North part whichwill be integrated with the China Netcom, originally a carriers’ carrier andwidely considered to be politically well connected. In addition, each companyis allowed to enter each other’s territory. After this round of restructuring, bothChina Telecom and China Netcom can provide long distance and local services.
Remember that China Unicom has been granted license in local services beforebut it has chosen to do it only to a limited extent. It seems that the governmentis not convinced by the natural monopoly argument of local services. Fueledby the desire to create competition in local services but also worried by thenetwork expansion needs, this time the government has chosen this horizontalrestructuring approach which will not only create competition in the marketbut also keep it viable.
It is important to note that competition pressures come not solely from within the same industry. Indeed, in the railways, competition by mode is themain form of competition and it works. Indeed, in response to the competitionpressures from road, airlines, navigation etc., the railways made great efforts toraise speed. A restructuring plan is being drafted by the government to separateinfrastructure from transport.
The regulation of natural monopolies requires finding a balance between efficiency and the cost of the information rents. High-powered incentiveschemes (such as price caps) which induce cost minimizing behavior yieldlarge rents to the most efficient firms, while low-powered incentive schemes(such as cost of service regulation) control those rents but create weakincentives for minimizing costs.
As stressed above, a major characteristic of developing countries is the high cost of public funds. It is easy to see that this high cost calls forhigher prices of the commodities produced by the natural monopoly andfor lower-powered incentive schemes (high shares of cost reimbursement).
Before presenting the intuitive reasoning for these results, it is importantto emphasize that we are assuming here perfect observability of cost andfull commitment of the regulator.
Intuitively, we know that higher costs of public funds mean a higher cost of giving up rents and also a higher inefficiency cost. However the relativecost of rents increases faster because when an additional rent is given up toa particular firm to support an efficiency improvement, the same incentivemust also be provided to all the more efficient firms. The optimal regulationsacrifices some efficiency in order to decrease such rents. Thus, this is anargument in favor of cost-plus schemes relative to fixed-price schemes or, in the language of regulatory theory, rate of return regulation versus pricecaps.
A higher cost of funds also means that it is more valuable to price above marginal cost, i.e., to use public utilities prices to finance fixed costs and thegovernment’s budget. In particular, it is a mistake to advocate marginalcost pricing for public utilities in developing countries.
The implied difference in pricing between developed and developing coun- tries can be substantial, since a move from a cost of funds of 0.3 to 1translates into a relative deviation from marginal cost which is double inthe second case. Since effort levels also decrease as cost reimbursementrules are tilted toward cost-plus schemes, marginal costs are higher and,therefore, prices should be even higher in developing countries.
Box 3: About the High Cost of Public Funds in China.
The high cost of public funds implies that it is better to finance the fixed cost and contributions to government revenues through tariffs or regulation taxrather than through general taxes. That is industrial wide budget balancingshould be maintained. In the power sector, for instance, prices were used tocover only operation and maintenance costs before 1992 and the investmentcosts were covered by the government through fiscal revenues. As a result,there was a lasting shortage of supply of power. Since then, electric tariffshave been raised to reflect full costs. More precisely, the Chinese governmenthas implemented the so called “one plant, one price” policy, which is essentiallymeant to guarantee full cost recovery regardless of the financing structure. Thishas helped to attract investments in the power sector.
Another important case is in telecommunications in which the installation fee was introduced since early 1990s. Indeed, about one third of each year’s capitalinvestments in network expansion was covered by installation fees. While thispolicy has been criticized a lot and the installation fee was eventually eliminatedin 2000, many argue that China would not have been able to develop so fast itstelecom infrastructure without the installation fee policy.
Still another example can be found in China’s railways where a special sur- charge was levied on the top of tariffs to finance the huge investment costs,which guarantee the funds necessary for the rapid development of railways net-works in China. Before this policy was introduced in late 1980s, however, allcapital expenditures of the railways sector had to be allocated from generaltaxes.
This issue also concerns a debate going or currently about how to finance the universal service cost in telecoms. The Chinese government is determinedto reform the current USO financing mechanism of cross-subsidization by cre-ating universal service funds. But it has been hotly debated whether or not itshould be the business of the Ministry of Finance or the Ministry of InformationIndustry or some other special agency.
The impact of monitoring on the power of incentives is quite different depending on the type of monitoring.
Monitoring of effort generally enables the regulator to reduce the in- formation rents and calls for higher-powered incentive schemes. A less- efficient monitoring technology will call for relatively less-powerful incentiveschemes. Indeed, low incentives and monitoring are substitute instrumentsto extract the firm’s rent. A decrease in the use of one instrument makesthe other instrument more attractive. As a result, an increase in the costof public funds induces low incentives both directly and indirectly (as ex-plained above) through a decrease of the more costly monitoring.
We have emphasized so far the strong assumption of perfect observability of costs. In practice, however, costs are not perfectly observable and onemust also take into account the possibility of cost padding, i.e., the manyways in which a firm can divert money. Cost can now be increased by unduecharges, which benefit the management and the workers. The analysis(Laffont and Tirole 1993) shows that the imperfect auditing of cost paddingcalls for a shift towards higher-power incentive schemes. In the extreme, ifauditing did not exist, only fixed-price contracts would be possible. Indeedthey would be the only ones preventing unlimited cost padding by makingfirms residual claimants of their costs. It is therefore very obvious thatweak auditing technologies, as can be expected in developing countries,will result in an even higher desire to shift toward fixed-price mechanisms.
This effect is reinforced by the savings in auditing costs resulting fromfixed-price mechanisms in countries with a high cost of public funds.
The impact of the lack of auditing cannot be overemphasized. It is a crucial point, which conflicts with the findings of the previous paragraphs,but easily dominates the other effects. In the absence of reasonable ac-counting, price cap regulation is the only way out. It is only through pricecap reviews that some cost elements can be brought in, leading to somecost-plus shift through the ratchet effect (see below).
Making cost information public may be a way for the regulator to im- prove the quality of accounting by fostering more truthful disclosure ofinformation by the firm, establishing its credibility for honest behavior.
Box 4: Monitoring and Auditing in China.
The weak monitoring and auditing system has major impacts on the regula- tory policies in China. For the moment, the Chinese government has chosen akind of cost of service regulation with strong cost-plus flavor, more precisely theadministered prices which in general have neither upward nor downward flexi-bility. Moreover, historical cost standards are adopted and cost disallowancesare rare. In theory, such pricing policy would need perfect observability of out-put or a good control system of monitoring and auditing, which are obviouslynot available in China. Constrained by such inabilities, the government mustask enterprises to make price adjustment proposals and then approve their pric-ing policy. As can be expected, these regulatory policies provide no incentivesfor enterprises to cut cost. But to appreciate the full impacts of such policies,one needs to realize that, like rate-of-rate regulation, there are also lags betweenprice adjustments. Moreover, these rigid prices have not been fully implementeddue to the weak enforcement power of the government.
The next point to consider is the need to devolve regulation to the reg- ulatory agencies or ministries. A main role of these institutions is to par-tially bridge the informational gap between public decisionmakers and theregulated firm. This gives rise to another issue, the possible capture ofthe regulatory agency by the firm. Such collusion will occur with greaterprobability if the stakes of collusion are high, if the cost of side transfersbetween the firm and the regulator are low, and if no incentive mechanismis in place for the regulators.
The stake of collusion amounts to the information rent that an efficient firm obtains when the regulator hides the fact that it is efficient. Fromour previous analysis, it is increasing with the level of effort chosen by theless-efficient firm (since it is equivalent to the gain obtained by an efficientfirm when it mimics an inefficient one). The maximum bribe that a firmwill be willing to offer to the agency is this stake. However, it should bediscounted by the price of internal transfers, which includes the cost ofbeing discovered as well as the need to use often-indirect transfers that areless efficient than monetary transfers. Capture is avoided if the agency ispaid an amount larger than the discounted value of the stake of collusionwhen it reveals the firm is efficient (we will call this constraint the collusion-proof constraint).
In the simplest cases, the regulatory response to the fear of capture is to satisfy the collusion-proof constraint at the lowest possible cost. Thisincludes shifting optimal regulation toward cost-plus schemes to decreasethe stake of collusion, and improving monitoring to increase the cost of sidetransfers.
Three features of developing countries call for even higher shifts toward cost-plus mechanisms. First, we can expect a lower cost of internal transfersbecause of less stringent monitoring of illegal activities. Second, incentivepayments to the agency are more costly because of the higher cost of publicfunds. Third, it may be politically more difficult to create such strongincentive payments.
So far we have dealt with a case where the optimal regulatory response entails no corruption. If we extend the framework to a case where, forexample, regulators are more or less susceptible to being corrupted (somerequiring low bribes, others requiring higher bribes), it may be optimalto let some corruption occur if the proportion of regulators requiring lowbribes is small enough. Creating incentive payments which suppress thecorruption of this type of regulators would be too costly, because the highpayments required to fight corruption would have to be incurred even forthe other type of regulators (for whom it is not necessary). Then, the samefeatures of developing countries, which militate in favor of low-powered incentive schemes (high cost of public funds, poor auditing technologies),suggest that it is optimal to let more corruption happen at equilibrium.8 Therefore, the effect of corruption appears complex. If we consider cor- ruption of cost auditing it calls for higher power incentives, but if we con-sider corruption in information reporting, lower powered incentives are re-quired.
Box 5: Hierarchical Regulation and Corruption in China.
Regulation of public utilities has been decentralized substantially in China both to the regional agencies and to the sectoral agencies. While no conclusioncan be drawn whether centralized or decentralized agency is more susceptibleto capture, there are some institutional factors that make regional regulationless robust to corruption.
On the one hand, the local regulatory agencies are subject to no effective control of the central government while the local governments can easily affecttheir policies. Such institutional arrangement will necessarily cause concerns ofmarket segmentation or favoritism to local players. On the other hand, socialnetworks are more developed and effective which imply that local regulationscan be captured more easily than national regulations.
A case in point is the development of many small-sized power stations. As a result of relaxed regulation on entry, in many regions small coal-fired plantsand hydro plants have been built. These plants with below-efficient sizes arenot only inefficient but also produce heavy pollutions. Indeed, the sizes of theseplants are in general below 5-MW and they produce on average three timesmore than those produced by the more efficient plants with a minimal capacityof 30-MW. To solve this problem and to create a more efficient industrial struc-ture, the government has issued strict regulations to close down these plants.
Unfortunately, these regulations are not strictly implemented. To the contrary,the number and installed capacity of small generation plants continues to in-crease and crowds out more efficient generation capacity. The problem is thatthe local governments exert their influence on the local regulatory agencies fornot implementing the restructuring policies initiated by the central government.
In some cases, the local governments simply collude with these plants againstthe central government through hiding information and false reporting. In othercases, when the central government checks on site the situation, the local gov-ernment sends a warning in advance to the plants and then the informed plantsclose the plants temporarily to avoid being caught. When the checks finish,business is as usual.
The local government’s incentives to help local generation plants come from the fact that local production help increase employment and local tax revenueswhich contribute to local officials’ promotion. So by keeping silence and col-laborate with local plants on this matter, the local government has an easylife.
However, there is another factor that may counter the argument that regional regulation is more prone to capture. This is related to the current division oflabor between central and local regulatory agencies. Remember that in generalthe central regulatory agencies are in charge of control of big projects in termsof investment size while the local regulatory agencies take care of small ones,which implies that there are higher stakes to bribe the central regulation. In 8See also Laffont and Meleu (2000) for an analysis of how the separation of regulatory this sense, one may argue that the probability of corruption may be smaller butthe impacts are bigger with central regulation.
Let us consider now the important issue of commitment, more specif- ically, the fact that governments in developing countries have even lesscredibility to commit to long-run regulatory rules than those in developingcountries.
A lack of commitment puts the ratchet effect into motion. Faced with incentives in the first periods, firms fear that taking advantage today ofthese incentives (efficient firms make more money by having low costs) willlead to more demanding incentive schemes in the future. The way to com-mit credibly to not expropriate rents in the future is to learn nothing todayabout the firms’ efficiency. Instead of offering, as in the static case, a menuof contracts with variable sharing of overruns, which induces self-selection,the extreme attitude is to offer a single contract which induces under-effortof the good type and higher-than-first-best effort of the bad type. The in-efficiency created by the lack of commitment is an inappropriate provisionof effort levels over the various periods, which has no simple interpretationin terms of the power of incentive schemes. In the case of linear schemesit can be shown (Freixas et al. 1985) that the ratchet effect pushes towardhigh-powered schemes which create higher rents in the first period to in-duce the revelation of types. More generally, the less commitment abilitythere is, the less the regulator should try to separate types and the moreso if the cost of public funds is high.
Box 6: Enforcement Failures in China.
Lack of commitment is indeed a serious problem that plagues regulations in China. The most serious case comes from the enforcement of price regulations.
In telecommunications, the regulatory officials openly admits that price regu-lation is not as effective as it is used to be. Even though administered priceswithout any flexibility are officially imposed, price wars are common. Indeed,when competition is introduced, it is questionable to what extent price regula-tion can be enforced in general in a rapidly developing sector like telecoms.
In China’s mobile phone sectors, the receiver-pays-principle is currently adopted.
But many cases have been reported where the caller-pays-principle is illegallyadopted. While the government has punished and corrected some cases, it hasnot been eliminated completely. It is also the case of IP phone services wherecompetitive pressures have led to dramatic price cuts in comparison to the offi-cial prices. It seems that the Ministry of Information Industry can do nothingbut to let it happen. There are also indirect price cuts in the form of free callingtimes and subsidized handsets etc. which are officially not allowed. But theyhappen daily.
The second case is related to the enforcement of concession contracts. Con- cessions have been introduced in power, toll road, and water etc. In many casesthese innovative forms of regulation have contributed to the development ofthese sectors. But there are also some cases of enforcement failures due to thechange of market conditions and the unsustainable terms put into the contracts.
In the power sector, the government has allowed independent power produc- ers (IPPs) to compete with the incumbent, the State Power Company (SPC).
These IPPs enter into the market by signing power purchase agreements (PPA)with the SPC which consist essentially of a load factor and a unit average priceto recover both generation costs and capacity costs. When a shortage of energycondition prevails, the PPAs are enforced without much problem. But whenthe market conditions change with an excess supply of capacity, conflicts ofinterests arise and the PPAs cannot be enforced. In particular, utilization ofinstalled capacity is much lower than the specified load factor and the bulkpower prices are also lower than the contracted prices.
The impacts on generators are different depending on the vintage of the plants. In particular, the new plants suffer seriously because they still have alarge part of cost to recover. To make things worse, the contract structure witha unit price and a load factor gives generators strong incentives to produce asmuch power as possible regardless of their economic costs, because the more theygenerate the more profits they can earn. This only complicates the favoritismproblem and makes economic dispatch more difficult to realize. It seems thatthe government can do nothing about this. With the impending reform tocreate competition in generation, it remains to be seen how the government canoverhaul these PPAs when part of their assets will become stranded.9 Enforcement failures of contracts have also taken place in water where conces- sion contracts have been used to attract foreign investments. A typical exampleis the Sino-French Water Company which is a joint venture for water productionwith a term of 30 years between the Shenyang Water Company (state owned)and the Sino-French Hong Kong Water and Investment Company. The own-ership structure is that each owns 50% of the joint venture. According to theagreement, the Shenyang Water Company should buy all the water producedby the joint venture. The purchase price should be negotiated each year be-tween the Chinese parent company and the joint venture but the prices shouldguarantee a minimum rate of return of 18% for the joint venture. Since it wasin operation in 1996, the purchase price rose rapidly while the retail price didn’tcatch up. This caused huge losses to the parent company which made the con-tract unsustainable. The contract was stopped in 1999 when a listed company,the Shenyang Development Company in which the parent company has 80%of ownership, bought out the joint venture with money raised from the capitalmarket. The operation of the joint venture was taken over by a subsidiary 100%owned by the Shenyang Development Company. In the end, the initial BOTcontract was changed into a management contract.
Another example which is related to the regulation of entry can be found in telecoms. A case in point is the so called “Sino, Sino, Foreign(Zhong, Zhong,Wai)”controversy. When the China Unicom was created in 1997, it neededhuge amounts of capital to deploy its own network both in fixed line and mo-bile services. At that time, raising a large amount of money through IPOseither in China or in foreign capital markets or from other channels seemednot immediately possible. On the other hand, foreign companies were eagerto invest in China’s huge telecom markets. But unfortunately, foreign invest-ments were not allowed in basic telecoms services. To solve this problem, ChinaUnicom overcame the legal barrier indirectly by establishing subsidiaries with 9There are factors both lessening and worsening the stranded cost problem. Since China has allowed an accelerated recovery of costs with short-term debt, most of thecosts may have been recovered. Indeed, there may be a windfall gain or negative strandedcost problem after competition is introduced. On the other hand, because of the cost-plus nature, capital cost and O&M cost may be higher than usual.
100% ownership. Then, these subsidiaries set up joint ventures with foreigncompanies. So comes the name of the arrangement which is essentially a wayof raising capital. By heavy closed door lobbying and, in the meantime, withthe recognition that the government has to give China Unicom some favor-able policy for its competing with China Telecom, the Ministry of Post andTelecommunications, the ancestor of MII, tacitly accepted this practice. Butlater on after huge investments were sunk, the government announced that thispractice was illegal and foreign capital had to exit. This has caused an out-cry. Even though the government has made some arrangements to compensatethose foreign companies that have sunk their investments, some problems haveremained and China paid its price in the negotiations toward entering into theWTO. While one can argue that the original practice was not legal so that itshould not be enforced in the first place, such practices are not uncommon in acountry like China which still has a weak rule of law. Indeed, it is easy to findother practices with similar quasi-legal features. For instance, the current Chi-nese regulations require that the ownership shares of ICPs by foreign companiescannot surpass 50%. But it is only a fact that most ICPs are actually ownedby foreign companies. It is easy to find such evidence but the government haschosen to keep silent on this.
The lack of ability of regulators to commit can be mitigated by the repetition of their relationship with the firms and the building of the regulators’ reputationof not expropriating the rents derived from future efficiency improvements.10It can be expected that this substitute to commitment of institutions will beless easy to achieve in developing countries.
No general analysis exists of how easy commitment is, depending on the type of regulatory regime. Regulatory institutions must be particularly scrutinizedin developing countries for their ability to provide long-run incentives throughtheir power of commitment, since a major goal is to attract foreign investment.
For example, price capping has been pushed in the Western world as a way toprovide high-powered incentives. However, price caps are regularly renegoti-ated while a commitment to a fair rate of return might be less prone to costlyrenegotiations (Greenwald 1984).11 Enforcement of regulatory rules is poor in developing countries for two reasons. First, enforcement is costly, and optimal enforcement decreaseswith the cost of public funds. Second, the principal agent paradigm withfull bargaining power attributed to the regulator does not fit the reality ofdeveloping nations. Note however that weakness in the bargaining positionat the renegotiation stage calls for increased investment in enforcement.
Finally, corruption of the enforcement mechanism itself or of the regulatorymechanism calls for less enforcement. Thus, the weakness of the rule of lawin developing countries is not only due to poor human resources, it is alsopart of an optimal regulatory response (see Laffont, 2001).
10See Gilbert and Newbery (1988) for a model of infinitely repeated contracting in which some collusive equilibria do not exhibit the trading inefficiencies associated withshorter horizons.
11However, one can also commit to a fair renegotiation of price caps.
Financial constraints compound the difficulties of asymmetric informa- tion for regulation in many circumstances. The basic intuition can bestated in simple moral hazard control problems with risk neutrality. Moralhazard in a delegated activity can be controlled without giving up a rentto the agent if penalties are possible even when the observation of the per-formance is noisy. However, if such penalties are not possible because oflimited liability constraints, only rewards for good performance can induceappropriate effort levels, i.e., information rents must be given up.
The greater the financial constraints the greater those rents. Both the strength of financial constraints and the high cost of public funds favor ashift toward less powerful incentive schemes in developing countries. Theirony of the situation is that, even though these countries should makemore effort to emerge from underdevelopment, inducing effort is much moredifficult in developing countries.
This section has detailed the many arguments that favor a move to- ward less powerful incentive schemes (and, therefore, a move toward lessefficiency) in developing countries.
However, the use of performance evaluation to improve the fundamental trade-offs between efficiency and rent extraction presumes a perfect or atleast unbiased auditing of that performance. The main argument againstsuch advice is the cost padding effect and the corruption of the cost au-dits which, on the contrary, favor fixed-price mechanisms that save all theauditing costs.
Thus, we may distinguish three stages of development concerning regula- tion. In the first stage, the auditing mechanisms are so poor that powerfulincentive schemes should be advocated. They promote short-run efficiencyin activities that are immune to ratchet effects, but they strongly favor expost inequality (since the efficient types make more money than the inef-ficient ones), they encourage some types of corruption of regulatory andpolitical institutions, and they are costly for the rest of the economy be-cause they create a money drain toward the regulated monopolies. Thisfirst stage should be used to develop a good auditing system. Once it is inplace, one can move rather discontinuously to stage two of development bypromoting less powerful incentive schemes for the reasons explained above.
Then, as development continues, the optimal solution is to slowly movetoward more powerful incentive schemes in stage three. The quality ofregulation in each of these stages depends critically on the ability of thegovernment to commit credibly to the implementation of the schemes.
4. PROMOTING COMPETITION BY PRICING ACCESS Let us again distinguish between the three market structures considered in Section 2 to discuss appropriate access pricing rules in developing coun-tries.
Consider the simplest case where the final services are produced by com- petitive industries at constant marginal costs. Ramsey pricing tells us thatthe access price markup over the marginal cost of access for a given goodrelative to the access price for this good should be inversely proportionalto its demand price elasticity. Such a pricing scheme can be decentralized;price caps can be applied to the regulated firm in charge of the infrastruc-ture, relying in this way on the firm’s demand information. Of course, thatinformation is the province of the users of the infrastructure. The utilitycan infer this demand information from the demand for access as long asthe users report truthfully the type of final good for which they use theinfrastructure.
It may be difficult to promote such truthful reporting in developing countries when inspection systems are easily corrupted. Moreover, pricediscrimination resulting from sophisticated Ramsey pricing may be manip-ulated by interest groups (see Laffont-Tirole, 1993, Chapter 11). Conse-quently, in the case of developing countries Ramsey pricing should be basedon broad categories of usage which do not raise complex inspection issuesand should be decentralized by price caps.
Another concern in developing countries is the market power of users of the infrastructure. However, the regulation should not attempt to undo, viaaccess pricing policy, the monopoly power of the users of the infrastructure.
Indeed, such a policy requires a lot of knowledge from the regulator andraises issues of favoritism. In the absence of long-term contracts, there is apotential for expropriation of some large users’ investments, which is quitenegative for attracting foreign capital. In this case, other policies shouldbe used to foster the competitive use of the infrastructure (see Section 5).
The discretion surrounding the determination of price elasticities and raising the problem of capture is transferred to the choice of weights whenusing price caps. A nondiscretionary method for choosing weights in theprice cap, such as last year quantities (plus an exogenous change in thelevel) should be selected in developing countries.
We consider now the case of a vertically integrated utility which provides access to the infrastructure and also sells a service using the infrastructure(the incumbent), and wediscuss two subcases.
Suppose first that the competitive users of the infrastructure provide an imperfect substitute to the service provided by the incumbent (mobilephones versus fixed link telephony with a lot of unsatisfied demand). Inthis case, regulation of access should be treated just like regulation of anend-user service, because the incumbent will be willing to provide accessthat increases its business with little effect on its own service market. Forexample, global price caps including final goods as well as access goods canbe used. (See Laffont-Tirole (2000), Chapter 6.) The situation is more difficult when competitive users offer services that are very close substitutes of the services provided by the incumbent. Then,the Ramsey rule tells us that the access price should be high enough toavoid inefficient business stealing and to balance the budget of the incum-bent. One is tempted to favor a generous (for the incumbent) access pricingrule, such as efficient component pricing, to avoid foreclosure and to focusregulatory resources on implementing quick and high quality interconnec-tion. Alternatively, one can use a global price cap supplemented by maxi-mum prices determined with the efficient component pricing rule. It shouldbe recognized that it is a very difficult case requiring a lot of regulatoryexpertise, making it difficult to implement good solutions in developingcountries. Indeed, examples from Cˆote d’Ivoire, Ghana, Tanzania and else-where show that incumbents in the telecommunications industry are usingvarious strategies to avoid competition (foreclusion, delays, raising rival’scost. . . ).
Two Way Access for Competition in Infrastructures When there is competition in infrastructures, as is the case of telecom- munications, in particular, final prices are usually deregulated but the reg-ulation of access prices remains an issue. For example, in the internet, thebill-and-keep doctrine amounts to a zero access charge, something that iscurrently being debated (see Laffont et al., 2001).
According to the literature, access prices in telecommunications should be regulated because firms (at least for symmetric networks) can use accesscharges to collude against consumers (high access charges induce high finalprices) and to block entry (see Armstrong, 1998 and Laffont et al, 1998aand 1998b). One possible solution is to impose the bill-and-keep doctrinebecause of its simplicity and because it encourages competition in finalprices.
A more difficult situation occurs when networks are asymmetric in size or traffic. In particular, it is important to ensure that network competitiondoes not interfere with network development.
The regulator may mandate negotiations for interconnection under the threat of arbitration by an international body. It is unlikely that he willoften have the information to choose access prices itself. This is an area where it is particularly clear that it is not enough to declare that competi-tion is possible or even to sell licenses for competition to really take place.
The inability to ensure fair competition may even delay competition andlead to implementation of the alternative option, that is, of regulating themonopolist with a strict program for developing the network.
Box 7: Access Policy in China.
Under the current development of competition, access pricing policies are implemented differently in railways, electricity, and telecommunications. Inrailways, since competition in transport services has not been introduced, thereis no separate access policy. Instead, tariffs are designed that integrate bothtransport and infrastructure services. However, there is a very complicatedsettlement system among different administrations12 which has been used tosettle revenues including access revenues among administrations.
The settlement system has been changed several times but the main features remain more or less the same.13 In a nutshell, in the settlement process therevenues received by each administration are divided into two parts: i.e., ac-cess and non-access revenues. The access revenues will be allocated or settledthrough settlement prices for each administration which are determined basedon various types of traffic and also on concerns about redistribution. Withoutgoing into the details of the determination process, we can conclude that theaccess charges are essentially based on a revenue-sharing scheme which dependsneither on cost nor on demand.
There is no explicit transmission prices in China’s power sector. All the transmission costs are incorporated into the final prices on a cost-plus basis.
The pricing mechanisms in China’s power sector are formed as follows. Firstcome the bulk prices which are, together with other elements of power purchaseagreements, regulated by local governments and subject to the approval of theSDPC. Then, transmission costs including fixed costs of transmission network,O&M, line losses, and retailing costs and cost of capital are added to obtainthe total costs of power supply to form the final prices.
In telecommunications, access and interconnection prices are also to a large extent determined on a revenue sharing basis. For instance, termination frommobile to mobile networks imposes no charge. But since China adopts RPPin mobile networks, such regime is equivalent to an equal sharing of revenuesunder CPP. Indeed, such revenue sharing scheme is also explicitly implementedfor the interconnection from fixed line to fixed line networks. More precisely, theinterconnection charge is regulated to be equal to half of the rival’s retail prices.
The termination charges for a call between the mobile and fixed line networksare a little bit more complicated. For a call from the fixed line network to themobile network, the former does not need to pay access charges. But rememberRPP is adopted in China’s mobile services. So it is equivalent to such a regime inwhich the calling party receives part of revenues just covering termination cost.
12The state railways enterprise consists of 14 administrations.
13More precisely, the settlement system in China’s railways has gone through three periods: (1) the period of settlement prices (1978-1986), in which all revenues had to beturn over for settlement and the settlement prices was determined arbitrarily, (2) theperiod of settlement prices and double connections (1987-1993), in which the administra-tion turned over all revenues for settlement and the settlement prices were determinedon performance basis, and (3) the period of in-administration revenues retained andthrough-administration revenues settled (1994-), in which only access revenues are set-tled.
For a call from mobile to fixed line network, the former will pay the later aninterconnection charge of 0.06 yuan/minute (the average marginal retail priceis 0.1 yuan/minute).
To sum up, the current access and interconnection pricing is in general not cost based. So one may ask what are the main motivations for adopting suchpricing principles. First of all, access and interconnection pricing determinedon a revenue sharing basis alleviates the regulator’s asymmetric informationproblem. Indeed, lack of information on cost and weak auditing systems arethe main features of the Chinese economy. Second, these policies have a flavor ofasymmetric regulation, at least in the way that they are practiced. Indeed, onecan argue that to price access and interconnection between asymmetric networkssuch as China Mobile, the dominant mobile player, and China Unicom, whichhave quite different calling patterns on equal sharing of revenues basis has theobvious objective to facilitate entry of the latter, because their access revenuesare got to be unequal. Indeed, some disputes have arisen between these twooperators in the past when new services were introduced. For instance, whenChina Unicom negotiated termination charges of its new CDMA network withChina Mobile and wanted to keep the current bill-and-keep policy, China Mobilewas strongly against it arguing that China Unicom has now obtained enoughmarket shares which make asymmetric regulation unnecessary. The dispute wasturned over to the MII for arbitrage and a closed door solution was arranged.
Of course, one may argue that revenue sharing schemes may be more sus- ceptible to collusive agreements which will be translated into high final prices.
But since China is still far away from well developed network competition, it isreasonable to conclude that collusion will be less a concern than the promotionof competition through access and interconnection pricing policy.
We have argued that competition policy is not appropriate to deal with the complex and rapidly evolving technical issues concerning the interfacebetween the competitive and noncompetitive segments of infrastructureindustries. It remains to be seen what kind of competition policy is appro-priate for the potentially competitive segments.
Three ingredients are needed for competition. First, there must be enough firms or potential entrants into an industry. Second, those firmsmust not enter into collusive side-contracts. Furthermore, if a firm hasdeveloped a dominant position through innovation it should not abuse thisposition.
It should first be stressed that, in most developing countries, the major problem is the dearth of participants, particularly in infrastructures whereinvestments are usually sunk for long periods. As a result, the major prob-lem is how to attract local or foreign capital to those industries, that is,how to create the conditions that make investment attractive. The workrequired to favor entry is not the usual task of a competition agency. Un-fortunately, it concerns most of the characteristics of developing countriesthat were discussed earlier and which cannot be easily resolved: inefficient financial sectors, lack of credibility of institutions, lack of enforcement oflaws, inefficient transportation and communications, lack of informationavailable to consumers, etc., what Carlin and Seabright (2000) refer to as“competitive infrastructure”.
This is particularly the case in infrastructures where technologies favor high concentration and international trade cannot be relied upon to createcompetitive pressures. The difficult question is: which rate of return willattract the optimal level of investment? If this optimal rate were known,competition policy should ensure this rate and no more. Probably, this canbe achieved more easily through concession contracts with regulated pricesthan with competition in infrastructures.
More traditional competition policy can be relied upon in the case of the competitive use of infrastructure. As observed by Rey (1997), col-lusion is facilitated by entry barriers, market concentration and capacityconstraints, and these factors are more likely to be present in developingcountries. As already observed, the transaction costs of collusion are alsolikely to be lower in LDCs. Similarly, predatory strategies may be partic-ularly dangerous in countries where credit markets are weak. Rey (1997)argues also that the high entry barriers often found in developing countriesgive more force to the market foreclosure argument when discussing theessential facility doctrine. He also recommends a more cautious attitudetoward vertical restraints.
Competition policy during the liberalization process should apply to the competitive segments of the deregulated industry; namely, generation inelectricity, long distance service in telecommunication, and operating ser-vices in transportation. This is particularly important in developing coun-tries where attracting capital for infrastructure investment generally re-quires giving sizeable market shares to investing firms.
In particular, merger and acquisition rules in developing countries must be designed with an emphasis on simplicity, nondiscretion, and adaptabilityto the rapidly changing market structures. One possibility is to establishexplicit market share constraints (foregoing efficiency arguments), whichare revised periodically.
Some industries may need more innovative combinations of regulation and competition. For example, under normal conditions, the electricityindustry may be appropriately competitive and need only the oversight ofcompetition authorities. However, when capacity constraints are binding,either under conditions of peak demand or because of supply shocks, gen-eration firms may enjoy such power in local markets that price regulationbecomes necessary.
More generally, the difficulty to attract capital generates market struc- tures that are imperfectly competitive and calls for a more intrusive regu-lation of conduct than classical competition policy. It also creates conflicts between privatization committees or regulatory institutions, which are wellaware of the constraints on competition imposed by the need to attractcapital, and the competition authorities, which ex post tend to breach theexplicit or implicit agreements that restrict competition.
In any case, it should be clear that US-style competition policy (with its armada of lawyers and economists) is neither affordable nor achievablein developing countries. Designing simple and transparent rules for thesecountries, particularly to prevent horizontal collusion and abuse of domi-nant position, remains a worthy task. Nevertheless, the benefits that can beexpected from competition policy are quite small in the foreseeable futurefor several reasons.
The lack of adequately trained staff is particularly acute, in view of the complexities and ambiguities of the economic analysis of such questionsas predatory behavior and vertical restraints. Emerging industries will benecessarily highly monopolistic and interest groups will have considerablepotential for interference.
Yet, competition agencies should be developed. Their first major goal is to play an educational role by advocating the social benefits of fair com-petition and concentrating on specific goals. For example, competition isweak in developing countries because transactions are localized as a re-sult of poor communications systems and inefficient trading organizations.
Focusing attention on these areas should be particularly fruitful.
Finally, in pushing for competition in infrastructures it must be remem- bered that a major goal is to achieve greater population coverage in accessto basic public services. Monopoly provision which allowed cross-subsidies,when properly14 used, was a powerful redistributive instrument. Com-petition makes redistribution via prices more difficult, and there are notalways easy substitutes, in countries with very inefficient and often corrupttax systems (Laffont and N’Gbo, 2000, and Gasmi et alii 2002). Then, itmay be easier to achieve universal service obligations within a concessioncontract than through oligopolistic competition Box 8: Competition Policy in China.
It is argued in China that competition policy is less relevant in developing economies because on the one hand, natural monopolies are taken care of byregulation, and on the other hand, there is no meaningful market power cre-ated by any enterprise’s dominant position which is the purview of competitionauthority. Indeed, most Chinese firms are still small in comparison with bignames of multinationals. While the view may underestimate the role of com-petition policy, it does point out the important fact that competition policymay have different dimensions in developing countries and one has to take intoaccount the institutional features in China. But since competition policy in- 14In addition to favoritism and rent-seeking, cross-subsidies may induce inefficient bypass and create poor incentives for service quality provision and proper coverage ofunder priced consumers.
cludes the promotion of fair competition, let us focus on the anti-trust aspectof competition policy.
The most important problem of competition policy in China’s context is the so called administrative monopoly which means that market power is usuallycreated by the abuse of administrative power. The unduly exertion of admin-istrative power, whether by ministries or local governments, is meant to createentry barriers which will segment the market, in particular the segmentation oflocal markets. Indeed, many cases have been reported on this. For instance, inthe power sector, power exchanges are not actively transacted because of localgovernments’ influence. Actually, the issue here is not a matter of competitionpolicy but how to solve the conflict of interests and counter the abuse of powerby the local governments.
Another feature of competition policy is it has to deal with price wars among SOEs. In other words, predation strategy is more relevant in China’s case. Forinstance, price wars are so fierce in the airline industry that price regulationcannot be seriously implemented even though the government tried various waysto curb them. In telecoms, price cuts, directly or indirectly, are often observed.
While it may be difficult to judge whether it is a real competition policy problemor a soft budget problem which is typical of SOEs, these problems do raise animportant question: to what extent competition can be introduced withoutownership reform? This paper has highlighted the departures from developed countries prac- tices that are required in developing countries on the basis of normativeeconomic theory. However, a number of caveats must be borne in mind.
First, more empirical work is needed to more precisely characterize the specific features of developing countries that are relevant for regulatory eco-nomics. Such work should naturally lead to distinguishing various stagesof development and to obtaining a classification of countries requiring dif-ferentiated policies.
Second, even though we have mentioned some characteristics of govern- ments, a broader political economy of reform, taking into account specifichistorical and political situations is necessary.
Third, liberalization, competition and regulatory policies are very recent developments, especially in the very poor countries. The empirical evidenceis limited and not of easy access. Moreover, it is never in a form thatwould allow rigorous econometric tests. Case studies and theory are theonly available tools that can be used under these circumstances, but thisshould be done with a lot of caution, in particular because the economictheory relevant for developing countries is so far only sketchy.
Nevertheless, we hope that this paper provides a useful framework for those who have the difficult task of advising developing country authoritieson more efficient ways of providing public services.
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The crucible

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